Marco Colantonio from Resolution Capital, the portfolio managers for the Nedgroup Investments Global Property Fund, provides his views on the global REIT market and what’s been driving the performance of the Fund over the last quarter.
Q2 Market snapshot
We had a relief rally in Q2 with the market up about 10%. Many of the hardest hit sub-sectors from Q1 regained some of their losses, e.g. retail, healthcare and hotel sectors. This was largely due to the substantial fiscal and monetary policy response that backstopped some of the markets, a gradual easing of some lockdowns and hopes for a vaccine. Over the last six months the sector was down about 20%. Retail and hotels have been the ‘losers’ or worst affected sectors, while data centres and towers, industrial, residential and self-storage were the ‘winners’ or least affected. In the early days of the pandemic, all sectors felt some downward pressure, but the retail and hotel segment was down close to 40%-50% at its extremes and is now down about 30% from their pre-COVID levels. The ‘winning’ sectors have regained almost all of their losses and are back at pre-COVID levels.
Going into COVID, we had about 50% of the portfolio in the ‘winners’ segment of the market, which has been more resilient and only about 11% in the ‘losers’ segment.
COVID crisis vs Global Financial Crisis
The most obvious difference is that this is not a credit crisis. The REITs went into this crisis with much better balance sheets than they did in 2008. Leverage was lower and better structured in the form of longer duration debt, more diversified sources of debt and well hedged. There has been a massive policy response, including from the US Fed and others to keep the debt markets functioning. So while we did see spreads blow out quite dramatically, even in the darkest days of late March, some of the better quality credit REITs were able to access the debt capital markets and were issuing 10-year paper at sub 5% all in costs. That 300bps spreads over pretty low base rates. The fact that the debt capital market was functioning was important for equity markets. So we have not seen, to any large extent, emergency capital raisings, forced asset sales or forced equity raisings from lenders. We have seen some equity raisings, but mostly from the stronger performing stocks in order to build their war chests to be opportunistic in this environment and perhaps take advantage of the distress of others. We haven’t seen a lot of property transactions yet. The REIT market remains very liquid and the public credit markets have been open for the better quality REITs.
Will the rent be paid?
A lot of pressure has been at the bottom end of the spectrum, within hotels and retailers with tenants who were not in a position to pay their rent due to no revenue. In many cases, governments have mandated rent abatement schemes that have required landlords to reduce rents while tenants are suffering significant cash flow duress. Hotels had virtually no rent collected in May. The discretionary end of retail in malls had about 18% collection for those that disclosed it while non-discretionary retail operators in US strip centres collected around 60%. The remaining REIT sub-sectors exhibited up towards 90%-100% of collections
In any recession, we normally see a reduction in construction levels, which is to some extent a double edged sword as construction is usually a large employer. We went into this cycle with relatively moderate levels of construction, mostly in the retail segment. This should bode well for the medium-term positioning for landlords, as speculative construction will decline resulting in less competition going forward.
Hotels: Revenues have been severely impacted with 70%-80% declines in occupancy levels in April and May. We are keeping an eye on opportunities within this sector where they are trading at discounts to replacement costs.
Retail: The retail we own is more focused on non-discretionary, supermarket oriented retail as well as service oriented retail that you can’t get online. Structural challenges have accelerated as shutdowns have occurred, triggering a pick-up in online shopping, which resulted in curtailed cash flows for many retailers. We expect a spike in bankruptcies in 2021. We believe that retail will exist, but that omni-channel will remain key.
Healthcare: Our main exposure is in Life Science office buildings and medical office space. Seniors housing has been hard hit given their age cohort and quarantine requirements with occupancy levels dipping 400-500 bps over a short space of time.
Logistics: This sector was a ‘winner’ enjoying the tailwinds of the growth in e-commerce. Retailers and manufacturers are building up inventory levels to offset the risk of future supply chain disruptions, which will drive further increased demand. The logistics REITs have therefore performed quite strongly with high rent collection.
Data centres and towers: There has been a significant increase in demand to support work-from-home capabilities as well as data for consumer apps. We expect spending on cloud infrastructure to grow more than 20% over the next five years, underpinning the demand for data centres and cell towers. So we think this segment will continue to perform quite strongly.
Office: We significantly reduced our exposure to this sector of the market early on in the pandemic as a result of the economic contraction. Office never does well in a recession.
Residential: This has been one of the more stable segments, reinforced by work from home during the lockdowns. Invitation Homes own a large number of US single-family residential rental homes, which have done extremely well during the crisis, with increased occupancy rates and very high rent collections of about 97%. Invitation Homes is a 5% position in our portfolio.
While it’s too early to assess the COVID impacts, REITS went into the crisis with really good balance sheets. Listed REITS seem to be trading at a discount to unlisted property. They are a very liquid form of global real estate exposure, which is an important point of difference compared to many of the unlisted property funds that have frozen redemptions.
We typically outperform in falling markets and that’s certainly been the case over the last 12 months where the market was down by about 21%. Our relative performance has been around positive 900bps and over the longer term about 370 bps of relative outperformance.
26% of the portfolio is in residential, 17% in industrials, 13% in office, 10% in retail, 10% in data centres and towers, 8% in healthcare, 5% in self-storage, 1% in hotels, 5% in diversified REITs and 5% in cash. We think the global REIT market remains an effective diversification tool for investors, particularly with an active manager that has the ability to tilt the portfolio to the most resilient part of the real estate market.