Building solid foundations (Archived)
Todd Briddell, CenterSquare
The out-of-fashion areas within the direct property market that bring value hold the most attractive and interesting opportunities for the year ahead, while the popular primary markets are poised to disappoint investors. Meanwhile listed real-estate securities, such as REITs, should continue to experience uplift in valuations. Although it may seem counterintuitive, rising interest rates could, in fact, be a boon for listed real-estate securities.
On the physical side of property investments, commercial real-estate investors have focused much attention on core assets in primary markets since the global financial crisis. They have sought those properties with the most secure cash-flows and that offer a store of value during uncertain times. As a result, this wave of investment has driven up capital values. Although core real estate continues to produce stable yields, the cost basis required to be paid for that yield has grown significantly, relative to other real-estate asset classes.
As interest rates and/or inflation rise from current levels, these stable yields will become significantly less attractive and owners of core properties will have limited options to increase their yields through asset enhancements. This, in turn, creates a very real risk of substantial capital loss in core real estate investments, which exceeds the perceived risk for the asset class.
Meanwhile, opportunities abound for the acquisition of fundamentally sound assets (so-called value added properties) that have been overlooked. This may be because investors have limited appetite for properties they see a challenge or risk. Yet such properties can be bought for less and offer the ability to create or optimise their income streams, thereby providing greater margin and downside protection than purchasing existing current yield in today’s unbalanced market.
For those with the capital and redevelopment expertise value-added assets can be transformed into core quality properties with a reduced risk profile, which a deep pool of investors will line up to buy. As such, we see an opportunity to arbitrage the mispriced perception of risk that currently exists between stabilised core assets and fundamental value-added investments.
We believe a middle market, value-added strategy represents a sweet spot in the current market for value creation and risk reduction.
REITs and rates
The efforts of central banks around the world to boost economic activity have been making headlines and playing a large role in the global markets. Many investors are keenly aware that traditionally, a spike in government bond yields will put downward pressure on real-asset pricing as debt financing becomes more expensive.
However, although sovereign yields have and may continue to increase, it should not necessarily be a cause for concern for REIT shareholders. Between 2004 and 2007, when increases in the Fed funds rate in the US were driven primarily by economic growth, US REITs not only did well in absolute terms but they outperformed the broader equity market during a time when the Fed funds rate rose nearly 500 basis points.
The effect of an increasing Fed funds rate on REITs has everything to do with why rates are being moved, particularly at the short end of the curve.
When rates are increased in response to economic growth, the positive effect on rental growth can offset, and sometimes outweigh, the negative effects of higher interest rates on real asset values. The economic recovery implicit in tapering could push US REITs up in spite of the traditional relationship between interest rates and REIT performance.
In addition, while they have moved higher, interest rates remain low relative to historic levels and still provide accretive refinancing opportunities for REITs whose assets have seen income growth behind healthy fundamentals.
Total return focus
As we look ahead, we expect monetary policy to continue to drive real-estate market returns around the globe. Despite delays in the tapering of US economic stimulus, there is reason to believe an inflection point is near and that tailwinds for global economic growth will provide modest upside. Going forward, we expect central banks will maintain easy monetary policy, keeping interest rates low, inflation down, and catastrophic crises at bay. We believe investors will come to accept a weak to modest growth, low yield environment as the ‘new normal’. In this environment, we are optimistic for future growth but we caution investors to temper their return expectations. As a consequence, we believe the most successful investment strategies will be those with the ability to provide both yield and total return.This is not investment advice. Regulatory Disclosure