Portfolio managers Guy Barnard and Greg Kuhl join Adam Hetts, Global Head of Portfolio Construction and Strategy to discuss REITs’ performance to-date and the impact of stagflation concerns, rising rates, and higher energy and other input costs on the sector.
- Year-to-date, global REITs have delivered returns in the middle of global equities and global government bonds, providing a more resilient, defensive income stream, with typically less exposure to short-term earnings from the global economy.
- Stagflation and rising energy costs remain a risk. Landlords with pricing power are increasingly differentiating themselves and should see more resilient demand and growth.
- Should bond yields and interest rates move significantly higher, this could impact property capital values. However, most REITs have been very proactive in recent years extending and fixing their debt book, which should reduce their exposure to short-term rate rises.
- There is an increasing focus on the sustainability of buildings, particularly in the office market where there is a huge polarisation in tenant demand and asset value between more sustainable, environmentally-efficient, lower energy costs buildings and those that lack these characteristics.
Adam: Welcome to Global Perspectives. Today I'm joined by Guy Barnard and Greg Kuhl. Guy is our Co-Head of Global Property Equities, and Greg and Guy are both portfolio managers on our Global Property Team. And since market chatter has turned to stagflation concerns, we're going to use Guy and Greg and REITs [Real Estate Investment Trusts] in general as a lens for some intel on the state of demand and inflation and growth in the economy. But before we get into stagflation, it'd be great to get a quick update on global listed real estate performance year-to-date. So thanks guys, for joining. And Guy, do you mind starting with where performance has been so far this year?
Guy: That's quite right Adam and thanks for having us back. Look, it feels like quite a long year already as we speak towards the end of March. I think we've had a lot thrown at us as investors, but if we look at what that’s meant in total for the global REIT sector, we've seen a return so far on the year of -6%. Now, I think it's important for a bit of context there, this year did follow a very strong year in 2021 for the sector where global REITs were up by 26% and we really sort of finished on a high as well with a 6% return in December 2021.1
So year-to-date [24 March 2022], the performance actually sits right in the middle of what we've seen from global equities and global government bonds, which over the long-term is often seen as a pretty good benchmark for real estate. It’s an asset class sitting somewhere between the risk profiles of those two different asset classes. But it's quite interesting just to look at what we've seen more recently. Obviously, the unfolding situation in Ukraine and if you look at how REITs have behaved over the last six weeks, we've actually seen since mid-Feb, REITs have generally been an outperforming part of the equity market.2And so I think investors looking for that more resilient, more defensive income stream that REITs can typically provide given much less exposure to short-term earnings from the global economy and the short-term impacts of that. And actually, even in markets like Europe, where you know clearly, we're at the heart of what's happening in Ukraine and Russia, the European property stocks [FTSE EPRA NAREIT Developed Europe Index] are actually higher today than they were pre the invasions. So again, that sort of relative resilience of the asset class I think has come through in recent weeks.
I guess one other interesting observation is just to look at some of the sector leadership that we've seen within real estate this year. And if we turn to the US REIT market, we've seen actually the strongest performances come from REITs exposed to hotels, offices and healthcare. And that really is a reflection of some of the laggards of 2021 and those perhaps seen as being more exposed to a recovering economy as we still expect in the US this year, essentially getting a bit of a catch up from a low starting point following underperformance in recent years.
And on the flip side, this most significant underperformance in the US has come from the mall REITs, a pretty small subsector of our market, but they're down around 18% this year. And I think that really reflected some of the hope and expectation that drove good share price performance in that part of the market last year, has hit a bit of a hard reality frankly, as we're all looking at consumers and discretionary income impacts of rising energy costs. And perhaps you know, that having a negative read across to some of those more consumer discretionary parts of the market. So that's a few sort of observations added Adam, on where we've been. I know you're much more interested on where we're going so I'll throw it back to you for that.
Adam: Yes, thanks Guy. So yes, a lot to unpack there. Kind of a mixed bag so some of the top performers in the US with the hotels and offices, but then a laggard being malls to them all. REITs at least the first two kind of speak to that kind of reopening and that demand increase and that demand stimulus, but then the big market discussion’s more about the stagflation and sort of lessening demand or at least lessening growth and inflation at the same time. So maybe we can unpack some of what you just mentioned through that stagflation concern. So on the stagnating growth concerns in the face of some of the performance and strong performance you mentioned Guy. I mean, Greg what are you seeing on the ground? Like how do you feel about growth in demand in property markets in general right now in the face of these falling demand and growth concerns?
Greg: Yes, it's a good question. And I think you know maybe somewhat counter-intuitively, we haven't yet seen any sort of signs of a slowdown in demand across most of the property types within commercial real estate. Yes, I would say really for most of the past year, we've seen strength across the board in just about every property type from retail through industrial. You know just to give some examples, I think you could look at what we're seeing right now in US apartments for instance. We are seeing rents that are growing you know, well into the double-digits you know, potentially even 20% or more on a year-over-year basis, depending on the market and specific asset. We're seeing similar rent growth in industrial properties. And we talked about hotels a second ago, we're seeing really strong rate growth in hotels. I think all of those things point to very strong demand. There's also an element of limited supply across all those too.
And then, you know on the lower side of the growth spectrum, you would have property types like retail and office where you know, office rents took a hit during COVID and they really haven't recovered. A lot of them, they’re not falling, we think they're pretty flat at the moment. And then on retail, we think we're seeing low single-digit growth in rents as well. So I think that sort of spans the spectrum of rent growth that we're seeing. You know, one question that you might have is, is that sustainable? And I think our view is, it's pretty tough to sustain something like 20% year-on-year rent growth in apartments. So that you know, we think that does have to slow you know, but we're not seeing it yet and it doesn't necessarily mean that it has to slow dramatically. I think it could, the rents that are at a high level could slow down, but not necessarily correct based on high occupancies that we're seeing and continued willingness of customers to accept higher rents. So from the stagnant growth perspective, we're not seeing it yet. I think it’s reasonable to expect slowing from the high level we’re at, but you know, no indication from our perspective at this point that there is a you know, a real sign of trouble on real estate demand.
Adam: And maybe it's that exactly that gets more to the heart of the slowing growth. It's not so much about slowing demand like you mentioned, there's apartments for example, very high demand but limited supply. And so if the demand is staying strong, then it's really the growth potential being throttled on the supply side is the bigger concern. So that sort of leads to that second half of stagflation on the inflation side. So maybe Guy, could you comment a bit on those supply constraints more broadly? And not just supply constraints in terms of vacancy, but just rising input costs in general and then major input costs for landlords could be financing and rising rates. So I'm also curious what you think about the impact of rates on the sector in general and how that might shift some behavior as well?
Guy: Yes, there's again a lot to unpack there. But generally, as we sort of think about inflation and real estate you know, there is clearly a positive long-term correlation between the two. Yes, we talk a lot about real estate companies being the landlords to the global economy. So [typically] as economies grow, so does demand and so do rents over time. And you know, I think that's really why when we look back, we see that REITs as an asset class have typically generated their strongest returns in periods where inflation is at sort of medium to high levels versus let's say, sort of 2% targets that we've seen in recent years.
But I think there's a question short-term about that inflation piece and where it's coming from and what's a healthy level of inflation? So you know, I think what we're seeing at the moment isn't so much demand-pull inflation, but cost-push inflation. And as a landlord you know, that's not necessarily healthy if you don't have pricing power, and you only get that pricing power if your underlying tenants are seeing good business and confidence is high.
So I think you know, we are going to see parts of the real estate market where that inflation can be passed through to tenants in rents and therefore you are generating sort of positive real income even with current levels of inflation. But there are also parts of the market where down inflation is going to put pressure on tenants and business and consumer confidence and I think that creates risk either in over-renting or that when leases expire you know, vacancy levels are higher and increasing. So I think there are some areas that we do have to be mindful of that you know, there is a healthy level of inflation and perhaps you know, the current sort of 7%, 8% level of inflation is not going to correspond to the same level of rental growth on average.
But I think as you look over the long term to your question around sort of input costs, there is definitely pressure on, in the construction market. Speaking to companies in different markets, you're probably looking at sort of 10% year-on-year increases, in some cases more in terms of the cost of construction. Availability of raw materials can be getting more challenged as well you know, as is the labour side of the equation as well.
So you know, I think we are going to see pressure on some of that construction activity. Now, the good news is most of that construction is in areas where there is good tenant demand as well. So your input costs might be going up, but if your rents are going up as well and the yield investors are willing to pay, it’s stable or coming down and you can still make that margin. But I think we do need to be mindful of the risks around new construction. Now over the long term, I think those risks probably translate into less supply. And you know, you go full circle again and that's good for existing landlords in terms of more demand, but there are clearly some moving parts around that today.
To your point around finance costs you know, I think when we look at the risks in REIT business models, yes, the reality is we are not as exposed to supply chain disruption or even rising labour costs in terms of the construct of a REITs P&L [profit & loss], that the finance cost clearly is a very significant component and we've got to be mindful that as we look at credit markets today, spreads have probably increased if you include credit spreads and then base rates by around 100 basis points on average over the last three months, so since the start of the year. And that eats into your risk premium for real estate. And if you're exposed to the floating end part of the curve [variable/non-fixed rates], then it has an immediate impact on P&L as well.
I think the good news for us as we look at certainly the REIT sector in isolation, is that balance sheets are in a very good position. Leverage [debt levels] is not too high, companies have been very proactive in recent years in extending and fixing their debt book, so their actual exposure to short-term rise in rates in terms of their P&L impact is limited. But I think the risk premium piece is something we have to be mindful of. The good news again, is that I think we had a pretty healthy cushion in terms of looking at the spread between real estate year one cap rates or income streams and where we were in in Treasury and interest rate markets. But that spread has been eroded pretty quickly in three months so we're now back to the sort of long-run average risk premium between the two. So if we do see bond yields and interest rates moving significantly higher from here, then you know, there does have to be a question about the impact on capital values.
As we stand today, we don't think we're there yet, but I think you know, expectations of capital value growth have clearly come down, having had a really strong run in recent years. And I think it's just something we have to watch very carefully from here.
Adam: So then a quick follow-up on inflation, if given the situation with Russia and Ukraine, if investors are specifically concerned about energy prices and energy cost inflation, does that have a huge impact on the REIT sector? Or how are you interpreting that and how you're thinking about the property markets?
Guy: For the sector itself it’s generally pretty limited. It depends a little bit on the business model but you know generally as a landlord, you're providing the building and not paying the heating costs directly, so that is borne by the tenant. But clearly the tenant themselves are probably looking at the total cost of occupation. So if energy costs are rising, does it limit your ability to move rents significantly higher? I think that's something we can be mindful of. You know today, that doesn't seem to be having a huge issue but you know again, let's see how this plays out over the next six to 12 months.
I think what it is likely to do is put greater focus on the green agenda in the sustainability of buildings and this is something that was really sort of rising to the fore, particularly in areas like the office market where there is a huge polarisation in tenant demand and asset value today between more sustainable, environmentally-efficient, the lower ongoing energy costs buildings and those with much lower levels of sustainability and energy efficiency. So I think that is going to come to the fore. And you know, there are also opportunities for our companies in that space because you know frankly, we have quite a lot of roofs and roof space.
So you know, we were chatting with a very large US industrial landlord a couple of weeks ago and they are in the process of rolling out a serious solar package onto the roofs of their you know, huge industrial logistics assets. And the scale of that opportunity is huge. This company is saying it could be the largest renewable energy provider or one of the largest renewable energy providers in the US and as battery storage technology is improving, instead of selling excess energy that's not used within the buildings back to the grid, they can save that on site and sell it to their tenants and you know, in a world where their tenants are moving perhaps more to EV [electric]vehicles you know, selling that back at retail prices rather than back into the grid at wholesale prices could be you know, really meaningful to these companies’ earnings. So you know, rising energy costs, I think is a risk in terms of that tenant affordability piece. But I think it will also be an opportunity for companies with more sustainable buildings and those that have the option to you know, literally benefit from the ability to harness solar [energy] in particular.
Adam: Okay, so you sort of set the stage talking about the year-to-date performance and the relative defensiveness of the asset class and how it's been playing that role so far successfully and then how we're still seeing strong demand. And we do have that inflation resilience kind of inherent in the asset class and I think those mechanics are in play as well going forward. So maybe Greg, just going forward the balance of the year, how would you put all those pieces together? What are you expecting the rest of this year? What are you watching most closely as far as global property performance in the months ahead?
Greg: Yes, I think we touched on the biggest thing already, which is pricing power. And you know, that is really going to be one of the keys to us across these different property types going forward. I think it's fair to say we have been in somewhat of a ‘rising tide lifts all boats’ environment, at least across the various property types in our asset class. But as we move through this year, I think our expectation is going to be that those that have pricing power from a landlord's perspective, are increasingly going to be able to differentiate themselves from those that don't. And this sort of ties back into the slowing growth dynamic that we touched on earlier.
The growth doesn't have to slow as much for those landlords that have pricing power because there's really strong demand for their assets. And you know, just to tie together with the inflation piece, I mean that's exactly how we think it should work for real estate. You know, you have a fixed asset base, we have supply growth that's lower across the board for some of the reasons that Guy touched on. So for those landlords with existing buildings where there's demand for space, you've got a fixed asset where you know, costs don't increase as much as they might for some other businesses and inflationary environments. But rents do [tend to] increase with inflation and also with kind of supply and demand fundamentals.
I think you know, one other point that we think is going to be increasingly important is kind of quality of balance sheets and access to capital. So tying back to you know, the question you had around rising rates and rising debt costs, we have seen for instance, a pretty big difference in the last three months just on a year-to-date basis, in terms of how much the debt spreads have increased for high yield [debt] borrowers versus how much they've increased for investment grade borrowers. You know, there's about 100 basis point difference there to the benefit of the investment grade rating credits. I think from a listed REIT perspective, we actually have a lot of investment grade-rated companies in the listed REIT space. And they are at an increasing advantage versus people with weaker balance sheets in the public markets and also versus you know, private market participants in the real estate market who generally don't have as strong cost of debt capital. So that's another thing we're watching and I think we'll be increasingly rewarded is low leverage and strong balance sheets as the year unfolds.
Adam: Okay, thanks again Guy and Greg. And thanks for listening. If you'd like to hear more from Guy and Greg, their views and Janus Henderson's other thought leaders are available on our websites. And please like and rate and comment on the podcast if you like that and we'll look forward to bringing you more Global Perspectives in the near future.
1 Source: Refinitiv Datastream. FTSE EPRA NAREIT Developed Index, cumulative total returns in US dollar terms, year-to-date to 24 March 2022, calendar year to 31 December 2021, monthly return to 31 December 2021.
2 Source: Refinitiv Datastream. FTSE EPRA NAREIT Developed Index vs MSCI World Index, cumulative total returns in US dollar terms, 15 February 2022 to 24 March 2022.
Past performance does not predict future returns.
Capitalisation rate/cap rate: refers to the rate of return on a property based on its net operating income (NOI). This metric is used to determine the potential return on investment or payback of capital.
Commercial real estate: property used only for business-related purposes (non-residential).
Open-ended fund: a collective investment that grows or shrinks in line with investor demand. New units are created when an investor buys/invest in the fund and units are cancelled when an investor sells their holding. The price of units is determined by the net asset value (NAV) of the underlying portfolio; the NAV will vary in line with portfolio performance in addition to investor inflows and outflows.
Credit spread: the difference in the yield of corporate bonds over equivalent government bonds.
Demand-pull versus cost-push inflation: demand-pull inflation occurs when prices increase due to increasing aggregate demand, and is associated with a healthy economy. Cost-push inflation occurs when the supply of goods or services is limited (eg. because of rising energy prices) but demand remains the same, pushing up prices.
Property yield: a measure of annual return on a property investment. It is calculated by expressing annual rental income as a percentage of property cost.
REIT: Real Estate Investment Trusts invest in real estate, through direct ownership of property assets, property shares or mortgages. As they are listed on a stock exchange, REITs are usually highly liquid and trade like shares.
Stagflation: an economic condition that occurs when there is a combination of slow economic growth, high unemployment, and rising prices.
Real estate securities, including Real Estate Investment Trusts (REITs) may be subject to additional risks, including interest rate, management, tax, economic, environmental and concentration risks.
Foreign securities are subject to additional risks including currency fluctuations, political and economic uncertainty, increased volatility, lower liquidity and differing financial and information reporting standards, all of which are magnified in emerging markets.
FTSE EPRA NAREIT Developed Index is designed to track the performance of listed real estate companies and REITs worldwide.
The FTSE EPRA NAREIT Developed Europe Index is a market capitalisation-weighted index consisting of the most heavily traded real estate stocks in Europe. It is designed to reflect the stock performance of companies engaged in specific aspects of the European real estate business as perceived by institutional investors.
MSCI World Index captures large and mid-cap representation across 23 developed markets.
S&P 500® Index reflects US large-cap equity performance and represents broad US equity market performance.
Equity securities are subject to risks including market risk. Returns will fluctuate in response to issuer, political and economic developments.
Fixed income securities are subject to interest rate, inflation, credit and default risk. The bond market is volatile. As interest rates rise, bond prices usually fall, and vice versa. The return of principal is not guaranteed, and prices may decline if an issuer fails to make timely payments or its credit strength weakens.
High-yield or "junk" bonds involve a greater risk of default and price volatility and can experience sudden and sharp price swings.