Real Estate Investment Trusts (REITs) typically focus on paying most of their income in the form of dividends. Given that interest rates are still low and 10-year Treasury yields have continued to fall, it has been a generally positive period for REITs. Japanese REITs performed very well, driven by the Bank of Japan’s negative interest rate policy, while falling interest rates in Australia also supported property stocks there. Conversely, developers have underperformed as investors have been disappointed by the slow pace of shareholder reforms.
Investment opportunities are becoming less country-specific and more stock specific, which plays towards the team’s strength as a global property team.
• North America – preference for companies that are embracing technology rather than viewing it as a threat (such as retailers and datacentres)
• Asia – seeing value in property developers, with valuations close to global financial crisis levels
• Europe – favour Barcelona, Madrid (office), Berlin (residential). In the UK, while the office market is heading towards the end of its cycle, there are opportunities in other sectors such as self-storage.
The team believes risks for the property sector have been more macro-related rather than stock specific. This includes currency risk, which the team tries to reduce by running a relatively neutral country top-down allocation focusing on bottom-up stock selection to drive excess returns. As global economic growth is likely to be lower this year, total returns are likely to be lower too, therefore income which has made up an increasingly large proportion of total returns could become even more important.
For Asian property its stocks have performed pretty well this year. It’s really not been so much about sectors, but it’s really been about what we would call REITSs versus non-REITS. And for Asia it’s about a 50/50 split between the two of those. REITS typically focus on paying most of their income in the form of dividends, and clearly as interest rates have continued to fall and ten-year Treasury yields have continued to fall, this has been a pretty positive backdrop for REITS in general. In Japan, where Japanese REITS have performed very well, this has been driven by negative interest rate policy which was introduced at the beginning of the year, and also in Australia where we have seen interest rates continue fall, again this has underpinned the Australian REIT market.
The developers on the other hand have not performed very well. If we look at Japanese developers and Hong Kong developers, then they’re down anywhere between 5% to 20%, and I think the Japanese developers have underwhelmed to some extent in terms of regulatory reform. So focus on shareholder returns, share buybacks, return on equities. I think that’s something that investors would like to see, but so far this has not come to fruition.
When we think about the sectors and how they have actually performed, then again it has been slightly underwhelming. So if we look at office for example within Hong Kong, where vacancy rates are 1%, within Tokyo, where vacancy rates are slightly higher, then we just have not seen demand translate into rental growth, and I think that that’s something which we have been a little disappointed in.
Within residential, the other main market for us here in Asia, then we have been in decline for some period of time, particularly within Hong Kong but also within Singapore. But I think the positive here is that the regulations that are in place in terms of buyer stamp duty, these things can all be rolled back, and I think as we progress through the cycle then we’re obviously closer to that point in time actually happening, and this will be a very, very strong positive for developers and a possible catalyst for these stocks to re-rate over the coming years.
The opportunities for global property equities are pretty broad based. I think what has changed over the last cycle is really that the opportunities are essentially no longer even within countries, but actually more within cities. So it’s become much more stock specific. It’s become much more granular. And I think that plays toward our strength as a global property team.
The areas that we would see opportunities within the US are in markets which have been impacted by trends around technology. So whilst we look at the US and see it as getting quite late in the cycle, that makes us a bit more concerned about the US office market, when we look towards retail we hear a lot about the threat of online. We hear a lot about the death of retail assets. But I think that that is only partially true. The devil is really in the detail, and if we look at companies whose management teams are much more focused towards embracing technology and view it as complementary rather than competitive, then these are the types of management teams that we want to back.
And therefore we would say that there’s pretty much a bifurcation within the retail market, particularly within the US. So prime assets with good quality management teams, these are the companies that we want to back. If there are other assets out there which are B grade or C grade malls then you simply don’t have to be there, and that’s where we don’t spend a lot of time focusing on.
The flip side of the threat of online is really felt in other sectors within property, particularly within industrial but also within data centres, and these are sectors that we like, not just within the US but also globally. So we look at companies like Prologis, companies like Goodman Group. These are the types of companies that we want to back, not just for the short term but also for the long term as we see these structural trends start to play out, and these are the impacts that we’re seeing within technology, particularly within the global property market.
Within Asia, I think it’s really looking towards the developers. I think that’s something that you’re going to have to be a little bit patient with, but valuations close to 2011 levels, and in some cases close to global financial crisis levels, for us represent huge value opportunities. The issue with these companies as always is one around timing. When will these companies re-rate and what will be the reason for this? And I think that’s where patience is required. But as longer term investors, we’re happy to do that because we back management teams, we look at high quality assets, and we also look at companies which have got their house in order.
So whenever we look at companies, not just within Asia but also globally, we’re looking at companies which have high quality balance sheets, companies which have taken the opportunity to lock in debt at very, very low levels. They’ve also taken the opportunities to increase the duration of their debt. And this gives them fantastic visibility on their earning stream for the future. So there are huge opportunities that continue to exist within global property, across the globe. And finally maybe just touching a little bit upon Europe, again much more city specific than even country specific.
So we like markets like Barcelona, Madrid for their office exposure. Even within Germany we like the German residential story, but really within Berlin. And even within the UK, it’s not all doom and gloom. Whilst the office market is heading towards the end of its cycle, we still see opportunities in certain sectors, for example in self storage and other markets across the UK. The risks as we see it today towards the property equity markets really don’t lie within the property stocks per se. I think the risks are more on a macro level, and clearly the first half of the year has really been dominated by Brexit.
Now clearly we’re much closer to a resolution on this, and hopefully that will provide some calm within the equity markets. But also within the currency markets. Currency this year, and as it has been over the last couple of years actually, have been a big driver of share price performance when you translate back into US dollars. So the Japanese yen for example this year has strengthened by about 15%. So currency is not to be underestimated when taking into consideration investment decisions and ideas, and in terms of how we construct our portfolio we typically try to reduce these currency risks by running a pretty neutral country top down allocation focusing on bottom up stock selection to drive alpha across the fund.
So the risks going into the second half of the year will probably be around the US elections. Clearly we don’t know how this will play out, but clearly that will again add to the volatility that we see across our space. And the one risk that was more prevalent back in 2015 was around China, and in particular around the currency and the renminbi. So far that risk seems to have abated, but clearly whenever people are not talking about certain risks, you always need to be aware of the risks that the people are not talking about, and therefore it’s something that we feel that will come back onto people’s radars sooner rather than later.
I guess the implications from Brexit as they sit today are actually quite difficult to fully work out, because the uncertainty is such that we really won’t know what shape or form Brexit will take for some period of time. We obviously know that the UK has two years to officially leave the EU once Article 50 has been actually sanctioned, but there is a huge amount of uncertainty even around Brexit. But even if we assume it does happen, then I think that the political risk has clearly increased, not just within the UK but within Europe, and probably wider than that. Potentially even to the US elections which happen later in the year.
At the moment markets are relatively sanguine about the implications. Clearly the view that they are taking is that this is a political crisis rather than a financial crisis, certainly at the moment. And from our stand point as real estate investors, what we have observed is that there has been certainly a flight to safety both in terms of currency, so US Dollar and Yen appreciation. But also in terms of Treasury yields. So they have collapsed even further. So UK ten year Treasury yields are now below 1% for the first time ever, and US Treasury yields are now below 1.5%. And this backdrop is generally pretty positive for global property equities.
We think essentially that the reset button has been pushed for our market and we think we’ve probably got another extension in terms of where we think property equities could go to. The other large implication is clearly not just political but also economic. The UK may go into a recession. Either way, whether that happens or not is slightly irrelevant, economic growth will slow, that will obviously slow economic growth within the wider European region, and therefore by default slow world economic growth as well.
And the implications from this are such that, because economic growth is lower, we think that total returns will be lower across the globe as well, and therefore income which has made up an increasingly large proportion of total returns will actually become even more important for the future. So the golden era that we have enjoyed within global property equities for the last 20 years, we think that this will continue for some period of time to come.