After a seven-year period of outsized absolute and relative outperformance, global real estate securities continue to offer investors attractive upside potential.
We believe there are three primary reasons for this: a favourable supply/demand outlook, continued access to capital and reasonable valuations. However, in a maturing cycle, we believe active stock selection is critical from here.
Global real estate stocks have performed strongly since the global financial crisis, with the FTSE EPRA/NAREIT Developed Real Estate index returning 18.5 per cent on an annualised basis between 28 February 2009 and 30 June 2016 in US dollar terms, compared to just 13.8 per cent for the MSCI World index.
While there are signs the bull cycle is entering its later stages, we believe it can continue for an extended period, potentially several more years. As we assess where the cycle stands now, we believe it is important not to focus on the mere passage of time, but on the opportunities defined by the three key drivers of real estate performance: demand, supply and financing availability. From this standpoint, conditions appear likely to remain favourable.
Barring any return to economic recession, we expect tenant demand will continue to grow against a backdrop of modest new supply, driving sustained growth in cash flows for the next several years. For landlords, a modest economic recovery has been good enough to generate meaningful gains in occupancies and rents, given limited new property supply. Tighter fundamentals should continue to create pricing power, translating into healthy per-share cash flow and dividend growth – potentially remaining greater than growth for companies in other industries.
We estimate these trends will continue for several years, although with growth rates moderating from above normal levels. In such an environment, we believe monitoring the pace of cash flow growth, compared with consensus estimates, will be critical to identifying attractive opportunities at a sector and company level.
Another positive aspect of real estate is an ample access to capital. The recapitalisations real estate companies undertook at the start of the current cycle fuelled a virtuous circle. Companies raised capital to strengthen balance sheets, enabling debt issuance to refinance at lower rates, which was used to further solidify financials.
Public debt issuance by global real estate companies has been at high levels, reaching nearly $240bn in 2015, compared with an average of $135bn in the previous 10 years, based on UBS estimates. The upturn has been afforded by historically low sovereign bond yields and stronger real estate company balance sheets.
Valuations are also supportive. As with the rest of the equity market, valuations for real estate securities have moved up through the recovery. However, relative to both net asset values and operating cash flows, valuations on listed real estate companies are well within their historical five-year ranges in most cases, and in certain instances – including the UK and Hong Kong – are near the bottom of those ranges. These levels are reasonable considering the strength of the underlying property markets.
Furthermore, at the start of September, real estate was separated from financials and given its own Global Industry Classification Standard (GICS) sector category – significantly raising the profile of this often misunderstood and under-represented asset class.
This change should have a far-reaching impact, as nearly everyone in the investment community uses GICS as a framework for portfolio planning and analysis.
Despite the importance of real estate to the economy, investors have generally shied away from REITs and other real estate stocks. With the new classification, real estate will likely see a significant lift in its profile. The creation of a new real estate sector should shed light on the fact generalist equity investors are significantly underweight real estate, especially in value oriented strategies.
Jon Cheigh is portfolio manager at Cohen & Steers Global Real Estate Securities fund