The fund benchmark, the FTSE EPRA/ NAREIT Developed Rental Net Total Return Index, recorded a net total USD return of -12.78% for the month of September. The best performing listed real estate market was Hong Kong, which recorded a total USD return of -7.67% for the month. The UK recorded the lowest total USD return of -20.93% for the month. Year-to-date (YTD), the fund benchmark has recorded a net total USD return of -31.20%. The best performing listed real estate market has been Singapore, with a YTD return of -15.17%, while Europe (ex UK) has the lowest YTD return of -49.75%.
As we close out the third quarter of 2022, it is worth pausing to reflect on what has been a year of firsts for many of us alive today. We are (hopefully) exiting a significant global pandemic; there is a major European war on the go; we are experiencing significant and broad-based inflation pressures and structurally higher interest rates across the globe. In the UK alone, we have seen the British Pound test parity with the US Dollar, and witnessed a new king ascend to the throne. For many of us, these are all first-time events. To say that we are in unchartered territories, would be an understatement. To make matters worse, when looking ahead, the range of possible economic and geopolitical outcomes are so broad, that it becomes even more challenging to make well-informed investment decisions. Anyone currently pounding the table with a single-view outlook, is likely somewhere between naïve and deranged. So, while no one can predict the future with certainty, it is worth unpacking the variables that may drive future returns. If we can identify what the risks are and where they may lie, then perhaps investors can start to make informed capital allocation decisions in this very testing market.
When trying to solve a complex problem, it is often useful to simplify, or even over-simplify it – distilling the problem down to its basics. If we assess stocks through the lens of a simple P/E (Price/Earnings) multiple, it implies that any movement in share price is as a result of a change in either one or two variables: either the earnings have changed (the E), and/or the price which people are prepared to pay for those same earnings (the P) has changed. When we look at global markets, all major risk asset classes have sold off significantly year to date. As of 30 September 2022, global listed real estate was down -31%[1]; global equities -25%[2] and global bonds -21%[3] YTD. Despite this prodigious sell-off, we currently see the global listed real estate universe as roughly fairly valued.
The market is always forward looking, so arguably some of this drawdown is from events which have occurred, and some from what the market expects to occur. As we believe most investors are asking themselves “whereto from here?” about all asset classes, we thought it might be useful to assess the global listed real estate universe through this simplified P/E lens, to try and identify the risks to the sector at this point in time.
Let us begin by looking at earnings. We have previously discussed in this forum the impact that rising rates and inflation have on global listed real estate. Simplistically, rising rates do impact earnings, but not as materially or as quickly as perceived. Global listed real estate stocks generally have long dated debt, which is swapped out for a fixed rate. Therefore, it is only when companies issue new debt, and/or when their existing facilities expire and need to be refinanced, that the earnings impact of higher rates is felt. This has reduced our companies’ earnings estimates, but nowhere near the quantum of the selloff in the share prices year-to-date. It is also worth reminding the reader that when we build up our unique required rate of return (hurdle rate) for each stock under our coverage, we spend a significant amount of time scoring each company’s balance sheet. We look at not only the level of debt, but also the sources, duration, type, etc. For stocks that do not score well on these metrics, we require a higher hurdle rate to compensate us for the additional balance sheet risk being taken on. This naturally skews our portfolio away from stocks with higher leverage, and short duration debt, i.e., the type of stocks that are currently facing more significant headwinds to earnings on the back of rising rates.
Looking forward, we are comfortable with our earnings forecasts for the sector. We discussed in our Q1 2022 Dashboard that numerous sectors within our global listed real estate universe have strong secular demand drivers behind them. We believe these drivers should sustain landlords’ pricing power in those sectors, even if general economic growth were to temporarily stall. It is also worth pointing out that global listed real estate likely has a different risk profile today than it did in the depths of the Covid-19 pandemic. One of real estate’s key benefits are the long lease lengths, which contractually regulate rental income. During the depths of Covid-19, one could have argued that there was potential for mass tenant default across the globe as entire economies were shut down, and that the value of a lease agreement would be somewhat diminished if you were to see mass corporate bankruptcies occur simultaneously across the globe. Today, even with a tenuous economic outlook, we would argue that the risk of broad-based corporate bankruptcies across the globe are less than they were in the depths of the pandemic. Therefore, some benefit can be ascribed to the contractual nature of real estate landlords’ income streams, particularly those operating in sectors with strong fundamentals. In summary, we are relatively comfortable with the defensiveness of the earnings profile of the global listed real estate sector. We believe that market participants may be overlooking this defensiveness of earnings, particularly when comparing to other general equity sectors.
We realise, at this point in time, that many investors are trying to make relative capital allocation decisions between different asset classes. As the reader will well know, we are solely listed real estate specialists, which makes us ill-equipped to give an informed opinion on other asset classes like general equities or even bonds. However, for the sake of illustration, it is interesting to make a few observations by assessing market data per Bloomberg. If we look at the S&P500, and we take a closer look at 2nd quarter earnings for the current year, broken out by GICS (Global Industry Classification Standard) sector, we notice that the real estate sector had the lowest percentage of negative earnings surprises. While this is not a full representation of our global listed real estate universe, it is the simplest and most objective way for us to compare US real estate versus other US sectors in the general equity market.
Source: Bloomberg
Furthermore, if we look at Bloomberg consensus blended 12 months forward earnings estimates, indexed to the start of 2022, it is interesting to note that within the GICS sectors of the S&P500, real estate’s consensus earnings trajectory (pink line) has been second only to the energy sector.
Source: Bloomberg
Again, we acknowledge that there are limitations to this comparison, but we think it is worth noting. So, to conclude this point, perhaps there is merit in our assertion that on a relative basis, global listed real estate earnings are potentially more defensive than currently appreciated by the market.
Let us now turn to the ratings or price part (the P in P/E) of the equation. It is our view that a large part of the selloff has been due to a significant derating, on the back of higher bond yields. This derating would be impactful to all risk assets as, simplistically, cashflows are now being discounted back at higher rates. The view is further supported by the higher correlation of global listed real estate to global equities and to global bonds over the past year, versus its long-term history.
Source: Bloomberg as at 30 September 2022
While it would be difficult to have a high conviction view on whether we see a de/re-rate in the markets in the near term, we would like to make two observations. Firstly, one could argue that any further derating (if bond yields were to move out further from here) would be impactful to all risk assets, as we have seen year-to-date. Secondly, one would think that on balance, even if we were to see bonds move out even further from here, we have (likely) endured the biggest movements already. It is difficult to fathom that in August of last year, US 10 Year Treasuries were sub 1.2%.
To conclude, without having a high conviction view on the rating variable (the P in P/E), and assuming all risk assets would be similarly exposed, one would likely look to earnings to be the key differentiator in the total shareholder return equation. As discussed, we believe that the earnings defensiveness of global listed real estate relative to other sectors, may be under appreciated by the market, and should warrant some consideration at the current time. However, as illustrated in the opening paragraph, there is an enormous divergence between the various global listed real estate geographies, sectors, and stocks. As such, this is an asset class where astute active management is essential.
[1] FTSE EPRA/NAREIT Developed Rental Net TRI
[2] MSCI World Index
[3] Citi World Global Bond Index (WGBI) All Maturities USD
