Most investors will probably be relieved that 2022 is in the rear-view mirror. The MSCI World Index was down -17.71% and global bonds, as measured by the Citi World Global Bond Index, returned -18.26% for the year, in one of the worst years on record for the traditional “60/40” equity/bond portfolio. The rise in real yields, from their all-time low levels in 2021, due to aggressive contraction of liquidity from central banks around the world, made for a challenging environment for all risk assets. After years of easy money and ultra-low interest rates, the inflation genie finally reared its head, forcing monetary policy makers to raise interest rates in an effort to combat inflation.

The real estate sector uses a fair amount of debt and was not spared from the effect of rising interest rates. The fund benchmark, the FTSE EPRA/ NAREIT Developed Rental Net Total Return Index, recorded a net total USD return of -26.51% for 2022. The best performing listed real estate market for the year was Hong Kong, which recorded a total USD return of -5.03%. Europe (ex-UK) recorded the lowest total USD return of -42.06% for the year.

* FTSE EPRA/ NAREIT Developed Rental Net Total Return Index

Europe (ex-UK)’s underperformance was impacted by the presence of companies with weaker balance sheets and lower starting valuation cap rates. The German Residential sector was particularly weak (-56% in USD) as balance sheet concerns and rent regulation, that limits the rental increases landlords can achieve, weighed on investors. The Nordic countries also delivered significant negative returns. Sweden and Norway do not have REIT legislation. Therefore, companies are incentivised to employ larger amounts of debt compared to their global peers, as they enjoy a tax shield benefit of interest rate deductibility. In addition, it is customary for Nordic real estate companies in the private and listed sector to use higher proportions of short term and floating debt. Compared to the rest of the world the Nordic real estate sector came out of the Global Financial Crises (GFC) relatively unscathed. Management teams have been complacent to the risk of leverage in our view, which has been one of the main reasons that we have been underweight the region for several years. In 2022 the chickens came home to roost.

The United Kingdom’s performance was significantly impacted by political, and resultant fiscal implications, combined with significant inflation from higher energy cost and the weaker pound. In addition, the Industrial sector makes up a significant portion of the UK weighting. Industrial has been one of the weaker sectors in Europe (including the UK). 2022 was a year where growth stocks generally underperformed as higher discount rates penalised duration and future earnings growth. The Asia Pacific region performed best, making up for its significant underperformance in 2021. Over a three-year period, the average return of the Asia Pacific countries is roughly equal to the average of the rest of the world (c. -14%).

*All returns are benchmark weighted average for the FTSE EPRA/ NAREIT Developed Rental Net Total Return Index, except the Developers and Towers sectors, which are not represented in the benchmark and calculated on a market cap weighted basis.

On a property subsector level, Gaming Net Lease (a niche subsector only available in the US) was the only real estate sector that delivered positive returns for the year.

Real estate returns are largely a function of supply, demand, and credit. Overall, the supply and demand fundamentals for global real estate is on a decent footing. The returns in 2022 were predominantly driven by the credit component. We are reminded of the quote “In investing, most of the time macro doesn’t matter, but when it does, it’s almost all that matters”. In his recently released memo titled “Sea Change”, investing legend Howard Marks states “In my 53 years in the investment world, I’ve seen economic cycles, manias and panics, bubbles, and crashes, but I remember only two real sea changes. I think we may be in the midst of a third one today”. The sea change Mr Marks refers to is the end of the last 40-year bull market in bonds, where interest rates were on an ever-decreasing path to the bottom they finally reached in 2021. Marks believes “inflation and interest rates are likely to remain the dominant considerations influencing the investment environment for the next several years.” He ends his memo with “If you grant that the environment is, and may continue to be, very different from what it was over the last 13 years (post GFC) – and most of the last 40 years – it should follow that the investment strategies that worked best over those periods may not be the ones that outperform in the years ahead”.

No longer will it be possible for investors to get the 10% plus p.a. returns they have become accustomed to by merely buying shares in companies that refinance debt at ever lower rates and use cheap capital for external growth and dividends or buybacks. No longer will it be possible to look like a rock star by buying index funds and passive investment vehicles that kept on marching higher due to expansion of money supply, where FOMO (fear of missing out) was the prevalent emotion among investors. This might sound pessimistic but is in fact good news for bargain hunters and investors willing to do the work to find superior risk adjusted returns. Just when value was declared dead by the financial media it came back with a vengeance (“value” stocks in the S&P 500 outperformed “growth” stocks by c. 20% in 2022). Just when active investing was declared dead by the Bogleheads, we believe that in the new investment environment we find ourselves in today, active investing strategies will be more important than ever.

For companies to deliver reasonable returns for their shareholders they will have to 1) be profitable 2) have reasonable balance sheets and 3) have management teams that will make astute capital allocation decisions. The tailwinds of declining rates, cheap capital, and passive flows from monetary stimulus will no longer be sufficient to keep companies afloat that do not deliver value to society. We believe allocating capital to the best risk adjusted return prospects will be crucial. At Catalyst Fund Managers we accomplish this through our robust bottom-up research process which focuses on free cash flows, balance sheet quality, and company management capabilities.

2022 might already be consigned to the history books, but public companies are still to report their earnings results for the year. Consensus estimated earnings growth for the S&P 500 is 5.1% according to Factset. Earnings growth estimate for the Real Estate sector is 15.1% according to the same data set. Only the Energy (151.7%) and Industrial (27.4%) sectors have higher earnings growth than Real Estate. On the other end of the spectrum, Financials (-16.2%) and Communication Services (-14.7%) are expected to report the lowest year-over-year earnings growth (or declines, to be accurate).

Looking forward to 2023, consensus analyst expectations for general equity earnings growth were reduced during 4Q22, with some being outright bearish. For example, the equity strategy team from Morgan Stanley expects year-over-year EPS growth for the S&P 500 to come in at -11% for 2023. In contrast, we see listed real estate in the US delivering c. 6.5% FAD (Funds Available for Distribution) growth in 2023 and c. 5.9% for our global listed real estate investment universe. FAD is synonymous to Free Cash Flow after Capex requirements to maintain property portfolio quality and is a widely used measure of real estate company earnings.

Due to the nature of the contractual lease agreements, usually with built-in escalations (either fixed or inflation linked), we have reasonably high visibility to future revenue and earnings from listed real estate companies. We believe listed real estate companies could stand out in 2023, and beyond, based on their earnings stability and growth.

Rising construction costs from increasing labour and material prices should act as a limit on future supply of real estate. Supply growth has in general not been a concern this cycle. The sectors that have seen the most supply (Industrial and Data Centres) have also experienced solid demand and low vacancies. Higher construction and finance costs will therefore also dampen the external growth opportunities for most real estate companies, and we expect a lower contribution to earnings growth from development for the sector. However, companies with superior cost of capital, for example in the Net Lease sector, might find attractive buying opportunities in the current environment.

The consensus view seems to be that most of the world’s developed economies will go into recession in 2023, if not already in a recession. As landlords to the economy, it would be impossible for demand for real estate to not be affected in a weak economic environment. As we have stated before in our quarterly commentary, different real estate sectors have different economic drivers and perform differently during various parts of the economic cycle.

For example, overall demand for office space will surely contract further if we experience a significant economic and earnings recession. In the Residential sectors we expect demand for rental housing (Apartments, Single Family Housing, Manufactured Housing) to increase as the rise in rates makes home purchases even more unaffordable. 30-year fixed mortgage rates in the US started 2022 at around 3% and ended the year at around 6.5%. When using the median US house price ($ 430k) this translates to a nearly 50% increase in the monthly mortgage repayment (from $1,800 pm to $2,700 pm).

The Industrial sector has experienced exceptionally strong demand over the past several years, predominantly driven by the growth of e-commerce. In a weaker economic environment, we would naturally expect demand for logistics warehouse space to soften. However, e-commerce is not the only demand driver. A reconfiguration of many supply chains and more on-shoring of manufacturing continues to drive demand for modern well located Industrial properties. Industrial landlords are still achieving significant mark-to-market adjustments on new lease singings and will continue to deliver strong earnings growth well beyond 2023.

Ageing demographics leads to significant growth in the 80-plus-year-old population and robust demand for Senior Housing. As Senior Housing is a needs-based product, demand for it is lowly correlated to general economic conditions in the short term. The sector experienced significant occupancy declines during the pandemic, however it has been on a steady path to recovery since the bottom in 2021. Increases in the room rates per day, combined with occupancy recovery, is driving strong earnings growth in the sector. Net Operating Income (NOI) from the two largest landlords, Welltower and Ventas, is expected to grow north of 25% in 2023 and still be in double-digit territory for the following two years.

With a few exceptions, listed real estate balance sheets are generally in good shape. Companies have done a good job of taking advantage of the favourable market conditions of the past several years to lock in low rates and extend and smooth debt maturity profiles. Absolute leverage on a debt to gross asset value basis (LTV) is currently just under 30% for our investment universe. The rise in rates unquestionably has a negative effect on earnings as companies refinance at higher rates. However, the impact is smoothed over many years as expiry profiles are well staggered with very few companies having any significant refinancing in any specific year. We do however foresee some difficulty for some companies, mainly in Europe where leverage is higher and the relative move out in finance cost has been the most significant. The German Residential sector, as we mentioned above, as well as certain Retail landlords specifically has some tough decisions to make to strengthen their balance sheet, in a market that is not easy to sell into.

At the end of 2022 we saw several of the largest non-traded REITs and private real estate funds in the world (Blackstone, BlackRock, M&G) suspend or limit redemptions. We have repeatedly stated over the years that the liquidity mismatch between the underlying real estate and redemptions make these vehicles unattractive for long term real estate investors. All is well in a rising market while funds are flowing in. However, when monthly redemption requests become significant, the underlying assets can’t be sold quick enough to raise the necessary cash to meet redemption requests. It takes months to market and sell properties in normal market conditions. In a market similar to the one we are currently experiencing, where there is very little transaction activity, it can take a lot longer to sell, and prices might need to be dropped significantly to achieve sales. In the meantime, the investor is waiting for the cash requested and might need to take a significant loss by the time the original redemption request is fulfilled.

The allure of these private vehicles is that they deliver the investor less volatile real estate returns (when compared to the listed market). But it comes at a cost, and usually at a time when the investor can least afford it (A quick Google search of “Taleb’s Turkey Problem” might be illuminating). Whilst the listed real estate market is more volatile, it is the price you pay for liquidity. In the listed space one can liquidate your investment almost instantly and with high certainty around the price. The volatility adds opportunity for active managers to create alpha, by selling overpriced shares and buying undervalued shares. If one has a long-term time horizon for investing (as should be the case when investing in real estate), short term volatility should not matter much, unless you are an emotional investor or a speculator.

Private market real estate valuations have barely budged, whilst the listed universe trades at significant discounts to private market values. Due to the appraisal-based nature of private real estate, valuations typically lag the listed market by 12 to 18 months, whilst the daily pricing and volatility of the listed market typically results in overreactions both on the up and the down. Over the long term, returns from the private and public market, adjusted for asset quality, should be the same given that the underlying investments are the same. For this to be the case, current private valuations will need to come down or public market valuations will need to increase, or a bit of both would need to happen. There is currently a significant arbitrage opportunity for those who can sell in the private market and buy in the public market.

Depending on one’s predilection you might be able to argue both the bull and the bear case for listed real estate.

The bulls might argue that:

• inflation has peaked, and rates are soon to follow;
• that capital markets will re-open and lead to more transactions and M&A returning;
• that listed real estate is defensive vs other sector based on earnings stability and growth;
• that the listed real estate market is very attractive compared to the private market and that capital on the side-lines will return to invest.

The bears might argue that:

• inflation comes in waves (look at what happened in the 70’s), that we are in a structurally higher inflation environment and that interest rates will be higher for longer;
• higher rates lead to lower multiples;
• economic contraction leads to defaults and tough credit market conditions, placing selling pressure on asset owners;
• higher rates lead to yield alternatives making listed real estate less attractive;
• significant private market write-downs limit real estate companies’ ability to address balance sheet issues.

We seem to be on the precipice of the most anticipated recession in history. Those who have been involved in the markets long enough might be wise enough to know that usually when everyone expects one outcome, something else often happens. The path that inflation, interest rates, and monetary policy take will surely impact the returns from all asset classes. The global economy is the most complex dynamic system known to man. Attempting to predict what happens to inflation and interest rates, and investing on this basis, is a fool’s errand and a wild goose chase. At Catalyst Fund Managers we will stick to our process of investing in the best risk-adjusted return opportunities available to us by doing thoughtful, yet humble, supply and demand analysis and estimating risks to the best of our abilities. The estimated forward FAD (Funds Available for Distribution) yield for the sector is 5.40%. We believe the global listed real estate market is currently fairly valued.

We wish our clients, fellow investors, and readers a prosperous 2023.