The sec­tor has at­trac­tive val­u­a­tions, but is fac­ing mount­ing down­ward pres­sure due to mod­er­at­ing in­comes and tight­en­ing credit con­di­tions

Investment Executive - - FRONT PAGE - BY MICHAEL RY VAL

Real es­tate stocks are hold­ing their own, but face down­ward pres­sure.

al­though real es­tate eq­uity funds have been hold­ing their own, pres­sures are mount­ing in the form of slip­ping in­come growth and cen­tral banks that are in a tight­en­ing mood. In turn, fund port­fo­lio man­agers are tread­ing cau­tiously and be­ing se­lec­tive about their real es­tate sec­tor bets.

“Gen­er­ally speak­ing, the fun­da­men­tals for com­mer­cial real es­tate and listed prop­erty com­pa­nies con­tinue to be good, al­though not great. It was great fol­low­ing the global fi­nan­cial cri­sis. What we have more re­cently is good but de­cel­er­at­ing growth,” says Steve Buller, vice pres­i­dent at Bos­ton­based FMR LLC and port­fo­lio man­ager of Fi­delity Global Real Es­tate Fund. “Net op­er­at­ing in­come [NOI] growth is still pos­i­tive, but not as pos­i­tive as a cou­ple of years ago. Back then, it was about 5%-plus, on aver­age. Now, it’s de­cel­er­ated to the 3%-4% range.”

The trend is clearly down­ward, Buller notes: “But it was el­e­vated a cou­ple of years ago, pri­mar­ily be­cause there were still re­cov­er­ing oc­cu­pancy rates in many prop­erty types. Now, gen­er­ally speak­ing, we live in a world where there are no fur­ther oc­cu­pancy gains. You are left with ren­tal rate growth.”

NOI is an eas­ier met­ric to use, says Buller, as it cap­tures both oc­cu­pancy gains and ren­tal rate growth mi­nus ex­penses. In short, 3%-4% NOI is still re­spectable, as it’s higher than in­fla­tion. “It’s just not great growth,” he says.

Mean­while, val­u­a­tions on real es­tate are at­trac­tive: on aver­age, most global prop­er­ties trade at a 7%-9% dis­count to net as­set value (NAV). Fi­nally, Buller says, ac­cess to cap­i­tal for debt and eq­ui­ties is still very good, even with in­ter­est rates edg­ing up­ward.

“The cost of cap­i­tal has gone up a lit­tle, but not much. The cap­i­tal cost side of the busi­ness is still pretty good,” says Buller, adding that the sec­tor is in bet­ter shape than it was a decade ago be­cause the amount of lever­age is con­sid­er­ably lower. “If there were to be a shock to the sys­tem, com­pa­nies are much bet­ter pre­pared than they were in 2007.”

Ten-year U.S. govern­ment bond yields, the bench­mark for bor­row­ing, are back down to around 2.1% — which raises ques­tions about fu­ture yields. How­ever, Buller is re­luc­tant to make any calls on bond yields.

As for risks on the down­side, Buller points to 1998-99, when the fun­da­men­tals were good, yet listed stocks did poorly, mainly be­cause in­vestors fo­cused in­stead on the tech­nol­ogy and tele­com sec­tors.

“I ac­tu­ally worry that when the Nas­daq and so­cial me­dia stocks do very well, that’s usu­ally not a good en­vi­ron­ment for real es­tate in­vest­ment trusts [REITs], around the world,” Buller says. “Prop­erty stocks have done OK, but one rea­son they haven’t done bet­ter is be­cause of the cap­i­tal go­ing into the so-called FANG [Face­book Inc., Ama­ Inc., Net­flix Inc. and Google, via par­ent Al­pha­bet Inc.] stocks. I am not call­ing it ex­actly like 1999 be­cause those four com­pa­nies ac­tu­ally make money and their stocks have done very well in the last year.”

From a strate­gic view­point, Buller has al­lo­cated about 34% of the Fi­delity fund’s as­sets un­der man­age­ment (AUM) to a catch- all sub­sec­tor known as di­ver­si­fied; 24% to res­i­den­tial REITs; 18% to of­fices; 8% to in­dus­trial real es­tate; and 10% to re­tail prop­er­ties. Sig­nif­i­cantly, the last weight­ing is half that in the bench­mark FTSE EPRA/NAREIT de­vel­oped in­dex, due to Buller’s con­cern about shop­pers shift­ing away from shop­ping malls and to­ward the on­line world. About 54% of the fund is held in the U.S., along with 27% in Greater Asia and 18% in Greater Europe. A top hold­ing in the 75-name Fi­delity fund is Bu­wog AG (sym­bol: BWO), an Aus­tria-based real es­tate firm that has a busi­ness model based on as­set man­age­ment, de­vel­op­ment and sales i n Aus­tria and Ger­many. “With the strength of Ger­many’s econ­omy and the lack of build­ing and con­tin­ued im­mi­gra­tion, you have a sig­nif­i­cant sup­ply/de­mand im­bal­ance,” Buller says. “Bu­wog is one of the only apart­ment de­vel­op­ers you can get in the listed world.”

BWO is trad­ing at 25.10 euros (C$35.30) and pays a 2.7% div­i­dend. There’s no stated tar­get.

An­other favourite is Prol­o­gis Inc. (sym­bol: PLD), a San Fran­cisco-based REIT that spe­cial­izes in lo­gis­tics and is ben­e­fit­ing from the global growth of e-com­merce. “It not only owns the prop­er­ties, but is also a large de­vel­oper in the U.S., Mex­ico, the U.K. and con­ti­nen­tal Europe,” Buller says.

A long-term hold­ing, PLD is trad­ing at US$58.15 (C$71.25), which is 24 times ad­justed funds from op­er­a­tions. The REIT has a 3% div­i­dend yield. in the medium term, the fact that cen­tral banks in North Amer­ica are tight­en­ing and the U.S. Fed­eral Re­serve Board may un­load some of the bonds on its bal­ance sheet this year is not wor­ri­some, says Tom Dicker, vice pres­i­dent at 1832 As­set Man­age­ment LP and port­fo­lio co-man­ager of Dy­namic Global Real Es­tate Fund.

“A strong econ­omy is gen­er­ally very good for the sup­ply/de­mand fun­da­men­tals for real es­tate. The rea­son why real es­tate eq­uity funds gen­er­ated pos­i­tive re­turns [in the first half of this year] was be­cause the fun­da­men­tals have been pretty good,” says Dicker, who shares du­ties with Os­car Be­laiche, se­nior vice pres­i­dent at 1832 AM.

A big source of re­turns, Dicker says, has been from the re­cov­ery of Euro­pean eq­ui­ties and the euro; an­other source was the de­cline in U.S. trea­sury yields, which have pro­vided a tail­wind for REITs.

“But the real source of strength is that th­ese com­pa­nies are still grow­ing their earn­ings and the growth in share price val­ues has been largely from earn­ings, and not from an ex­pan­sion of val­u­a­tions,” says Dicker.

He notes that the aver­age div­i­dend yield from Cana­dian REITs is about 5%, while U.S. REITs’ aver­age div­i­dend yield is 3.5%-4%.

“Canada has been pretty good

Com­pa­nies are much bet­ter pre­pared to deal with shocks to the sys­tem than in 2007

this year. Apart­ment rents have been very strong be­cause it’s ex­pen­sive to own a home, es­pe­cially in the Greater Toronto Area, where many com­pa­nies have res­i­den­tial sup­ply,” says Dicker. “That’s been a good-news story for many REITs.”

Like Buller, Dicker notes that the sole ex­cep­tion to the class has been weak­ness in the re­tail space.

“Al­though sales have not fallen a lot, mar­gins have com­pressed be­cause re­tail­ers must be much more price-com­pet­i­tive with the likes of Ama­zon, es­pe­cially on the ap­parel side” he ex­plains. “Since rent is paid out of gross mar­gins, gross mar­gin per square foot is much more im­por­tant than sales per square foot. This has hurt shop­ping mall own­ers.” This prob­lem is far less acute in Asia and Europe, he adds, where com­pet­i­tive pres­sures are lower for mall own­ers.

Dicker ar­gues that credit mar­kets are in good shape, as in­di­cated by the tight spread be­tween lend­ing to an in­vest­ment-grade real es­tate firm vs risk-free govern­ment bond yields.

“It’s per­ceived that the risk is very l ow. That’s driven by l ow bond yields and bal­ance-sheet re­pair in the cor­po­rate world since the global fi­nan­cial cri­sis,” says Dicker, adding that the spread is about 65 ba­sis points (bps), com­pared with 180 bps in early 2016.

“We are near the lows,” he says. “And that’s very healthy for real es­tate, which means there is a lot of credit avail­able for debt fi­nanc­ing, out­side of the re­tail sec­tor, which is go­ing through a tough pe­riod.”

On the risk side of the equa­tion, Dicker con­cedes, the cri­sis sur­round­ing Toronto-based Home Cap­i­tal Group Inc. could prove to be an “in­flec­tion” point for risk cap­i­tal. “Look­ing back in a year or two,” he says, “we might say that was the first time that credit stan­dards started to tick up and peo­ple got more cau­tious about lend­ing.”

In ad­di­tion, Dicker notes that the com­bi­na­tion of the On­tario govern­ment’s mea­sures to cool res­i­den­tial prices and more care­ful scru­tiny of credit stan­dards by the Of­fice of the Su­per­in­ten­dent of Fi­nan­cial In­sti­tu­tions in­di­cate that Canada’s credit mar­ket prob­a­bly has peaked. “The prob­a­bil­ity of a head­wind over the next 24 months is higher to­day than it was a year ago,” Dicker says. “It’s time to be a bit more care­ful.”

From a strate­gic per­spec­tive, Dicker has al­lo­cated about 25.8% of the Dy­namic fund’s AUM to re­tail, 17.7% to res­i­den­tial, 17.3% to di­ver­si­fied, 7.9% to of­fice, and smaller hold­ings in hold­ings such as health-care prop­er­ties. On a ge­o­graph­i­cal ba­sis, about 75% of the fund is in­vested in North Amer­ica, with 15% in Greater Asia and 9% in Europe.

A top hold­ing in the 50name Dy­namic fund is Eq­uity Res­i­den­tial Prop­er­ties Trust (sym­bol: EQR), a Chicago-based REIT that is ac­tive in multi-res­i­den­tial prop­er­ties in so-called “gate­way” mar­kets, such as New York, Bos­ton and Los An­ge­les.

“Long term, ur­ban mar­kets are the ones that will de­liver the most growth,” says Dicker. “The stock has been a lit­tle de­pressed be­cause of near-term pres­sure on or­ganic growth. But [EQR] is a high-qual­ity name trad­ing at a dis­count to NAV.”

EQR is trad­ing at US$65.50 (C$80.50) and pays a 3% dis­tri­bu­tion. There is no stated tar­get, al­though the REIT’s NAV is about US$70.

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