By Hamlin Lovell, NordicInvestor
”Property equities are attracting investor interest for five key reasons: dividend income; earnings stability; valuation; as a potential inflation hedge; and for alpha generation potential”, says Will Lee, Investment Director for Global Property at Wellington Asset Management.
REITS as an asset class have lagged the technology-led stock-market over the five years, but on a 10 year lookback they have kept pace with global equities – and over the past 20 years REITS have actually outperformed global equities by a meaningful margin: delivering averaging returns of 7.90% versus 4.86% for the MSCI All Country World index. “This is due to lower interest rates, greater return of capital through dividends and better returns on capital”, says Bradford Stoesser, portfolio manager for Wellington’s Global Property strategy since 2010 and for the UCITS launched in June 2020. He is also a global industry analyst and the team lead at Wellington for real estate.
“Much of REIT earnings is returned through dividends and can be reinvested and compounded. REIT structures vary but they generally eliminate corporate taxes, and also allow for tax efficient reinvestment of retained cashflows”, says Stoesser. “Historical dividend yields on US REITS are around 5%, and even after the impact of Covid-19 related cuts from sectors including hotels and retail, the prospective yield is estimated to be 4.2%”, he adds. REITS now yield about 3.5% more than ten year US Treasuries, whereas the historical average spread since 1994 has been just 1.3%2. REIT equity yields could also be attractive relative to high yield and investment grade corporate debt, which have seen their yields tighten after central bank asset purchases.
Bradford Stoesser – Global Industry Analyst, Wellington Asset Management
Given that the Coronavirus crisis could dramatically cut global equity earnings this year – and possibly beyond – REITs are looking resilient, and this is typical of their history: “through a full cycle REITS, have less volatile earnings than other companies, due to contracted leases”, says Stoesser. “They should be able to recoup rental income lost during the lockdown”, he expects.
Currently, valuations are relatively low. “The earnings-related valuation is a forward PE ratio of 13.5 times2, using end of March estimates that incorporate some Covid-19 impacts. This is at a discount to both the sector’s own history and the wider US market on 19.1x forward earnings”, he adds2.
Valuations could also be appealing relative to asset value, with Global REITS at a 20% discount to private market valuations, based on year end 2019 NAVs. “Since then, we have seen limited transactions in the private market, and Covid-19 may change utilization rates, but we still judge them to be at a discount”, says Stoesser. Since 1996 REITS have, on average, traded in line with NAV, fluctuating between approximately 20% premiums and 20% discounts4.
Some of the deepest discounts are seen in the UK market, where certain REITS and real estate companies can trade 50% below NAV, partly due to Brexit ‘No Deal’ fears. “We view this as a long term opportunity given London’s dynamic, flexible and business friendly environment”, says Stoesser.
If US interest rates stay near zero until 2022, as per the central Federal Reserve forecast, the search for yield could drive yield compression and increase valuations.
US Tax Status of REITS
Since US REITS are Stoesser’s largest exposure, it is worth touching on their tax status and how this might be impacted by a change of administration. A Joe Biden Presidency from November 2020 could conceivably increase the tax efficiency of REITS relative to other companies, known as C-companies. Since the 2018 corporate tax cuts reduced the differential between the two structures, a partial reversal of them could help to restore the gap and make REITS relatively attractive. “As of now there are no proposals that would materially impact the REIT structure, which has been intact through changes of administration and congress since the 1960s. Even if the Democrats take both houses and the Presidency, we do not expect significant changes”, says Stoesser. (He clarifies that proposals for higher taxes on dividends would have an equal impact on REITS and other corporate structures).
Over time, residential and commercial property valuations have risen, with residential outperforming in some geographies and commercial in others. Over the past 25 years, New York and London office rents have advanced faster than inflation, during a period when inflation was declining or stable. If inflation starts to accelerate, real estate could become even more sought after: “real estate could become an inflation hedge versus currency debasement risks that are inherent in protracted QE from central banks”, say Stoesser.
This does partly depend on the overall economic picture however. Inflation combined with some GDP growth would be a benign scenario. In contrast, “a 1970s style stagflation combining inflation with no or negative growth could actually be bad for most asset class valuations including real estate. In particular, if interest rates and inflation rise faster than GDP, landlords cannot pass on costs in terms of rents, and then valuation multiples would contract. Leveraged firms might suffer most, but fortunately, the commercial real estate industry is now better capitalized than it was during the great financial crisis, or the savings and loans crisis of the 1980s”, says Stoesser.
Will Lee, CAIA, FRM, CFA – Investment Director, Wellington Asset Management
The breadth of the investment universe, spanning REITS, corporations, and developers, in multiple sub-sectors, across developed and emerging markets, creates plenty of potential for alpha generation. The Wellington Global Property strategy selects between 50 and 80 holdings from a universe of 600 globally. Two sources of edge are exploiting the breadth of expertise within Wellington, and its growing ESG integration.
Stoesser’s team only invest in common equity, but they have colleagues investing across the capital structure, including in corporate debt and asset backed securities such as RMBS and CMBS. “We view real estate as one asset class and we gain insights that influence our equity positions through a weekly real estate hub meeting”. This includes equity and credit analysts focused on regions and sectors, as well as an ESG analyst.
Other global industry analysts who specialize in different sectors are also a useful resource: “we can identify insights from tenants even before landlords are aware of them, based on our knowledge of industry dynamics. The consumer team inform our view of demand for retail real estate; the finance team have a clear view on demand for New York and London office space, and the healthcare team inform our view on demand for medical offices and laboratories, where we have been underweight due to policy and regulatory risk”, says Stoesser.
Moreover, analysts based in US, Asia, and Europe/Canada round out the perspective. The global team have an 0830 London morning time meeting between London and Asia, and an 0830 Boston morning time meeting between the US and Europe, each day. Once a week the whole global team dial in for a high level discussion amongst the global industry analysts. “Currently, the largest exposure is in US equities, but going forward we are excited about the opportunity set. Asia is growing faster and public real estate in Asia is an emerging asset class”, says Stoesser. Indeed, Asia has a strong pipeline of public offerings in the real estate space.
Wellington’s ESG integration is another source of informational edge. The firm signed up to UNPRI in 2012, and its Director of Sustainable Investment, Wendy Cromwell, sits on the UNPRI board. Wellington has an ESG analyst, Jennifer Rynne, dedicated to the global real estate sector. The environmental side of ESG is clearly of special relevance because buildings are one of the largest sources of carbon emissions. “The market does not fully appreciate climate risk but we incorporate climate data from the non-profit, Woods Hole Research Centre, in an exclusive partnership with big US and Canadian pension funds. Social and governance are also important: two identical buildings can have very different valuations based on management, employees, tenants, diversity etc”, points out Stoesser. “We marry the data with our research, quantitatively assessing each ESG factor including climate change and augmenting our price targets.
More broadly, ESG reveals insights into corporate culture: “the ESG framework also lets investors evaluate if a company is forward looking”, says Stoesser.
Market timing has not created outperformance as cash has stayed well below 5%. Some 60% of the alpha has come from stock selection and 40% from sector selection, though a nuance here is that up to 30% of the portfolio has been in “off benchmark” sectors that could also be perceived as a type of stock selection alpha. Off benchmark bets can include some emerging markets, hotel brand operators and sometimes even homebuilders, depending on geography. The most important wagers have exploited some of the same technology megatrends that have driven global equity market leadership. This has been expressed through both off and on benchmark positions.
Real Estate Technology
Stoesser’s biggest single alpha generator over the decade has been real estate technology, which includes telecom towers and data centres, both of which are mostly off benchmark. The investment thesis here is a secular growth story based on data using rising 40% per year, and set to be spurred by 5G networks and wider smartphone adoption in emerging markets. Telecom tower operators have benefitted from strong rental growth globally, and Wellington’s macro team have helped to identify the most attractive geographies, which have included North America and Spain.
Instore versus Ecommerce
The second largest alpha driver has been warehouse logistics, which belongs to the benchmark and exploits another technology oriented megatrend: ecommerce and last mile delivery. Stoesser has also added alpha by being underweight of retail malls, which tend to be large, out of town locations housing department stores and clothing stores, which face secular pressure from ecommerce.
Yet the dynamics in the retail landscape are nuanced, underscoring the importance of detailed tenant analysis. Stoesser has been overweight of retail shopping centres, which tend to be smaller format, local centres, which offer services including groceries, pharmacy, and home improvement that cannot always be found online.
Covid 19 and the next real estate cycle
Stoesser’s recent outperformance has been remarkable. It has come from investors’ growing sensitivity to ESG and from enhanced risk analytics highlighting factor exposures to eliminate unforeseen risks. The portfolio has also benefitted from tactical repositioning around the Coronavirus crisis. In February 2020, Stoesser made three defensive changes to the portfolio: “we decreased retail and hotels; increased balance sheet quality of holdings by reducing exposure to more levered companies, and we also increased liquidity by adding to large cap exposure”. Most of the book is in core value creators, but Stoesser has spotted some interesting cyclical opportunities: “after the correction, we are starting to see stocks mispriced on long term fundamentals. These include a cyclical play on selected housebuilders”, he says. Though the strategy is liquid enough to swiftly make defensive and offensive changes in the short term, its predominant time horizon is medium to long term with average holding periods remaining around two years.
To some degree, Covid 19 has accelerated multi-year trends such as shifts from instore to ecommerce, and growing data usage, but it could also set in motion new patterns in property usage. “Every real estate cycle is different, and the best opportunities to generate outsized returns come at the start of a new cycle when trends are less evident. Changes in how we live, work and play mean we are on the precipice of a new real estate cycle and are optimistic about the opportunity set. Warehouse logistics could see a change of geographic focus if Covid19 reverses globalization and results in more local sourcing, giving rise to logistics demand in different locations. Trends yet to emerge could include changes in office use and travel, and shifts from urban to suburban living. We are well positioned to identify disconnects between private & public market valuations and future demand from tenants”, says Stoesser.
1 Index: FTSE EPRA Nareit Developed. Dates: 30 June 2000 – 30 June 2020
2 CITI Research
3 Based on 12-month forward estimated yield. Source: Factset
4 Everscore ISI