Global Listed Property: Why We Have a Low Conviction (est read time: 5 mins)
Bianca Rose, Portfolio Manager, Asia-Pacific
Eugene Visagie, Portfolio Specialist, Europe, Middle-East & Africa
Real-estate investment trusts, or REITs for short, have become an increasingly popular vehicle for real estate ownership in many global financial markets. The REIT sector has grown significantly over the last two decades; both in terms of REITs being introduced in new countries, as well as the increase in the size of the sector across existing jurisdictions. In fact, it’s currently estimated that the global REIT market exceeds US$1.2 trillion. The bulk of these assets remain in the U.S. (more than half of the global REIT market). Other prominent markets include Europe (both the Euro area and U.K.), Hong Kong, Australia, Singapore, Japan and smaller markets such as South Africa. Like many asset classes, REITs find themselves at an important juncture in 2019, with the potential for rising interest rates over the medium to long-term threatening the strong returns achieved from this asset class over the last decade. Of course, any short-term cuts to interest rates could likely have the opposite effect. This comes at a time of stretched valuations, adding further risk to an already complex setting.
Is Listed Property a Defensive Asset?
Historically, this sector has been considered to offer defensive characteristics. In part this is due to the stability of the underlying cashflows and in part due to its relationship with bond markets – often considered a “bond proxy”. However, we are of the opinion that valuations need to come down to justify such an assessment going forward. Let’s not forget that real estate values are high in most developed markets. This has made it more difficult for REITs in those regions to locate and execute profitable acquisitions.
The Downside to Listed Property
During the Global Financial Crisis (GFC) many of the largest REITs in the U.K. and Australia had to undertake “rescue” rights issues due to high gearing levels involved in the sector. This was exacerbated by the significant devaluation of properties that occurred. Given a similar setting today—with stretched property valuations and a continued reliance on debt—it should not be controversial to say that leverage concerns could resurface if asset valuations were to fall significantly from here. To provide further context, we can scan the globe. The best performing REIT market over the 12-month period to 28 February 2019 has been Hong Kong, mainly driven by investors favouring domestic assets which are expected to be less impacted by trade wars between the U.S. and China (as well as the market expectation that the U.S. Federal Reserve will delay raising interest rates). To the contrary, South African REITs were among the worst performing region, although this is perhaps nuanced. South African REITs experienced a large sell-off in early 2018, due to reports from Viceroy around certain valuation principles followed by listed property providers.
Underlying this, prices have already come down considerably in several areas, such as retail REITs, while other areas like industrial assets have propped up the performance numbers. The question that needs to be asked is why the prices have deviated so significantly and what specific risks investors are already pricing in, versus those that they can’t yet see. For example, the U.K. faces an interesting period, in part due to Brexit fears that are likely priced in, although we’d caution that risks remain.
The Risks Faced by the Listed Property Market
- Rising interest rates over the medium to long-term, especially in the U.S. market.
- Slowing economic growth or an inflation shock (particularly in the U.S. or China).
- Already stretched valuations (especially following the large jump in January 2019).
- Retail pressure, especially in developed markets. For example, the trend in the U.S., Australia and U.K. is to have destination malls—with more food and service.
A Low Conviction in a Popular Asset Class
Over the next decade, REITs likely face two significant headwinds:
1) a predisposition of stretched valuations and reasonably high debt, and
2) a vulnerable growth rate that could easily move back towards trend and result in pockets of divergence.
Market darlings at the moment include industrial REITs, however investors should be aware that it is currently a relatively crowded trade. When considering industrial REITs, investors with unique and well positioned assets, such as those near ports, are less susceptible to supply competition. Put together, the large price increases over the past five years may unwind, posing a potential danger to real estate investment. In addition, we’d add that new construction has been moderate (approximately in line with demand), keeping vacancy rates stable combined with rising rental charges. That said, any increase in interest rates, which could be reasonably expected over a 10+ year period, would pose a challenge to REITs pricing going forward.
Any Pockets of Opportunity?
So, where are we currently seeing opportunity? Value-orientated investors may find opportunities amongst retail REITs and/or South African REITs, however there are risks that need to be balanced with the potential reward.
Taking these factors into account REITs can be a diversifying asset in a multi-asset portfolio but are of the opinion that high valuations would lead to adopting a lower weight at the present time.
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