Julian Campbell-Wood is a Portfolio Manager at Resolution Capital, the managers of the Nedgroup Investments Global Property Fund. Julian provides an update of the portfolio’s performance and positioning in Q1, how REITs are well positioned in the context of potentially increasing interest rates and the market outlook for 2021.
The quarter was characterised by the rollout of vaccines and a path to normalisation. Significant stimulus in certain markets gave renewed confidence around the pace and magnitude of the recovery. This was one of the contributing factors to bond yields close to doubling in the US and Australia, but also some inflationary pressures, such as rising commodity prices due to supply bottle necks and pent-up consumer spending. REITs delivered total returns of just more than 7% just beating global equities. Over the last 12 months, global REITs have, on aggregate, underperformed the global equity market, reflecting some of the restrictions still in place in many developed markets.
In Q4, post the vaccine announcement, some of the more impacted areas of the REIT market started to make up some lost ground, including hotels, select retail formats and office property with some of the more resilient areas lagging during that rotation. The secular winners with strong, visible demand and cash flows, including data centres, cell towers, life science, residential and self-storage, have performed very well since the onset of the pandemic. The more challenged areas have still underperformed, but saw a sharp rally when the vaccine was announced and this continued early in the most recent quarter. The Fund performed very well entering the pandemic with about 700bps of alpha in March 2020. The vaccine rotation impacted relative Fund performance, which was disappointing over the last 3-12 months with a return of 23.3% for the year and 3.6% in Q1. We see this rotation as a more cyclical phenomenon and need to continue to focus on strong secular drivers.
The major change has been retail with a 10% repositioning into this sector. We took the opportunity during Covid to add exposures that were facing some of the cyclical disruption rather than the structural challenge that e-commerce is putting on certain retail formats. To fund those investments, we reduced office exposure and took some profits in the logistics and industrial exposures. These are still 13% of the portfolio, as there are very powerful demand drivers in that segment. The diversity of the opportunity set and the exposures in the Fund are leveraging the major secular or demographic drivers. These will continue to underpin demand and total returns for these property types well beyond the cyclical disruption and well beyond the pandemic. These secular drivers are e-commerce, digitisation, ageing demographics, urban/suburbanisation and research and development. Approximately 22% of the portfolio is in various forms of residential property, benefitting from urbanisation. Logistics and industrial make up 13%, healthcare is 9%, data centres and towers are 6% and benefitting from digitisation. The portfolio has a hugely diverse range of high quality real estate, which is impossible to replicate in private markets.
REIT earnings resilience
REITS had reasonably resilient earnings and were less volatile during the pandemic compared to broader equities. Despite that earnings resilience, the REITS have underperformed and are at a relative multiple discount. 2020 was one of the worst relative performances for global REITs, which reflects the significant demand shock that real estate faced, but this is not systemic to real estate. As we move into the recovery phase with significant economic growth expected, we believe this sets up the sector to perform.
REIT returns are not all about interest rates
Over a long period of time, there is no consistent relationship between global REITS and bonds. The argument that REITS are bond proxies does not hold. Even during periods of interest rate hikes, REITs have generated positive total returns. It’s important to know why interest rates are increasing. If it’s an expanding economy and the fundamentals of real estate are in good shape, REITs and real estate can continue to generate competitive total returns.
Focus on things that matter
You rather need to focus on what matters when it comes to REITs. The first is demand. There are secular demand trends, such as digitisation, e-commerce and demographics and these will persist well beyond Covid. Then there is cyclical demand, which will recover from what has been a very sharp contraction in demand due to lockdown restrictions. REITs started from a relatively solid point of occupancy. The strength of economic growth will support tenant demand to rebuild occupancy in areas of the market that saw cyclical disruption. Many areas haven’t seen any impact. The next critical factor is building supply, new construction or new buildings, and this dictates landlords’ pricing power. This is critical at all points, but even more if you have a view that inflation is likely to continue. Pricing power is what will enable REITs to generate total returns in an environment of increasing interest rates and inflation. Covid wasn’t categorised by widespread overbuilding or too much supply when we entered the crisis. New commercial construction as a percentage of total stock was below the long-term average entering the crisis. Landlords still had pricing power and ability to increase rents and drive cash flow, which sets up the sector well as we move into the early phase of the recovery.
Lastly, we didn’t see material levels of financial distress within REITs as balance sheets were in reasonable shape at the outset of the crisis. There was low 30% debt to gross asset values, diverse sources of debt and they maintained access to debt and equity during the crisis. There were minimal examples of permanent capital impairment outside of select retail REITs.