The recent increase in borrowing costs for real estate investors might negatively impact private market values and lead to a slowing of leveraged privatisations, but Reits still offer better values relative to private market real estate than seen for many years
The past few months have been difficult for the global real estate securities market. The pull-back in Reit prices around the globe is primarily a spill-over from the recent turmoil in the credit markets. Notwithstanding the decline in Reit prices, the fundamentals for commercial real estate remain robust, with favorable supply/demand dynamics. In turn, the financial health of the public Reits has never been better.
Year to date through 16 October, the index has fallen 5.7% in local currency. The UK and Continental Europe have been the two weakest regions, with year-to-date declines of 28% and 11%, respectively.
With the re-pricing of risk for secured and unsecured debt, some investors have become concerned that the increase in borrowing costs for real estate investors will negatively impact private market values. The uncertainty in the credit markets has also cast doubt over the future of privatisation activity, which has been an important performance driver. Much of the privatisation activity over the past two years has been fuelled by access to inexpensive debt. With the widening of spreads and market uncertainty, there is likely to be a pause in privatisation activity by highly leveraged buyers.
With these concerns in the marketplace, fund flows to the real estate securities sector have turned negative. Selling pressure from retail and momentum investors has driven down prices for real estate securities out of proportion to the change in the debt markets, and to a level well below net asset value. This is particularly true for the UK and Continental Europe, which have been the hardest-hit markets year to date.
Notwithstanding these concerns, there is an attractive buying opportunity in many Reit markets around the globe today. At current market prices, Reits offer better values relative to private market real estate than seen for several years.
Reasons for the decline in Reits
At current prices, global real estate securities are trading at a modest discount to net asset value. This is well below the long-term-average pricing for the sector. Globally, real estate securities have traded at an average premium of 8% to net asset value over the long term.
While it is likely that highly leveraged privatisations will slow, there continues to be tremendous demand for private real estate from institutional investors. Low-leverage investors have filled some of the void left by departing highly leveraged investors, and the acquisition market remains competitive. It is also likely that cap rates may increase, which is likely to be modest, but strong revenue growth will tend to reduce the impact of higher cap rates.
It is important to recognise that the decline in Reit prices is not directly related to any change in fundamentals or the financial health of the companies as these remain robust, with favorable supply/demand dynamics.
Commercial real estate companies have benefited from the strength of the global economy, and this trend is expected to continue in most markets. Although a slowdown in the US economy is projected, the US is still expecting strong growth in earnings over the next few years.
Despite underperforming traditional equities and bonds year to date, global real estate stocks have generated competitive returns over the past five, 10 and even 15 years.
From a risk perspective, the sector falls in between bonds and traditional equities, with historical average annual standard deviation of 12%. And because of low-to-moderate correlations relative to traditional bonds and equities, global real estate securities provide significant portfolio-diversification benefits (up to 2% of incremental return while holding risk constant). These investment characteristics combined suggest that long-term investors should hold a 10% strategic allocation to global real estate securities in a mixed-asset portfolio.
With a strong global economy supporting robust property fundamentals in most major markets around the globe, positive revenue growth over the next several years is expected. This top-line growth should help to mitigate the potential impact of an increase in cap rates on net asset values.
With the current disconnect between private and public market values, the return potential of the sector over the next several years is strong. Finally, with strong diversification benefits relative to traditional equities and bonds, investors should look to global real estate securities as a long-term strategic investment for their mixed-asset portfolios.