- The valuation multiples for REITs look a little bit elevated
- Valuations for equities and bonds are also elevated on a multiple basis, which reflects the growth potential from an improving economy
- The global economy is improving, which should lead to further rising occupancy for many segments of the real estate market, with reasonable prospects for rental growth
Marco Colantonio is a Portfolio Manager at Resolution Capital, the managers of the Nedgroup Investments Global Property Fund. Marco discusses the performance of REITs, provides an overview of the Fund’s performance and positioning, and takes a look at the prospects for REITs in the prevailing environment.
Q2 market snapshot
REIT returns were quite strong at 9% over the quarter, largely reflecting improved operating conditions for REITs in a strengthening global economy. At the same time, bond yields came down slightly. We had some M&A transactions underpinning the REIT market and saw some rotation out of value into growth. Self-storage, residential and industrial all demonstrated very solid pricing power, which is critical in an inflationary setting. Over the longer 12-month timeframe, the more harder hit sectors like hotels, retail and aged care senior housing all experienced some of the re-opening trade, which was not the theme during the most recent quarter.
We marginally underperformed after fees returning 8.8% versus the benchmark of 9.2%. Our exposure to data centers and healthcare outperformed but was offset by some negatives in office. Our performance is consistent with our longer-term investment philosophy of providing downside protection. Given our preference for higher quality, strong balance sheets, that does tend to trail in a market led by weaker businesses. Over the long term, our excess returns remain intact and looking at rolling three-year periods, we continue to outperform, but with downside protection. We have outperformed in 74% of down markets and 50% in up markets.
In terms of attribution over the last 12 months, retail has been a big detractor for us, as many distressed retail stocks, particularly malls that we don't own, rallied quite significantly. We still have concerns about those companies and remain underweight. The other sector that has detracted for us was data centers, which lagged the rebound in a relative sense. They hadn't fallen in value but had been strong performers during the worst of the pandemic and therefore didn't participate in the rebound as much as other stocks, particularly since the vaccine announcement.
Portfolio active weight changes
Over the last 12 months, we added a fair bit of retail to the portfolio, but more at the defensive end of the retail sector. Grocery anchored, open air strip-mall centres in the US and very selectively in European and Australian malls where the tenant mix is more diverse. We reduced our data center exposure and rotated out of some of the more defensive names, like residential, mainly on relative valuation grounds.
The portfolio reflects the diversity that's available in the global listed property sector, which gives us the opportunity to gain exposure to a broad range of different property sectors that are relevant to the economy and are supported by major secular or demographic growth drivers. Residential, which is 21% of the portfolio offers multiple different streams of property types that we can invest in. Our retail exposure of 17% is in what we think is the more defensive end of the retail segment. Industrial logistics is 14% of the portfolio with ecommerce and supply chain reconfiguration strong drivers. Healthcare is 8% of the portfolio and we have data centers and towers at 6% of the portfolio to cater to the digitalization theme. Within office at 11% there is an exposure to specialized lab space used for research and development and life science businesses.
Building cost pressures = inflation hedge
One thing that has been obvious lately is rising construction costs in part due to supply bottlenecks for materials and labour. As the economy improves, we’re beginning to see a spike in material costs and labour and it’s important to understand these dynamics in the context of real estate in a rising inflationary environment.
Over the last 20 years, lower inflation and falling interest rates have explained why real estate has performed well. The assumption is that rising interest rates and inflation will be negative for real estate. In our view, people are forgetting two important factors. If that were true, why have we seen retail real estate struggle over the last 10 years compared to industrial real estate? Supply and demand fundamentals matter much more than interest rates.
The second thing that people forget is that when inflation was rising and interest rates were higher and rising, real estate was sought after as an inflation hedge with the same supply and demand fundamentals. If inflation and interest rates are rising because of a strong economy and rising construction costs, then as long as your real estate caters to the sectors of the economy that are growing, then developers and landlords will be able to pass on those costs through higher rents. It's important for inflation to be driven by economic growth.
Focus on things that matter
Supply & demand
Right now, we’re seeing strong demand as the economy improves and we have reasonably steady occupancy rates. Covid has probably just slowed supply quite significantly.
The pleasing thing about the listed REITs sector is that leverage is pretty moderate. We're not seeing excessive leverage and the bad practices evident in the lead up to the Global Financial Crisis. There are some stocks that we're avoiding because they have too much leverage, but it’s not widespread.
Covid reinforced secular real estate trends
The major growth themes that we're seeing at the moment were mostly present before Covid and have been reinforced by the pandemic. Ecommerce is benefiting logistics; data centers and cell towers have benefitted from digitalization; science laboratories have performed very well and have been catering to a massive boost in R&D spending in the biotech industry. We're also seeing some M&A activity, which reflects supportive capital markets, but also that REITs are trading cheap to the underlying real estate and is an opportunity for investors to scale in this market. We think there are opportunities within retail, but you need to be very selective.
Outlook for REITs in a post-pandemic world
The valuation multiples do look a little bit elevated for REITs, but they are not alone in that space. Equities and bonds are also looking quite elevated on a multiple basis, which reflects the growth potential from an improving economy. Overall, we think that REITs remain in good shape as the fundamentals of supply and demand are relatively solid. There is not excessive amounts of construction, as costs are rising, which makes it harder for developers to make easy money. The global economy is improving, which should lead to a continued rise in occupancy for many segments of the real estate market, with reasonable prospects for rental growth. The balance sheets are sound, and M&A is beginning to occur because REITs are trading reasonably cheap to the underlying real estate. Global REITs provide us with a diverse opportunity set enabling us to position the portfolio to relevant segments of the economy that have structural growth drivers, as well as reasonable prospects for recovery in earnings from somewhat depressed levels. Real estate can perform in a rising inflation and interest rate environment, or even if they don't, they can still perform given the macro backdrop we have discussed.