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Real Estate - Changing mood music

Issue date: 2019-12-10

Despite the recent sell-off due to the rise in bond yields, some REIT sectors are well-placed to benefit from improving economic conditions and higher levels of inflation.

Jon Stewart
Fund Manager, Listed Real Estate 

Real estate investment trusts (REITs) are listed instruments that allow investors to access the traditionally illiquid direct property market at a lower cost. They possess a unique feature in that 90% of their earnings must be paid out in dividends to their shareholders.

 

Bond market headwinds

It is not hard to see why REITs have been a popular asset class during the recent years of low interest rates – few equity sectors can boast the kind of cash flow resilience, underpinned by long-duration lease income, that REITs can offer, while the spread remains attractive compared with government bonds. This makes it unsurprising that the REIT sector has sold off in recent months as an improved outlook for global growth and higher inflation expectations have led to a rise in global bond yields.

However, in our view it is too simplistic to see REITs as mere ‘bond proxies’ – there is a great amount of diversity within the asset class. While some subsectors might struggle in an environment of rising bond yields, others should benefit from higher inflation and stronger economic growth.

 

REITs in a reflationary world

One of the key attractions of REITs is the requirement to pay out the majority of property rental profits in dividends, making them a liquid route to access the high-quality cash flows of direct property markets. However, it is important to recognise that REITs are not fixed income instruments; their lease structure might shelter cash flow from downside risks when times get tough, but it can also capture the upside of economic growth.

Rents are to varying extents a function of the business cycle, determined by the supply of space on the one hand and demand for it on the other. If economic growth improves and inflation picks up then this should be accompanied by rising rents that in turn should drive growth in earnings and dividends. Moreover, in many parts of the world rents are explicitly linked to inflation, further helping to protect real returns.

The degree to which REITs can benefit from reflation will vary by country and sector, as will the valuation impact as growth trajectories change. Consider, for example, US lodging REITs, whose hotel properties are generally more sensitive to short-term economic changes. While they have outperformed strongly since the US presidential election, their valuation discount to the more interest-rate-sensitive net-lease REITs has only partially corrected and remains elevated in a historic context (see Chart 1).

Bond market headwinds

It is not hard to see why REITs have been a popular asset class during the recent years of low interest rates – few equity sectors can boast the kind of cash flow resilience, underpinned by long-duration lease income, that REITs can offer, while the spread remains attractive compared with government bonds. This makes it unsurprising that the REIT sector has sold off in recent months as an improved outlook for global growth and higher inflation expectations have led to a rise in global bond yields.

However, in our view it is too simplistic to see REITs as mere ‘bond proxies’ – there is a great amount of diversity within the asset class. While some subsectors might struggle in an environment of rising bond yields, others should benefit from higher inflation and stronger economic growth.

 

REITs in a reflationary world

One of the key attractions of REITs is the requirement to pay out the majority of property rental profits in dividends, making them a liquid route to access the high-quality cash flows of direct property markets. However, it is important to recognise that REITs are not fixed income instruments; their lease structure might shelter cash flow from downside risks when times get tough, but it can also capture the upside of economic growth.

Rents are to varying extents a function of the business cycle, determined by the supply of space on the one hand and demand for it on the other. If economic growth improves and inflation picks up then this should be accompanied by rising rents that in turn should drive growth in earnings and dividends. Moreover, in many parts of the world rents are explicitly linked to inflation, further helping to protect real returns.

The degree to which REITs can benefit from reflation will vary by country and sector, as will the valuation impact as growth trajectories change. Consider, for example, US lodging REITs, whose hotel properties are generally more sensitive to short-term economic changes. While they have outperformed strongly since the US presidential election, their valuation discount to the more interest-rate-sensitive net-lease REITs has only partially corrected and remains elevated in a historic context (see Chart 1).

 

Managing the transition

The main risk to REIT cash flows in an environment of higher bond yields is that the cost of credit – the single largest cost item for most REITs – increases, dampening the benefit of higher rents. In the long term, this might be inevitable; however, the years of low rates were not wasted on the REIT sector. REITs have greatly reduced the cost of their debt facilities and also pushed out maturities, locking in the benefit of negative real rates for years – and in some cases decades – to come.

This means that any impact of rising rates on cash flows should be gradual. We therefore expect that global REITs will continue to offer an attractive and sustainable dividend yield with strong cash flow backing. Furthermore, a world of stronger economic growth and higher inflation will create opportunities to improve cash flow and dividend growth.

 

Our strategy within global real estate

In the UK, we prefer high-quality, higher-yielding industrial-type assets and resilient, high-quality retail assets that are located in areas with a lack of competition. Elsewhere in Europe, expectations have not changed dramatically following the UK’s EU referendum; core markets are forecast to produce attractive risk-adjusted returns supported by low development and accommodative monetary policy. Meanwhile, recovering markets continue to experience a rebound, generating higher absolute returns. Expectations for continued US economic expansion amid low supply growth should drive sturdy growth in cyclical office markets. ‘Gateway’ office markets continue to attract well-heeled foreign buyers and support pricing. Japan has been at the top of our House View since the second quarter of 2012 and while we continue to see an attractive year ahead for returns in Japan, it will lose its dominant position in Asia. Relatively high property yields in Australia and healthy fundamentals are supporting double-digit returns there.

 

Disclaimer

This material is for informational purposes only and does not constitute an offer to sell, or solicitation of an offer to purchase any security, nor does it constitute investment advice or an endorsement with respect to any investment vehicle.

All information, opinions and estimates in this document are those of Standard Life Investments, and constitute our best judgement as of the date indicated and may be superseded by subsequent market events or other reasons.

Standard Life Investments (Hong Kong) Limited is licensed with and regulated by the Securities and Futures Commission in Hong Kong and is a wholly-owned subsidiary of Standard Life Investments Limited.

Standard Life Investments Limited is registered in Scotland (SC123321) at 1 George Street, Edinburgh EH2 2LL. Standard Life Investments are authorised and regulated by the Financial Conduct Authority.

www.standardlifeinvestments.com

 



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