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