For financial professionals in Italy

Real estate bubbles? Chance would be a fine thing…

Guy Barnard, CFA

Guy Barnard, CFA

Co-Head of Global Property Equities | Portfolio Manager


Greg Kuhl, CFA

Greg Kuhl, CFA

Portfolio Manager


Tim Gibson

Tim Gibson

Co-Head of Global Property Equities | Portfolio Manager


29 Jan 2021

Real estate shares have been out of favour in recent years, and there are indications that listed property is currently undervalued. Portfolio managers Guy Barnard, Tim Gibson and Greg Kuhl assess the indicators and explore the associated risks and opportunities.

Key takeaways:

  • Listed real estate underperformance versus the wider equity market appears increasingly stretched relative to history.
  • There are indications that REIT debt investors view the risk profile of the asset class as having fully recovered from the pandemic; the same is not reflected in equity markets.
  • Cheap and plentiful long-term funding is supporting the refinancing of existing debt and may drive merger and acquisition activity in real estate.

In a recent panel debate we were asked to discuss if we had seen any signs of valuation bubbles; our response in relation to the real estate market, was a somewhat flippant “chance would be a fine thing”. The other panel participants, investors in technology, healthcare and sustainable equity strategies all agreed that there are segments in their asset classes in which caution was certainly warranted – hydrogen technologies anyone?

Unlike the general equity market, listed REITs have not seen high profile examples of stocks recording exponential share price gains in recent years, with the overall performance of the sector having lagged the wider equity market by 25% since the start of 2020. In the five years to 31 December 2020, global real estate stocks returned 4.7% p.a versus 12.9% for global equities.1

As illustrated in figure 1, this level of relative underperformance is rare and was last witnessed in the build up to the dot-com crash. Property stocks subsequently generated returns of 16% p.a. over the  five years from 2000 to 2005; in contrast global equities' returns were flat.2 While we would certainly not claim that ‘all else is equal’, it certainly bears some consideration.

Figure 1: Listed real estate has lagged global equities

article bubbles 1

Source: Bloomberg, Janus Henderson Investors as at 31 December 2020. Listed real estate = FTSE EPRA NAREIT Developed Total Returns Market Index, global equities = MSCI World Total Returns Index. Rolling relative returns is calculated as the excess returns of listed real estate over global equities. Returns are annualised and reported in US dollars. Past performance is not a guide to future performance.

Will this time be different?

While the pricing of underlying real estate assets may not be seen as ‘cheap’ in absolute terms relative to their long-term history  ̶  the rental yield on a prime long-let London office asset today is circa 4%, the same as in 20063 (prior to the last correction) – the monetary backdrop is very different. In 2006 UK 10-year UK gilts yielded 5%, meaning there was no compelling reason for owning real estate and therefore a bet on future capital growth “greater fool theory?” was needed to justify pricing. Today, with 10-year gilts yielding less than 0.5% there is a close to historically wide spread for REITs over the cost of debt, providing investors with a sound income rationale for owning a real asset, that has also historically shown it can provide long-term inflation protection.4

While much attention recently has fallen on a shift in expectations toward rising inflation and a steepening bond yield curve, the US 10-year Treasury yield (at the time of writing), is around 0.7% lower than it was a year ago. This makes the relative difference in performance between wider equity markets and the real estate sector seem somewhat outsized.

Same assets, different valuations?

One observation worth highlighting in the current market is the divergence in valuations between the REIT equity and REIT debt markets (US data shown in figure 2). In the debt market, REIT corporate credit and commercial mortgage-backed securities (CMBS) yield spreads over treasuries have returned to pre-pandemic levels, and are also in-line with their longer-term history (figure 3). This suggests that debt investors view the risk profile of the asset class as having fully recovered from the pandemic. However, in the equity market, many valuation metrics including REITs’ dividend yield spread versus the yield on their own debt instruments are at or close to all-time wides.

Figure 2 : REIT equities appear historically cheap versus REIT debt

article bubbles 2

Source: Bloomberg, Janus Henderson Investors. REIT debt = Barclays Investment Grade (IG) REIT Index REIT equities = FTSE NAREIT Equity REIT Index). Spread: here refers to the difference in the yield of US REITs and REIT debt over that of an equivalent government bond eg US treasuries. Yields may vary and are not guaranteed.

Given that debt financing is a key part of most REITs’ capital structure, it is also hugely beneficial that the yields on REIT investment grade (IG) corporate credit and investment grade CMBS are at around 20+ year lows (both 1.7% at the end of 2020) – see figure 3. This presents REIT management teams with a significant opportunity to generate interest savings by refinancing existing debt, or to fund new acquisitions with very cheap long-term debt. Plentiful debt at low interest rates could also present private buyers with opportunities to generate outsized returns via merger and acquisition activity involving listed REITs or private real estate.

Figure 3: Real estate fixed income spreads over treasuries (%)

article bubbles 3

Source: Bloomberg, Janus Henderson Investors as at 31 December 2020. Real estate = Bloomberg Barclays Investment Grade REIT Index (IG REIT OAS), US treasuries= ICE BoFA US Fixed Rate CMBS Index (CMBS Govt OAS). Spread: here refers to the difference in the yield of REIT debt over that of an equivalent government bond (US treasuries).The option-adjusted spread (OAS) measures the difference in yield between a bond with an embedded option, such as a mortgage-backed security or calling back the issue.

In conclusion, against a backdrop where return expectations across many other asset classes have declined, we believe real estate income is beginning to stand out as being attractive in both the direct and listed real estate markets. Moreover, in our view, the recent strength in real estate debt markets could be a precursor to future strength in listed real estate.

 

Footnotes

1,2 Source: Bloomberg as at 31 December 2020. Listed property = FTSE EPRA NAREIT Developed Index, general equities = MSCI World Index.  Index returns in USD total return terms. Past performance is not a guide to future performance.

3 Source: Deutsche Bank research, CB Richard Ellis as at 31 December 2020.

4 Source: NAREIT (National Association of Real Estate Investment Trusts) as at 26 January 2021.

Commercial mortgage-backed securities (CMBS): fixed income investment products backed by mortgages on commercial properties. CMBS provides liquidity to real estate investors and commercial lenders. In the event of default, the mortgage loans that form a single commercial mortgage-backed security act as the collateral, with principal and interest passed on to investors.

These are the views of the author at the time of publication and may differ from the views of other individuals/teams at Janus Henderson Investors. Any securities, funds, sectors and indices mentioned within this article do not constitute or form part of any offer or solicitation to buy or sell them.

 

Past performance does not predict future returns. The value of an investment and the income from it can fall as well as rise and you may not get back the amount originally invested.

 

The information in this article does not qualify as an investment recommendation.

 

Marketing Communication.

 

Glossary

 

 

 

Important information

Please read the following important information regarding funds related to this article.

The Janus Henderson Horizon Fund (the “Fund”) is a Luxembourg SICAV incorporated on 30 May 1985, managed by Henderson Management S.A. Henderson Management SA may decide to terminate the marketing arrangements of this Collective Investment Scheme in accordance with the appropriate regulation. This is a marketing communication. Please refer to the prospectus of the UCITS and to the KIID before making any final investment decisions.
    Specific risks
  • Shares/Units can lose value rapidly, and typically involve higher risks than bonds or money market instruments. The value of your investment may fall as a result.
  • The Fund is focused towards particular industries or investment themes and may be heavily impacted by factors such as changes in government regulation, increased price competition, technological advancements and other adverse events.
  • This Fund may have a particularly concentrated portfolio relative to its investment universe or other funds in its sector. An adverse event impacting even a small number of holdings could create significant volatility or losses for the Fund.
  • The Fund invests in real estate investment trusts (REITs) and other companies or funds engaged in property investment, which involve risks above those associated with investing directly in property. In particular, REITs may be subject to less strict regulation than the Fund itself and may experience greater volatility than their underlying assets.
  • The Fund may use derivatives with the aim of reducing risk or managing the portfolio more efficiently. However this introduces other risks, in particular, that a derivative counterparty may not meet its contractual obligations.
  • If the Fund holds assets in currencies other than the base currency of the Fund or you invest in a share/unit class of a different currency to the Fund (unless 'hedged'), the value of your investment may be impacted by changes in exchange rates.
  • When the Fund, or a hedged share/unit class, seeks to mitigate exchange rate movements of a currency relative to the base currency, the hedging strategy itself may create a positive or negative impact to the value of the Fund due to differences in short-term interest rates between the currencies.
  • Securities within the Fund could become hard to value or to sell at a desired time and price, especially in extreme market conditions when asset prices may be falling, increasing the risk of investment losses.
  • Some or all of the ongoing charges may be taken from capital, which may erode capital or reduce potential for capital growth.
  • The Fund could lose money if a counterparty with which the Fund trades becomes unwilling or unable to meet its obligations, or as a result of failure or delay in operational processes or the failure of a third party provider.
  • In addition to income, this share class may distribute realised and unrealised capital gains and original capital invested. Fees, charges and expenses are also deducted from capital. Both factors may result in capital erosion and reduced potential for capital growth. Investors should also note that distributions of this nature may be treated (and taxable) as income depending on local tax legislation.
The Janus Henderson Horizon Fund (the “Fund”) is a Luxembourg SICAV incorporated on 30 May 1985, managed by Henderson Management S.A. Henderson Management SA may decide to terminate the marketing arrangements of this Collective Investment Scheme in accordance with the appropriate regulation. This is a marketing communication. Please refer to the prospectus of the UCITS and to the KIID before making any final investment decisions.
    Specific risks
  • Shares/Units can lose value rapidly, and typically involve higher risks than bonds or money market instruments. The value of your investment may fall as a result.
  • If a Fund has a high exposure to a particular country or geographical region it carries a higher level of risk than a Fund which is more broadly diversified.
  • The Fund is focused towards particular industries or investment themes and may be heavily impacted by factors such as changes in government regulation, increased price competition, technological advancements and other adverse events.
  • This Fund may have a particularly concentrated portfolio relative to its investment universe or other funds in its sector. An adverse event impacting even a small number of holdings could create significant volatility or losses for the Fund.
  • The Fund invests in real estate investment trusts (REITs) and other companies or funds engaged in property investment, which involve risks above those associated with investing directly in property. In particular, REITs may be subject to less strict regulation than the Fund itself and may experience greater volatility than their underlying assets.
  • The Fund may use derivatives with the aim of reducing risk or managing the portfolio more efficiently. However this introduces other risks, in particular, that a derivative counterparty may not meet its contractual obligations.
  • If the Fund holds assets in currencies other than the base currency of the Fund or you invest in a share/unit class of a different currency to the Fund (unless 'hedged'), the value of your investment may be impacted by changes in exchange rates.
  • When the Fund, or a hedged share/unit class, seeks to mitigate exchange rate movements of a currency relative to the base currency, the hedging strategy itself may create a positive or negative impact to the value of the Fund due to differences in short-term interest rates between the currencies.
  • Securities within the Fund could become hard to value or to sell at a desired time and price, especially in extreme market conditions when asset prices may be falling, increasing the risk of investment losses.
  • Some or all of the ongoing charges may be taken from capital, which may erode capital or reduce potential for capital growth.
  • The Fund could lose money if a counterparty with which the Fund trades becomes unwilling or unable to meet its obligations, or as a result of failure or delay in operational processes or the failure of a third party provider.
  • In addition to income, this share class may distribute realised and unrealised capital gains and original capital invested. Fees, charges and expenses are also deducted from capital. Both factors may result in capital erosion and reduced potential for capital growth. Investors should also note that distributions of this nature may be treated (and taxable) as income depending on local tax legislation.
The Janus Henderson Horizon Fund (the “Fund”) is a Luxembourg SICAV incorporated on 30 May 1985, managed by Henderson Management S.A. Henderson Management SA may decide to terminate the marketing arrangements of this Collective Investment Scheme in accordance with the appropriate regulation. This is a marketing communication. Please refer to the prospectus of the UCITS and to the KIID before making any final investment decisions.
    Specific risks
  • Shares/Units can lose value rapidly, and typically involve higher risks than bonds or money market instruments. The value of your investment may fall as a result.
  • If a Fund has a high exposure to a particular country or geographical region it carries a higher level of risk than a Fund which is more broadly diversified.
  • The Fund is focused towards particular industries or investment themes and may be heavily impacted by factors such as changes in government regulation, increased price competition, technological advancements and other adverse events.
  • This Fund may have a particularly concentrated portfolio relative to its investment universe or other funds in its sector. An adverse event impacting even a small number of holdings could create significant volatility or losses for the Fund.
  • The Fund invests in real estate investment trusts (REITs) and other companies or funds engaged in property investment, which involve risks above those associated with investing directly in property. In particular, REITs may be subject to less strict regulation than the Fund itself and may experience greater volatility than their underlying assets.
  • The Fund may use derivatives with the aim of reducing risk or managing the portfolio more efficiently. However this introduces other risks, in particular, that a derivative counterparty may not meet its contractual obligations.
  • If the Fund holds assets in currencies other than the base currency of the Fund or you invest in a share/unit class of a different currency to the Fund (unless 'hedged'), the value of your investment may be impacted by changes in exchange rates.
  • When the Fund, or a hedged share/unit class, seeks to mitigate exchange rate movements of a currency relative to the base currency, the hedging strategy itself may create a positive or negative impact to the value of the Fund due to differences in short-term interest rates between the currencies.
  • Securities within the Fund could become hard to value or to sell at a desired time and price, especially in extreme market conditions when asset prices may be falling, increasing the risk of investment losses.
  • The Fund may incur a higher level of transaction costs as a result of investing in less actively traded or less developed markets compared to a fund that invests in more active/developed markets. These transaction costs are in addition to the Fund's Ongoing Charges.
  • Some or all of the ongoing charges may be taken from capital, which may erode capital or reduce potential for capital growth.
  • The Fund could lose money if a counterparty with which the Fund trades becomes unwilling or unable to meet its obligations, or as a result of failure or delay in operational processes or the failure of a third party provider.
  • In addition to income, this share class may distribute realised and unrealised capital gains and original capital invested. Fees, charges and expenses are also deducted from capital. Both factors may result in capital erosion and reduced potential for capital growth. Investors should also note that distributions of this nature may be treated (and taxable) as income depending on local tax legislation.
Janus Henderson Capital Funds Plc is a UCITS established under Irish law, with segregated liability between funds. Investors are warned that they should only make their investments based on the most recent Prospectus which contains information about fees, expenses and risks, which is available from all distributors and paying/facilities agents, it should be read carefully. This is a marketing communication. Please refer to the prospectus of the UCITS and to the KIID before making any final investment decisions. The rate of return may vary and the principal value of an investment will fluctuate due to market and foreign exchange movements. Shares, if redeemed, may be worth more or less than their original cost. This is not a solicitation for the sale of shares and nothing herein is intended to amount to investment advice. Henderson Management SA may decide to terminate the marketing arrangements of this Collective Investment Scheme in accordance with the appropriate regulation.
    Specific risks
  • Shares/Units can lose value rapidly, and typically involve higher risks than bonds or money market instruments. The value of your investment may fall as a result.
  • Shares of small and mid-size companies can be more volatile than shares of larger companies, and at times it may be difficult to value or to sell shares at desired times and prices, increasing the risk of losses.
  • The Fund is focused towards particular industries or investment themes and may be heavily impacted by factors such as changes in government regulation, increased price competition, technological advancements and other adverse events.
  • The Fund invests in real estate investment trusts (REITs) and other companies or funds engaged in property investment, which involve risks above those associated with investing directly in property. In particular, REITs may be subject to less strict regulation than the Fund itself and may experience greater volatility than their underlying assets.
  • The Fund may use derivatives towards the aim of achieving its investment objective. This can result in 'leverage', which can magnify an investment outcome and gains or losses to the Fund may be greater than the cost of the derivative. Derivatives also introduce other risks, in particular, that a derivative counterparty may not meet its contractual obligations.
  • If the Fund holds assets in currencies other than the base currency of the Fund or you invest in a share/unit class of a different currency to the Fund (unless 'hedged'), the value of your investment may be impacted by changes in exchange rates.
  • When the Fund, or a hedged share/unit class, seeks to mitigate exchange rate movements of a currency relative to the base currency, the hedging strategy itself may create a positive or negative impact to the value of the Fund due to differences in short-term interest rates between the currencies.
  • Securities within the Fund could become hard to value or to sell at a desired time and price, especially in extreme market conditions when asset prices may be falling, increasing the risk of investment losses.
  • Some or all of the ongoing charges may be taken from capital, which may erode capital or reduce potential for capital growth.
  • The Fund could lose money if a counterparty with which the Fund trades becomes unwilling or unable to meet its obligations, or as a result of failure or delay in operational processes or the failure of a third party provider.
  • In addition to income, this share class may distribute realised and unrealised capital gains and original capital invested. Fees, charges and expenses are also deducted from capital. Both factors may result in capital erosion and reduced potential for capital growth. Investors should also note that distributions of this nature may be treated (and taxable) as income depending on local tax legislation.