Year-to-date (YTD), the fund benchmark recorded a net total USD return of 15.30%. The best performing listed real estate market was the US, which recorded a total USD return of 22.83%. Hong Kong recorded the lowest total USD return of -2.64% year to date.
The best performing sectors globally YTD in USD were Storage (46.35%), Single Family Housing (42.02%), Manufactured Housing (41.35%), Apartments (29.28%), and Strip Retail (28.17%). The worst performing sectors were Towers (-18.91%), Hotels (6.19%), Data Centres (9.14%), Office (11.45%), and Diversified (11.79%).
After delivering strong returns this year, the global listed real estate market was also affected by the general sell off that occurred in bonds and equities in September. Several factors contributed to the risk-off move in markets. Concerns about the ripple effects of a potential collapse of Evergrande, one of the largest property developers in China, hints of tapering from central banks, concerns about the Delta variant infection rates, US government debt ceiling worries, supply chain issues, and several weak economic data releases all contributed to the pullback.
Despite the recent increase in government bond yields, interest rates remain near their historical lows. Investor demand for income producing assets continues to be strong. Accommodative debt markets, in addition to the strong demand, have resulted in rapidly rising prices for most commercial real estate. However, there is a great disparity in performance of property types that are in demand versus property types with less certain outlooks.
As mentioned in our previous quarterly report, the pandemic has for the most part accelerated trends that were already in place. Some of these economic and societal themes include i) the rise of e-commerce, ii) technology’s impact on how and where we work, iii) digitalisation of the economy, and iv) aging populations in developed markets. These themes have had an uneven effect on property sectors, benefitting some at the cost of others.
In the US, data from Green Street’s proprietary Commercial Property Price Index show that private market values of Industrial real estate have increased a staggering 41% compared to pre-pandemic values, closely followed by Self-Storage (up 40%) and Manufactured Housing (up 31%). On the other end of the spectrum, Mall values are 14% lower, followed by Offices, down 6%, and Hotel private market values are down 4%.
Inflation is understandably a topic that is currently on many investors’ minds. We have fielded several questions about real estate’s ability to keep up or act as an inflation hedge. As discussed in our 2Q2021 fund commentary, global REITs have managed to grow their earnings and dividends slightly ahead of inflation over the long term, providing investors attractive real returns.
However, making claims about real estate returns and inflation without considering the fundamentals (i.e., balance between supply and demand) is a fool’s errand. The reality is that property types with favourable supply and demand dynamics can deliver returns far in excess of inflation, whilst property types with structural headwinds could possibly deliver negative returns. The fundamentals trump blanket statements about historic returns and inflation. With this in mind, let’s look at the themes mentioned above and their impact on the fundamentals of various property sectors.
The Rise of E-commerce
According to data from the U.S. Census Bureau e-commerce sales increased a remarkable 57% from 2Q19 to 2Q21, compared to 16% for brick-and-mortar sales over the same period. In 2012 e-commerce accounted for c. 5% of total US retail sales; in 2Q21 this figure has reached 13.3%. At the current rate of growth, it is expected that up to a third of total retail sales could be from online sales by 2030. It is estimated that e-commerce requires approximately three times the warehouse space compared to traditional brick and mortar retail. It is fair to say that demand for well-located logistics warehouses is exceptionally strong and keeps increasing.
Rental growth for industrial properties continues to be strong as supply has not been able to keep up with the strong demand. The location of modern logistic warehouses is of critical importance. Transportation cost is by far the biggest component of total supply chain costs, with rent only a fraction. Cushman & Wakefield estimates that rent is c. 5% of total logistics cost, and transport c. 50%. Being in the right location, near transport channels and closely located to the end user, can mean significant savings in transport cost. This means tenants can afford to pay more for rent to be in the right location and still save on total supply chain costs.
Barriers to supply of new logistic warehouse development include physical availability of land in the right locations, as well as building permit and zoning restrictions. Often land near densely populated areas also have higher and better use as residential or other commercial development, as rents per square foot are higher for the latter. These supply/demand dynamics all point towards continual strong rental growth for logistics warehouses for some time.
On the other hand, retail properties were already under pressure before the pandemic hit, as e-commerce claimed a growing share of total retail sales at the expense of brick-and-mortar sales. Malls were especially hard hit by the lockdowns. Apparel store sales, the most significant tenant category for most malls, are particularly at risk of being cannibalised by online sales. Mall landlords have had to grant rent discounts or waivers to assist tenants through a period of low sales. We have even seen a landlord buy the operating business of a tenant to prevent tenant failure and vacancy. Although, the landlord is adamant that the investment will deliver adequate returns, it blurs the traditional lines between landlord and tenant and investing in real estate and an operating retailer business.
It’s not all doom and gloom in the mall space though. Simon Property Group, the largest mall owner in the US, reported that foot traffic in its malls is almost back to pre-pandemic levels. Additionally, brick-and-mortar sales recovered in 2Q21 as the economy reopened, with apparel and restaurant sales in the US exceeding 2019 levels for the first time since the onset of the pandemic.
Open air shopping centres, like Strip Retail in the US and Retail Parks in Europe, have fared better than Malls. Although foot traffic at these centres was also negatively affected by the pandemic, it was less severe. In the US, Strip Centre foot traffic was c. 4% higher at the end of 2Q21 compared to pre-pandemic levels. Apart from the difference in physical nature between open air shopping centres and enclosed malls, the former contains tenant categories which have experienced stronger retail sales.
Many Strip Retail centres are Grocery anchored and have significant exposure to Sporting Goods & Hobbies and Furniture & Home Furnishing tenants – which have all fared better than most Mall tenants. Retail sales numbers have recovered strongly in these categories, with 2Q21 vs 2Q19 up by 40% for Sporting Goods & Hobbies, 22% up for Furniture & Home Furnishing, and up 16% for Grocery Stores. This has translated into rental growth for Strip Retail landlords who reported positive releasing spreads on new leases in 1Q21 and increasing spreads in 2Q21.
How and Where We Work
The pandemic has forced employers and employees to adapt to more flexible working arrangements. As people have learnt how to work from home (WFH) it seems likely that hybrid work arrangements will become the norm. Many surveys indicate that most employers expect some form of WFH to continue post the pandemic, with some days spent in the office. The office of the future needs to be a place where employees will want to spend time in and collaborate with colleagues.
Office vacancy rates around the globe have increased since the onset of the pandemic, as most leasing activity was put on hold. Many employers have delayed making decisions about future space needs as they wait and see how their organisation adapts to a world where WFH is more prevalent. We don’t expect the office to disappear, but that more emphasis will be placed on the quality, location, tenant wellbeing, and environment impact of the office.
As economies and cities have reopened, and office leasing and sales transactions have started picking up, we have observed a two-tier market developing. Demand, both from tenants and investors, has been strong for modern, well located, energy efficient/green buildings. On the other hand, leasing activity and investor appetite for average quality office have been very low. We expect the aggregate demand for office space in the coming years to be lower than what it would have been pre-pandemic. However, it seems likely that demand for quality modern office space could increase, at the expense of older average offices.
Tenants, investors, and regulators continue to place a growing emphasis on the environmental impact of offices. Newly developed or retrofitted buildings, in the right locations, that meet environmental standards can continue to be in demand. In contrast, older average quality office buildings will require significant capital expenditure to meet the new standards. Often these capital expenditures would not make economic sense, as the increase in rent would not justify the capital spent. This leaves many commodity office buildings at risk of becoming stranded assets, where future rent potential could be materially lower than current rent. We continue to shy away from landlords that own commodity office space and focus on those that own and are adept at creating modern, efficient buildings that meet the latest environmental standards.
With most people working from home for an extended period over the past year and a half, more emphasis has been placed on where we live. The residential sectors have been remarkably resilient during the pandemic, as could be expected from a necessity-based product. A notable exception was coastal Apartments in the US, that experienced negative same-store rental revenue growth as a portion of the populations of cities like New York, Los Angeles, and San Francisco left for cities that were less restrictive in their lockdown measures, mainly in the Sun Belt. A recovery in Apartment fundamentals is underway in these coastal markets as people return to cities. Demand for apartments in the Sun Belt remains strong as a mixture of low living costs, better weather, lower taxes, and business friendly jurisdictions keep drawing populations form the coast to migrate. In general supply of new apartments across the US remains in check, however there are certain pockets like Nashville, Austin, and Raleigh that warrant close monitoring for oversupply.
In the Single-Family Rental sub-sector rental and capital growth have been exceptional, with strong fundamentals pointing to a continuation in these trends. The main demographic category of new single-family home renters, the 35- to 44-year-olds, is forecasted to grow at double the pace of the total population in the US. Robust home price appreciation also means that a greater portion of this age cohort is more likely to rent a new single-family home than purchase one, for affordability reasons. Since the global financial crisis (GFC) in 2008, construction of new homes has lagged the demand, and will take years to catch up. The combination of demographic tailwind, pent up demand, and low supply bodes well for investors in the sub-sector.
Manufactured Housing is another residential sub-sector enjoying favourable fundamentals. Rental levels for Manufactured Housing are significantly lower than that of Single-Family homes. Demand from those priced out of the Single-Family market, or those looking for more space than an apartment, remains strong. In addition, downsizing baby boomers provide an additional demographic tailwind. Supply in this sub-sector is negligible due to the low availability of suitable land for development. Potential development land sites often have higher and better value as hotel or resort developments.
Digitalisation of the Economy
As we spend larger parts of our lives in the digital world, the demand for infrastructure related to the transmission, processing, and storage of data keeps increasing. By 2026 data usage from smartphone users, measured in gigabytes, is expected to be four times as much as today. This strong growth in data demand from wireless carriers directly translates to demand for tower space, as owned and operated by Real Estate Investment Trusts (REITs) like American Tower. Businesses around the globe are also increasingly migrating to the cloud, which is housed in data centres, many of which are owned and operated by REITs like Digital Realty and Equinix.
The growth in data usage and resulting demand for digital real estate infrastructure will hardly surprise anyone. As we’ve mentioned before, the attractiveness of potential real estate investments always depends on the intersection between demand and supply, and a careful consideration of the risks involved. Construction of new data centres has increased materially in recent times, in anticipation of the high demand. This has shifted bargaining power from landlords to tenants in most of the established data centre markets like Northern Virginia, especially for commodity data centres where a strong tenant network does not exist and bulk power and storage requirements are the focus. Most Data Centre REITs have responded to the subdued outlook in organic rental growth by increasingly focusing on external growth through developments in new markets in Europe, Asia-Pacific and Latin America. Although yields on new developments have come down in recent years, they still look attractive compared to yields on stabilised assets.
Aging Populations
It is estimated that US healthcare spending per capita for the above 65-year-old population is roughly three times as much as for the 20- to 65-year-old population. As populations in developed economies age, spending on healthcare is expected to increase. A significant part of this cost is related to care for seniors in Senior Housing facilities – which make up roughly a third of the Health Care sector in the listed REIT universe. The Senior Housing sector was severely affected by the pandemic, as increased mortality, and cessation of new move-ins, drastically reduced the occupancy levels in these operators.
The demand for Senior Housing has not disappeared though, as this is a needs-based service. Move-in rental rates have not materially changed since the onset of the pandemic. Since the introduction of successful Covid vaccines earlier this year, Senior Housing facilities have been accepting new tenants again. Two of the biggest landlords and operators in the US, Ventas and Welltower, both started reporting positive occupancy gains since March. It is expected that net operating income levels will recover to pre-pandemic levels by mid-2023.
The secular demand for Senior Housing from an aging population is no secret. It is forecasted that long term supply of new facilities will roughly match demand, effectively limiting the upside in rental growth that can be achieved over the long term. Despite this, we believe the sector is currently still priced for acceptable risk-adjusted returns over the medium term.
Life Science, or Lab Space, is a niche but rapidly growing sub-sector in the Health Care sector. Life Science properties are essentially specialized offices where biotech and pharmaceutical companies research and develop therapeutical treatments for disease and general health afflictions. The demographic tailwind, as well as the human need to live longer healthier lives, will continue to drive the demand for therapeutics and growth in the life science industry. Global pharmaceutical sales are predicted to grow at an annual rate of c. 7.5% to reach nearly $1.4 trillion by 2026. Advances in technology have also led to new areas of research and treatments like biologics (a product that is produced from living organisms or contain components of living organisms), which have significantly higher sales growth expectations than traditional pharmaceuticals.
Unlike traditional offices, the structural characteristics, as well as the location, of life science properties are of critical importance. Lab Space properties require increased floor load capacity, higher floor-to-ceiling heights, additional interstitial space above ceilings for mechanical systems, specialized below slab plumbing, expanded loading zones, and backup generator space among other things. Nearly all life science research occurs within clusters that are anchored by research institutions, which are usually universities. Access to talent, capital, and regulatory agencies are vital for companies conducting research in these fields. In the US, there are three main clusters namely Boston, the San Francisco Bay Area, and San Diego. The infrastructure ecosystems that have been built up at these locations over decades are extremely difficult to replicate.
The combination of exceptional tenant demand and high barriers to new supply is leading to very strong rental growth in the sector. REITs that own Lab Space properties have been reporting high double digit renewal spreads (difference in rental rates of old leases and new leases signed) for several years, with expectations of this to continue as current market rents keep growing at a strong clip.
Nothing New Under the Sun
Although there are idiosyncratic nuances with the current Evergrande saga, the main cause for a potential collapse is nothing new: excessive leverage. It’s hard to know exactly how much debt and leverage the company has. The well-known use of off-balance sheet financing hides the true extend of leverage. From what is publicly disclosed by the company, it’s safe to say that the debt-to-assets ratio of the company exceeds 80%. This is a staggeringly large debt load for a developer with thin margins, operating in a cyclical and politically sensitive sector: residential development.
The Catalyst Global Real Estate fund has negligible exposure to residential developments in China, or Hong Kong. However, Evergrande shares trade on the Hong Kong stock exchange. The fund has c. 2% exposure to Hong Kong landlords, which have been impacted by the risk-off mood that gripped the market when news of a potential collapse started circulating. We don’t currently expect any significant direct real estate investment implications due to the unfolding story in the markets we invest in. However, the extent to which the Chinese government intervenes and the action it takes, can affect the local and global market sentiment.
We mainly bring up the Evergrande point, to contrast the leverage levels in the global listed real estate universe that the fund invests in. Overall debt levels are very reasonable. The average loan-to-value (LTV) ratio of the global listed real estate companies we cover is c. 30%. There are exceptions, mainly some retail landlords, but these make up a tiny fraction of the investable universe. In addition, debt principal repayments are well staggered, with no great concentration risk in any specific year – which was the main issue in 2008. Most companies have also taken advantage of favourable capital markets to lengthen the term of debt and fix debt costs.
Relative to fixed income the real estate sector screens cheap, with expected total return spreads near all-time highs. The estimated forward FAD (Funds Available for Distribution) yield for the sector is 4.21%. Based on our earnings estimates and market break-even inflation expectations, we expect the global listed real estate sector to deliver approximately an 8.0% return in USD for buy-and-hold investors over the medium term. Within the real estate universe, more attractively priced opportunities exist in specific real estate sectors and stocks, providing opportunities for astute active managers.
