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Guy Barnard, Co-Head of Global Property Equities and Matt Bullock, EMEA Head of Portfolio Construction and Strategy review how listed property has fared this year and explain why 2024 may be a more favourable backdrop for the sector.
Alternatively, watch a video recording of the podcast:
Guy Barnard: Thank you for having me.
Bullock: So, Guy, I’ve been really looking forward to doing this particular podcast because there’s so much to talk about in the world of property right now. We’re recording this podcast mid-November 2023 here in the UK. Over the last few weeks in particular, but you could also take this out to months, there have been plenty of articles about property and they’ve not all been that positive. Investors are falling out of love with property funds. An increase in insolvent German housebuilders. An increase in delinquent commercial real estate loans in the US. The demise of WeWork. Now, I’m going to stop there because I could keep going, but it all goes to the question of, well, why are we here and why are we talking about property?
Barnard: Yes. As you say, I think it’s certainly been a sector that has made the headlines over the course of 2023 and often it’s been in the headlines for the wrong reasons. Challenges in commercial real estate and the threat of wider distress from commercial real estate have clearly been some big themes in markets and in the press in recent months.
I think really for us, what we’ve tried to do this year is to, I guess, look beyond the headlines and to make it clear that the headlines a lot of people are reading don’t necessarily reflect the reality of the listed REIT (real estate investment trust) sector in which myself and the global team at Janus Henderson invest. So, yes, there are risks in commercial real estate, but we think there are also opportunities as well. I think it’s those opportunities which are why we’re here today.
Bullock: So what would help the market stabilise right now? Because that’s one of the challenges that investors are facing.
Barnard: Yes. I think clearly the biggest headwind that we’ve faced in real estate over the last 18 months has been the rise in interest rates and bond yields. I think they’ve gone further than most of us would have expected 18 or 24 months ago in terms of the level and speed of those rate rises from most central banks across the world. Certainly our conversation with prospective clients, with companies, is that people are really waiting to see a stabilisation in that interest rate backdrop before they step back in.
What we want to see on the real estate side is more transactions in the direct (private) property market. We want to see buildings being bought and sold, and that giving us confidence in the pricing of real estate in the new backdrop of high rates, but that’s something that is taking time. Six months ago, I’d have hoped that was a process we were going through in the back end of this year. It feels like that clearly has been pushed into 2024.
Bullock: That’s interesting because when I’m out talking to clients, they’re all saying they understand [the headwinds]. We’ll talk about the opportunities in property, but they understand while they could be opportunities, but the biggest concern is… when you talked about rates and the impact of rates, what if rates don’t come down? What if rates stay where they are for the next six or 12 months? Should you hold and wait?
Barnard: Yes. Look. I think a stabilisation is a good first step. I don’t think you need to be too aggressive in assuming central banks are going to be cutting aggressively in three or six months’ time. There are differing views out there as to the pace of those rate cuts as and when they do come, but I think stabilisation is just a really good first step. I think people have not wanted to step in and make the risk of just going too early and being made to feel very foolish very quickly, which has been quite possible in markets over the last six to 12 months.
So I think if you get a stabilisation, you then get confidence. You then start to see, as I say, that transaction volume rebuilding in the underlying markets in which we invest. I think at that point, we can then see whether these discounts and the valuation opportunity that we see in the REIT market is real and is backed up by evidence based off the new reality of higher rates.
Bullock: So a bit later on I’m going to get you to get your crystal ball out, but staying with the current market environment, what’s the biggest risk in your mind right now? So what’s the thing that you’re most worried about and keeping you awake with property?
Barnard: Rates clearly has been the biggest challenge for the sector over the last 12 or 24 months. If you do take a more aggressive view that inflation is going to reaccelerate in the new year and rates are going to go higher again, then that’s not going to be good news for the sector. But again there, I think there are reasons to believe that we are reaching that inflection point. Inflection points normally create opportunities and, as you say, we can talk to that.
I think the other piece we’ve just got to be really conscious of is the top line, the rental income, and the rental income growth that our sector can generate. I think what’s interesting for us is, despite the very disappointing performance of listed REITs over the last 24 months, it’s not been an income story. It’s not been an operational issue. It’s been all around, what’s the right yield in an environment of higher rates, not, do I trust this rental income stream? So actually we’ve seen earnings growth from the REIT sector over the last 12 and 24 months.
So, looking to next year, clearly I think we are seeing a normalisation in economies. We are seeing a slowing in many economies around the world and that is going to create issues in some sectors of the real estate market around that ability to continue to grow your rental income stream. So something we are very focused on as a team is finding those sectors, finding those companies where we believe we can continue to see rental income, earnings, and dividend growth, even in a potentially slowing economy.
Bullock: And just in response, then, you mentioned listed REITs. I know that’s where you focus on. We don’t want to spend a huge amount of time talking about the listed space versus the private space, but investors out there and a lot of the investors I work with do have private real estate exposures as well. Do you see a distinction looking forward about the return potential of listed REITs versus the private real estate market?
Barnard: Yes, very much. We on the listed side are priced every day by stock markets around the world, so 250 times a year or whatever it may be. We are priced based on investors’ view of the future and the uncertainties that are existing in investors’ minds at that moment in time. That is very different from a private real estate fund valuation where valuations are going to be conducted periodically, be it monthly, quarterly, semi-annually.
And they will be based on valuers’ backward-looking view as to what has happened in the direct property market over that preceding period. So what it means is that the listed REITs in which we invest react first to changing circumstance. We saw that last year. The REIT sector began selling off and underperforming really in March-April 2022, around six to nine months before valuers in the direct and private fund world were starting to mark down values.
But the good news for us on the public side is, the same will happen in reverse. So the REIT sector will typically bottom six to nine months before the direct property market finds its inflection point. If you believe, as we do, that that inflection point in terms of underlying values is likely to be in the middle of next year, then it tells you that now is an interesting time to be looking at a sector that has already reacted to higher rates and, in our view, has overreacted to higher rates. So there’s a valuation opportunity.
But then I think what’s really important for any investor in property today is to look beneath the hood of what they’re investing in. Property is not equal across different geographies, across different cities, across different buildings within the same city, and certainly not across different property types. So we wrote a piece several months just highlighting that we think the listed REIT sector is in an incredibly strong position in terms of the types and quality of real estate that we get exposure to.
So less exposure to those more challenged sectors, the US office market, traditional shopping malls, that are facing structural headwinds and more exposure to those areas where we believe there are long-term drivers of demand that will lead to sustained rental growth. So think of tech real estate, cell towers, data centres. Think about affordable family housing. Think about the industrial and logistics market.
There is a third point as well, Matt, which is just balance sheets. So I said earlier we think it’s an environment of risk and opportunity, of winners and losers. We feel really good about the access and cost of capital particularly on the debt side of the listed REITs.
They de-levered in the good times. So they’ve entered a more challenging period with historically strong balance sheets and we think are going to start to deploy some of that balance sheet strength to acquire high-quality real estate from people that need liquidity and need capital. That’s going to be hugely accretive to us as investors over the long term.
Bullock: So I do want to go a bit further into some of those subclasses that you mentioned before because if I look at a number of studies that we do on the team, we look at market sentiment and try to work out, when is the best time to start moving into different areas, different asset classes?
What we find is, especially a sector a bit like property that is very unloved, is probably the nicest way to put it, right now – sometimes they can be the right entry point, but there’s going to be winners and losers with a very big distinction between those two. So I just want to break those two pieces out, the winners and the losers. Maybe if we start with the losers, what are the areas within property that are going to be or you think are going to be the losers in the years ahead and why?
Barnard: I think some of the more traditional property sectors are facing longer-term challenges from changes in the way that we all live, the way that we work, the way that we’re consuming goods and services. So over the last five to seven years, we’ve really seen significant structural pressure on retail and, in particular, larger fashion-led shopping malls as the growth of e-commerce has clearly taken a lot of the consumer spend and retailers are investing more in their online than their physical store presence.
Now, clearly there’s going to be a balance. The best malls are going to continue to exist. They’re going to continue to provide a service and an offer to customers that they can’t get online, but that is clearly an area where there have and will continue to be some headwinds, in our view. The office sector, as I said, is clearly again facing challenges from the shift to more working from home.
We think that reduces overall demand for office space, but again, within that office market, what we’re seeing is 80% of the incremental demand today is going towards 15% of the best-in-class, A-grade sustainable buildings in the right locations in the right cities. So, again, even in the office market, we are seeing areas where rents are growing alongside areas where there is almost no price that will attract new tenants.
So some of those traditional sectors are clearly facing headwinds. The winners, as I said, at a sector level, we are very focused on larger structural themes. So the growth of digitisation, as I say, driving demand for data centres, that’s been an area that has done incredibly well this year. It probably exceeded our expectations on the back of the NVIDIA AI boom. So that’s an area where we’ve seen very strong share price performance over the course of 2023.
Then, as I say, areas that we’ve spoken about in the past, industrial and logistics. Trends are normalising after the COVID boom, but we do expect to see a continued reacceleration of those rents over time.
Bullock: And those observations you’ve made about the winners and the losers… Does the country depend?
Barnard: Yes, it does. So again we can talk at a very high level here, but the reality is, things are very granular in the property sector. “Location, location, location,” as they say. So within cities, there are going to be areas where there is a lack of available space, where rents are going to be growing faster than other parts. Across the world, clearly there are different trends. So the level of vacancy in US offices is north of 20%. In the centre of Paris, grade-A vacancies are less than 2%.
So, again, different markets; there are going to be different dynamics. Even from a macro and yield perspective, Japan’s been one of the strongest areas of the global real estate market this year as the central bank is just marching to a very different beat there from other parts of the world.
Bullock: And one of the winning side, the positive side. You mentioned about sustainability and I just wanted to spend a little bit more time on that because a lot of our listeners will be very conscious about the impact of sustainability and carbon reduction. Property has a big part to play in that.
Barnard: I think if you look at the physical footprint of the real estate market around the world, it’s responsible for 30% to 40% of global carbon emissions. So it is clearly an area where there is going to have to be an investment and improvement in the sustainability credentials of buildings to help work towards the net-zero ambitions that many countries and indeed companies and tenants of buildings have.
So we are certainly seeing a continued improvement in the companies in which we invest in terms of the level of disclosure that they’re giving us around their sustainability credentials, in terms of working towards again [alignment with] the Paris Agreement and verifying that with a third-party (ESG data) provider.
So, generally, again, we feel pretty good on the listed side that the companies, being public, either by carrot or by stick are moving in the right direction of improving their disclosure but, more importantly, improving the underlying environmental credentials of their buildings. That is going to be crucial to attract the best tenants, to get the best rents, and to maximise value for shareholders.
Bullock: Does geopolitics figure into your decision-making as well as we’re starting to see some governments roll back their carbon emissions targets.
Barnard: Yes. Look. I think, especially with the global footprint that we have, what ESG means in different geographies is clearly different. I think, as I say, there’s a bit of carrot and stick. The carrot is, it’s the right thing to do and you’re going to maximise your underlying returns from the real estate. The stick is top-down government pressures. There’s a balance between the two in different regions around the world, but I think the direction of travel is pretty clear in most of our markets.
Bullock: And I mentioned earlier on that I was going to get you to pull out the crystal ball and talk about 2024 and beyond. We’re almost out of time, but I wouldn’t mind spending the next few minutes or so just hearing your views on 2024. What does it hold for property? Why are you excited? What should we be looking out for?
Barnard: I think as investors, we try to look for inflection points. So we’re looking at that rate of change, that second derivative. Where is it improving? Where is it accelerating? Where is it decelerating? I think as we think about the macro backdrop, and again, we don’t profess to be macro experts, but it’s pretty clear to us that the rate narrative is shifting.
Now, maybe there’s one more hike. Maybe there’s two more hikes. Maybe there’s no more hikes in the US. Let’s wait and see, but the heavy lifting has been done. In markets like Europe, again, you could argue that we’re likely there. Now, with that inflection point, we think there is going to become opportunities for investors to think about, where are we going to be in 12 months’ time?
Are we going to be in an environment where there’s much less talk about inflationary pressures, where we’re already in an environment where rates are starting to be cut? Which asset classes are going to work in that environment that perhaps have not worked in the last 12 to 24 months? We certainly think that real estate and listed (public) real estate in particular is going to see a shift in sentiment as that rate narrative shifts and as we take away that headwind of rising rates from central banks.
Clearly there aren’t going to be winners across every part of the market and every single company, we’re quite excited about that prospect of the macro narrative shifting and finding companies that we think can give us dependable earnings growth even in the slowing economy, which perhaps starts to look more attractive versus other parts of the equity market.
Then we spent a bit of time talking about this winners-and-losers construct. We have seen in the US REIT market, a volume of debt issuance year to date that is 30% above the long-term average. It’s more expensive than it was, but they’re continuing to access debt at a time when others are going to face challenges. Now, again, that is going to create some quite exciting opportunities for our companies to do things differently, to expand their portfolios, to harness opportunities from others.
So, again, it’s not going to be plain sailing. I’m sure it’s going to be volatile, as it has been over the last 12 to 18 months. But I do think that we are entering a backdrop that is going to be much more suited towards the performance of listed real estate versus other parts of the equity market.
Bullock: Great. Well, thank you, Guy. Unfortunately we’re out of time, but I wanted to thank you very much for all your thoughts, but also thank you to the audience for listening. So if you wish to learn anything more about Janus Henderson’s investment views or if you have any other questions, then please feel free to contact your client relationship manager or visit our website. So, with that, thank you very much for joining and goodbye.
Balance sheet: a financial statement that summarises a company’s assets, liabilities and shareholders’ equity at a particular point in time, used to gauge the financial health of a company.
Bond yield: the level of income on a security expressed as a percentage rate. For a bond, this is calculated as the coupon payment divided by the current bond price. There is an inverse relationship between bond yields and bond prices. Lower bond yields mean higher bond prices, and vice versa.
Cash flow: the net balance of cash that moved in and out of a company. Positive cash flow shows more money is moving in than out, while negative cash flow means more money is moving out than into the company.
De-lever (deleveraging): reducing the amount of debt that a REIT, or other investment vehicle or company, carries.
De-rating: the downward adjustment of a company’s financial ratios, such as the price-to-earnings (P/E) ratio, in response to business or market uncertainty.
FTSE EPRA Nareit Developed Index tracks the performance of real estate companies and real estate investment trusts (REITs) from developed market countries.
Net zero: a state in which greenhouse gases, such as Carbon Dioxide (C02) that contribute to global warming, going into the atmosphere are balanced by their removal out of the atmosphere.
Paris Agreement: an international treaty on climate change, also referred to as the Paris Accords or the Paris Climate Accords. The Paris Agreement entered into force in 2016.
Top line: the sales or revenues of a company that represent the total income generated during a particular period.
Volatile/volatility: the rate and extent at which the price of a portfolio, security or index, moves up and down.
REITs or 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.
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.