The best performing sectors globally for the year in USD were Storage (77.62%), Single Family Housing (53.49%), Industrial (46.38%), Manufactured Housing (40.95%) and Strip Retail (40.82%). The worst performing sectors were developers (-1.93%), offices (9.94%), Hotels (10.64%) Diversified (14.70%) and Health Care (14.90%).
As we start a new year, we take this opportunity to discuss the year that has passed, where we currently stand and the outlook for the real estate asset class.
It is no secret that navigating through a global pandemic has been a herculean task on a global scale. Individuals and businesses have been stress-tested in ways and forms that were perhaps previously inconceivable. The beginning of the pandemic was characterised by panic and fear of the ensuing unknowns, followed by the devastating loss of lives and livelihoods, disruption to global economies and spiking volatility across global asset markets.
The onset of Covid and its rapid spread elicited government-mandated responses worldwide, enforced as restrictions to movement and human interaction. These temporary measures to prevent the spread of the virus, save lives and protect livelihoods, will have permanent effects on society. While acutely aware of the destructive force of Covid, it has positively brought about a much needed ‘reality check,’ providing a rare opportunity to introspect, reflect, re-evaluate, and re-prioritise our ways of living. Indeed, 2021 was a year of adaptation. For many the way in which we will live, work, and interact in the future will be different from what we once were accustomed to. The real estate sector as an expression of this evolution, as a landlord to the economy and its changing needs, will likewise adapt.
From an asset class perspective, it proved to be a rebound year for the real estate sector. Overall, listed real estate companies enjoyed significant appreciation in their share prices driven by a stronger and faster economic recovery than initially anticipated, helping most companies achieve financial results that met or exceeded market expectations. The macro environment was one of significant liquidity in capital markets, historically low interest rates and a resultant search for yielding assets, as well as growing concerns over inflation.
Listed real estate was well positioned to benefit from this macro-economic backdrop, having fixed income and equity attributes, and offering a total return profile comprised of both dividend income and capital appreciation. The income component being underpinned by long-term contractual tenant leases with contractual rental escalations, provides a reasonable degree of certainty and visibility to companies’ earnings and cashflows. The income yield continues to meaningfully exceed that offered by fixed income alternatives, while providing inflation protection through contractual rental escalations of in-place leases as well as reversionary potential towards market rents for expiring leases.
The capital appreciation return component is realised through share price increases as public market investors ascribe value to a combination of factors not limited to, the income streams and their expected growth, underlying property portfolios, management teams as well as systematic and other company-specific risks. While public and private market pricing often differ in the short term, and mispricing may occur, over the long-term listed and direct real estate performance is highly correlated as the tangible underpin of physical real estate is a common thread. As land prices and construction costs have increased, so to have the replacement costs of existing real estate, which in turn increases the value of property held in listed real estate vehicles and consequently the value of listed shares. This variety of factors, over the long-term, has enabled real estate to be an effective inflation hedge.
Another important facet having contributed to property price appreciation has been the influx of capital into the sector. Private equity and institutional behemoths have taken advantage of their low costs of capital and aggressively pursued real estate acquisitions in the private market, in cases at eye-watering prices. Overall, all these factors have created significant appreciation in real estate values. However, the range between sub-sectors that are experiencing favourable fundamentals and structural tailwinds, compared to their counterparts that continue to encounter more challenging prospects, is evidently wide and warrants caution. Specialised, active investment management is imperative when allocating across the variety of nuanced sub-sectors comprising the real estate sector.
As we look ahead, underlying demand and supply fundamentals in general remain supportive. Additionally, a confluence of persistently low bond rates, a shift in view of inflation from one that is transitory to more meaningfully entrenched, and deeply liquid debt markets at exceptionally low financing rates have created both the need and means for market participants- most notably these private equity and institutional firms- to raise an abundance of capital for deployment into real estate assets. In fact, a record amount of capital was raised and invested into real estate in 2021, while as at the end of the year a record amount of capital is earmarked for future real estate investment. This bodes well as support for asset values in 2022 and beyond.
At this juncture, it is important to note that caution is warranted when forming expectations about the future. The currently supportive macro-economic environment does have its risks and is prone to change stemming from potential new Covid variants and associated disruptions to the economy, changes to monetary and fiscal policy, supply chain bottlenecks, inflation and the ever present ‘unknowns.’
When investing on behalf of our clients we recognise the need to diversify investment exposure as good risk management. As listed real estate investment specialists we similarly appreciate the merits of specialisation and the additional value it enables one to create. Fortunately, the opportunity set globally is vast and as it currently stands, we have approximately 20 sub-sectors under coverage within our investable real estate universe, spread across multiple geographies in global developed markets. Many of these companies are specialised by location or through focused operations in their specific niches. Some of these include cell towers, data centres, industrial logistics, laboratories, single family rentals and self-storage in addition to traditional sectors such as offices, hotels, and retail.
This optionality enables us to construct a portfolio comprised of shares in specialised companies while simultaneously creating portfolio diversification across geography and sub-sector. The fact that investors can invest in this portfolio on a fractionalised basis (shares representing proportionate ownership in the underlying companies are held in the portfolio) is a key advantage over private real estate investment where the capital requirement to replicate this would be impossible for most people. It also further provides greater liquidity and price discovery as shares trade daily on stock exchanges, as opposed to private real estate valuations that often only occur annually, over which time changes in property values can be a sudden, rude awakening for unsuspecting investors. All of this is achievable without the frictional costs all too synonymous with direct real estate investment.
As previously mentioned, on the whole fundamentals remain healthy with continued robust demand for real estate and benign levels of supply. However, as has become increasingly evident over the past few years, averages and aggregates can be misleading. The various sub-sectors exist in unique environments with their own specific sets of fundamentals and nuances. Certain sub-sectors are experiencing secular growth from structural tailwinds that remain intact, whilst others continue to encounter structural headwinds that will pose persistent challenges long-term. Let us now explore some of the behavioural shifts that have been observed and discuss the implications for the various real estate sub-sectors.
Necessity is the Mother of Invention
It is difficult to imagine how humanity would have navigated the Covid-19 pandemic without far more dire consequences had technology not advanced to where it is today. Economies have globalised and integrated with technology. Lockdowns globally have necessitated a change to the way we live, work, and interact and technology has facilitated this.
The internet and proliferation of smart devices continues to exponentially grow our data consumption requirements. Thinking of our day-to-day lives, a significant portion of our time is spent either communicating through voice calling, text messaging and/or email, conducting business meetings online through platforms such as Zoom or Microsoft Teams, relying on software and applications to provide and render services online, and so on. In our downtime most people browse the internet, shop online, consume social media content, or make use of downloading or streaming services to watch their favourite series or movies.
There is a constant information flow where data is stored on computer servers, accessed, and exchanged between parties. These servers are housed in data centres. When we use our smart devices outside of Wi-Fi range, they connect with signal propagated from cell towers, which are connected to data centres by underground fibre. Data centres and towers form the backbone infrastructure supporting the digitization of the global economy.
Data centre landlords have enjoyed phenomenal demand growth from tenants who entrust them with the secure storage of their data and uninterrupted and seamless access to it when needed. Today, more than half of data centre deployments remain in-house, either in company server rooms or owned data centres. This data storage function continues to migrate to specialist data centre providers, as companies identify a need for cyber security, unfettered access to information at all times, as well as the downsizing of their office space requirements as more businesses implement hybrid work models that allow flexible work from home/anywhere (WFH/WFA) solutions.
Unfortunately, while the enormous wave of demand is unquestionable, a surge in data centre development and higher input costs have been the equilibrating factors suppressing pricing power and lowering development yields. For this reason, our outlook is preferential for retail-centric data centres with highly dense and interconnected tenant ecosystems as these networks are extremely difficult to replicate. In contrast, wholesale data centres appeal to a more limited tenant base that is dominated by large cloud providers such as Google, Amazon and Microsoft whose primary requirements are bulk power and storage space; requirements that are commodity in nature. A large wholesale data centre is often occupied by one or two tenants, meaning that there are limited network effects, if any. As such, these facilities have lower barriers to supply and should provide lower rent growth long-term.
The tower sector enjoys a more favourable supply/demand construct than data centres. There are three incumbent listed tower REITs (landlords) in the US, and a comparable number of dominant carriers (major tenants). The latter have begun a multi-year build out of their fifth generation (5G) wireless networks, aimed at increasing network coverage and speed that will support mass scale adoption of progressively more data intensive applications. Some use cases include virtual reality, augmented reality, autonomous driving, and the Internet of Things, all of which require extremely low latency in processing data.
These carriers locate their telecommunication equipment on steel tower structures owned by tower landlords. The nature of network expansion means that new supply is commissioned in response to a demand requirement, which is not conducive to an environment of speculative supply that would outstrip demand. Long-term this is a positive for the sector, however consolidation among carriers, such as that following the T-Mobile/Sprint merger, initially results in decommissioning of existing towers on overlapping footprints as networks are reconfigured. Therefore, while the long-term outlook for towers remains constructive, short-term headwinds from site decommissioning exist.
In another display of how technology is becoming more integrated, American Tower (ticker: AMT) who are the world’s largest owner and operator of tower assets, acquired US focused data centre REIT Coresite (ticker: COR) as the year closed. This represents a meaningful foray into exploring how the convergence of towers, data centres and fibre may foster technological innovation to expand influence and population reach worldwide.
Offic(e)ally A New Normal
Global lockdowns and technology have unlocked new opportunities in the way we work, live, and interact. Stay-at-home orders resulted in the largest ever mass work from home (WFH) experiment in history. Despite the occasional ‘hiccups’ that most would have experienced adapting to a home-work environment, in general we can now say it was more productive and successful than anticipated. Work flexibility is gaining greater traction in industries where employees are proving that they can work from anywhere (WFA) effectively.
Post-pandemic, a hybrid work model will be more prevalent. Employees will most likely WFH two to three days a week, and commute into the offices for meetings and collaboration. Lenience and flexibility in work policies will differ across companies and sectors, with certain industries like finance and technology lending themselves to greater flexibility. Overall, this trend should lower the requirement for office space long-term, but the impact will differ by the location and quality of assets. As office days will increasingly be set aside for meetings and collaboration, high-quality office space that is modern, spacious, amenity-rich, environmentally friendly, and which boasts high wellbeing scores, will remain relevant.
Likewise, purpose-built offices catering to the needs of the life science sector continue to perform well. Laboratory space is a niche sub-sector, where tenants are engaged in the research of disease and health conditions as well as the development of cures and preventative measures to address them. With approximately ten thousand known diseases in the world today, research and development (R&D) remains a key priority brought into sharper focus by the novel Covid-19 virus and its variants.
Location is paramount to attract and retain talent from leading global universities, as well as source funding from established healthcare systems, non-profit organisations, and venture capital firms, which is highly abundant today and continues to expand. Given that R&D takes place under strictly controlled lab environments, lab space landlords are insulated from the shift to WFH/WFA. We expect the key life science clusters of Cambridge (in Boston) and San Francisco to continue to flourish, while others will emerge. The entry of healthcare REITs and other new competitors into the life science sector, as well as office conversions to lab space, warrant monitoring as they pose risks to elevated supply. However, given the specialised nature of the asset class and a need to partner with long-standing established landlords, our outlook currently remains favourable for lab space specialists.
Sunnier Days Ahead
As individuals look ahead to a more promising future, they are placing emphasis on quality of life and embracing flexibility and a healthier work-life balance to achieve this. For some this may mean moving to more affordable, spacious suburban homes in urban peripheries outside of core central business districts (CBDs) and commuting into office for meetings and collaboration. This supports our view that gateway cities will remain relevant as hubs for business and socialising. However, there is a noticeable trend of population movement out of gateway markets like San Francisco and New York City to the Sunbelt markets in the southeast of the US, which is expected to be an incremental headwind for gateway markets.
Sunbelt markets such as Austin, Charlotte, Atlanta, and Raleigh are benefiting from inward migration as people seek higher quality of living standards at a lower cost. This has driven attractive positive rental growth for sunbelt apartments over the past year, while gateway market apartment rental growth has in cases been meaningfully negative, in part due to these markets bearing the brunt of lockdown measures. For this same reason, the recovery in gateway apartment rents has gained momentum more quickly as restrictions have eased.
Much of the appeal of sunbelt markets stems from their more favourable climates, family friendly orientation and overall lower costs of living. For many moving from gateway cities it is more cost effective to live in a standalone home that allows for separate work, eating, sleeping and outdoor areas, as opposed to in a two-bedroom gateway city apartment where these areas are seldom separate. For those looking to relocate to start a family this offering holds more appeal.
The single-family rental (SFR) sector is a real estate sector that was borne out of the global financial crisis (GFC) of 2007-2008, where institutional companies opportunistically bought standalone houses from distressed sellers at cheap pricing. Many of these houses are in the suburbs of sunbelt states and rent levels are ideally priced to benefit from a demographic trend of changing life stages, where individuals are relocating from gateway apartments to suburban homes. The scars from the GFC remain, meaning that those looking for homes have a higher propensity to rent. Furthermore, single-family REITs possess an enormous opportunity set to consolidate a highly fragmented market where only a low-single digit percentage of homes are under institutional ownership.
Having scale though the ownership of thousands of homes, a superior technology platform as well as internalised property management functions, are major advantages over private peers who typically own less than a handful of homes. Given the inherent difficulties in developing and delivering a disruptive number of standalone new homes in such a deep market, the REITs enjoy limited new competitive supply and can retain pricing power. Our outlook for the sector is constructive and fundamental strength should persist.
Clicks Vs Bricks
Industrial warehouse demand continues to remain at exceptionally high levels. The pandemic accelerated the structural shift from in-store retail shopping to online shopping. The growth in e-commerce penetration that was expected over a few years was compressed into a few months, and tenants were ill-equipped to handle this increased demand from consumers, exacerbated by disruption to global supply chains. As such, users of industrial logistics space have been reconfiguring supply chains to be more resilient and efficient. Tenants are transitioning from ‘just-in-time’ to ‘just-in-case’ inventory management models, holding higher levels of inventory to ensure that stock can be sourced and delivered to customers without delay as they focus on shorter delivery times. Additionally, tenants are looking to spread and expand their footprints by having more warehouse locations.
This has not gone unnoticed. Industrial asset values continue to rise with landlords enjoying unprecedented levels of market rent growth. Past periods of robust demand have usually brought on a supply response that inevitably suppresses high levels of market rent growth. However, new supply, while expected to rise over time, is limited currently by challenging and lengthy entitlement processes and a lack of suitable land plots. Additionally, supply chain bottlenecks continue to delay the sourcing of both construction materials and labour, further limiting new development activity. Those fortunate enough to possess land banks and a development capability are delivering new projects, where profit margins greater than 50% are becoming commonplace globally. Therefore, well-positioned companies within the sector are poised to generate significant growth in earnings both organically, as well as through external development activity. Strength in industrial fundamentals should persist for at least the next few years barring any unforeseen macro-environment shocks.
While e-commerce growth has been a boon to the industrial sector over the past few years, physical bricks-and-mortar retail has grappled with a declining share of retail sales as they are increasingly channelled online. Mall landlords have been subjected to an onslaught of falling in-store retail sales, tenant bankruptcies, rent and incentive pressures, all of which were amplified by the Covid lockdown restrictions to movement.
The gradual easing of lockdown restrictions over 2021 brought a reprieve to the mall sector, as an economy re-opening beneficiary. With significant pent-up demand, consumers were eager to leave their homes, socialise and experience in-person shopping once more. Retail sales accelerated meaningfully, recovering faster than expected, and allowing vacant space to be backfilled. Given that international tourism remains below normalised levels, there may yet be some further growth in foot traffic and retail sales into the new year.
As we look ahead, the potential for recurring lockdown restrictions in lieu of further Covid variants remains a downside risk. Growth in e-commerce will moderate from recent years, however the trend remains intact and structural in nature, and should continue to appropriate retail sales from malls. We expect that amenity-rich, grade A malls that provide a differentiated shopping experience, will remain relevant and will perform decently long-term. However, malls lower down the quality spectrum that have no unique appeal will remain challenged and at risk of closure.
The year that has passed has been truly transitionary in nature. From the onset of the pandemic until now, society at large has experienced fear, loss, hardship and now relief and hope as vaccines are distributed, economies are re-opening and a return to normalcy is in sight. We have been forced to adapt by living more isolated lives with a greater reliance on technology to enable new ways of living, working, and interacting. This has had a profound impact on the economy and the wide variety of real estate sub-sectors that serve its needs. All considered, the broader real estate sector is well positioned to align with the new normal that lies ahead. Listed real estate remains an ideal vehicle to partake in this evolution.
Sector Valuation
Relative to fixed income, the real estate sector screens as attractively priced on expected total return spreads, while fairly valued relative to equities. The estimated forward FAD (Funds Available for Distribution) yield for the sector is 3.88%. Based on our earnings estimates and market break-even inflation expectations, we expect the listed real estate sector to deliver approximately a 5% USD real return for buy and hold investors over the medium term. Within the real estate universe, more attractively priced opportunities exist in specific sub-sectors and stocks, providing opportunities for astute active managers to generate additional returns.
