Virtus Global Real Estate Securities Fund
3Q 2016 COMMENTARY
MARKET — Global real estate equities produced positive returns for the third quarter, although mounting concerns surrounding global central bank monetary policy and the potential for a Fed rate hike later this year led the asset class to lag broader global and U.S. equities.
PERFORMANCE —The Fund underperformed the global real estate benchmark in the quarter. Country allocation made positive contributions to performance, led by overweight exposure to the strong-performing regions of Finland and Norway, however, security selection proved a larger detractor, in particular overweight positions in two U.S.-based data center REITs.
OUTLOOK — We believe the global real estate space market cycle has room for further growth, as we expect demand to exceed supply across most property sectors and major cities. In addition, with the recent establishment of real estate as a standalone sector in the MSCI and S&P Dow Jones Global Industry Classification System (GICS®), we would expect the visibility of listed real estate to increase, particularly among generalist equity investors, and this may lead to higher allocations to the sector than historically has been the case.
The third quarter started off with a bounce in both global equities and bonds following the U.K.’s surprise Brexit vote in late June to leave the European Union (EU) and the ensuing market sell-off. As markets digested the vote outcome, the U.S. 10-year Treasury bond yield peaked intra-day on July 6.Two days later, a strong U.S. payroll report for June came in well above expectations. In the next week, months before a new U.K. prime minister was expected following the resignation of David Cameron, Theresa May was appointed to the position. It became apparent that Article 50, a two-year negotiating process for the U.K. to leave the EU, would not be engaged anytime soon.
In response, the markets exhibited an increased appetite for risk and a desire to source it with what had been the outperforming more defensive areas. This led to some outperformance in lower quality and cyclical equities, including in listed global real estate. As examples in the U.S., an increased appetite for risk was sourced from more defensive industry sectors like utilities, consumer staples, and ultimately real estate, which had thus far been outperforming on the year. Conversely, financial shares, which had been year-to-date underperformers, began to outperform on a relative basis.
Another tone shift also became more evident during the quarter and came courtesy of major global central banks. Based on the rhetoric leading up to their respective September policy meetings and the meetings themselves, the Bank of Japan, European Central Bank, and FOMC to varying degrees seemed to be questioning the efficacy of current monetary policy to achieve their medium-term inflation goals. More than ever, the central banks appear to be indicating that it will be difficult to achieve their inflation goals without an assist from fiscal policy and structural economic reforms.
Additionally, there seems to be a greater recognition of some of the negative consequences of current monetary policy, particularly on the banking sector. Although no coordinated message has been announced, based on recent comments and policy actions it appears that all three major global central banks would like to see steeper yield curves. Not surprisingly, the yield curves in each respective market did steepen over the course of the third quarter. Moreover, while the FOMC did not raise rates at its September meeting, they did provide fairly clear guidance that the case for a rate increase was growing. As a result, the probability of a rate increase at the December FOMC meeting increased significantly.
GLOBAL REAL ESTATE MARKET REVIEW
Given the change in tone in the markets during the quarter to a more risk-on environment and the shift in interest rate expectations, particularly post early July, we would expect global real estate shares to lag broader global equities and they did. While the performance of global real estate equities was positive during the quarter, they underperformed global equities, as demonstrated by the 0.2% increase in the FTSE EPRA NAREIT Developed Rental Index versus the 4.9% increase in the MSCI World Index (both in U.S. dollars). Global real estate equities also trailed U.S. equities during the quarter, as represented by the 3.9% rise in the S&P 500® Index during the quarter.
Currencies – The movement of the U.S. dollar during the quarter was rather benign and a small tailwind for international real estate equity returns in U.S. dollars, given its 0.7% depreciation as measured by the U.S. Dollar Spot Index. Two notable currency moves to highlight would be the nearly 3% appreciation of the U.S. dollar relative to the U.K. pound and the 6% increase in the U.S. dollar relative to the Mexican peso, which has in recent months become highly correlated to the movement in presidential candidate Donald Trump’s poll numbers. As we go to print, the pound has continued to weaken and the peso has lifted.
Top 5 Countries – Within the FTSE EPRA NAREIT Developed Rental Index, the countries with the strongest total returns in the quarter (in U.S. dollars) were Norway, Finland, Austria, Hong Kong, and France. While Norway has a small representation in the benchmark with only two listed companies, they continued their winning ways, elevating Norway to the best performer on the year as well. The Norwegian economy and commercial real estate market have benefited from the improvement in the price of oil and the fiscal stimulus provided by the government. Additionally, the performance of one of the listed companies continues to benefit from a creeping takeover of the company by one of the wealthiest individuals in Norway. Hong Kong was one of the top performers for the second consecutive quarter as its real estate shares benefited from the growing exchange linkages with mainland China and the flow of capital into the Hong Kong equity market.
Bottom 5 Countries – Italy, Canada, Australia, Switzerland, and the U.S. were the weakest performers in the quarter. Italian real estate shares came under pressure, not because of underlying property fundamentals, but because of growing concerns regarding the solvency of the Italian banking system. While initial steps have been taken to shore up capital at some of the banks, markets have yet to be convinced that enough has been done at this point. Also weighing on Italian markets was uncertainty regarding the outcome of a referendum on economic reforms that is to be voted on during the fourth quarter which could cause political turmoil depending on the results. Canada and Australia gave back some of their gains during the quarter, though remain outperformers on a year-to-date basis, as their markets digested the shifting interest rate environment.
Observations from Our Travels – During the quarter, we visited several U.S. cities as well as the U.K. and France, where we attended the European Public Real Estate Association’s annual conference in Paris. From our time in London it was difficult to detect negative ramifications from the fallout of the Brexit vote. On the contrary, the anecdotal observations were positive as it related to tourist activity and retail spend, both of which have benefited from the dramatic fall in the U.K. pound since the June vote. However, based on the limited amount of commercial real estate transaction activity that occurred during the quarter, we know there has been a small negative impact to real estate values, particularly city-oriented offices, and that rental levels have softened a bit. Moreover, tenants are seeking shorter-lease terms and termination options to protect against future uncertainty.
On the other hand, Central Paris offices are currently the highlight of the French commercial real estate market, demonstrating strong occupier demand and modestly growing rental levels with limited new supply. While there was no evidence of a Brexit-related benefit yet, that could be an incremental demand driver in the future. However, Paris would have to compete with the likes of Frankfurt, Dublin, and New York for some of the possible relocations from London depending on how the future Brexit negotiations shake out. As a whole, new development would be needed in any of the European cities to accommodate a significant move, were it to occur, from London.
The Fund underperformed its benchmark, the FTSE EPRA NAREIT Developed Rental Index, during the quarter. Although country allocation made positive contributions to performance, security selection proved a larger detractor.
What Helped Performance
Based on country allocation and security selection combined, the biggest positive contributors to the Fund’s performance were exposures to the real estate markets of Finland, Germany, and Norway.
Country Allocation – The Fund’s overweight exposures to Finland and Norway were the most positive drivers of performance. Finnish real estate shares reversed their negative performance from the prior quarter and may have been a beneficiary of capital reallocation following the Brexit vote. The Norwegian economy and commercial real estate market have benefited from the improvement in the price of oil this year and the fiscal stimulus provided by the government. Additionally, as discussed, performance of one of the listed companies continues to benefit from a creeping takeover of the company by one of the wealthiest individuals in Norway.
Security Selection – The Fund’s overweight exposure to a U.S. office REIT with a West Coast geographic concentration was the largest positive contributor. The company’s shares performed well following positive second quarter earnings results and positive employment market reports during the quarter. The next most positive contributor to security selection was our lack of exposure to a large-cap U.S. shopping center REIT. The performance of the shares lagged its peers and the benchmark during the quarter following a reduction in its full-year earnings outlook due to corporate and debt restructuring charges.
What Hurt Performance
Looking at country allocation and security selection in combination, the top detractors were the real estate markets of the U.S., Japan, Hong Kong, and Sweden.
Country Allocation – Detractors from performance were small and no more than a few basis points. Modest underweight exposures to Sweden, Singapore, and Hong Kong were detractors on their outperformance in the benchmark.
Security Selection – Overweight exposures to two U.S.-based data center REITs were the largest negative contributors to security selection. Data centers lagged after demonstrating strong performance through the first half of the year and into the start of the third quarter, as they became one of the sources of funds for an increased risk-on appetite following strong payrolls and the U.K.’s new prime minister announcement. In addition, one of these holdings experienced lumpiness in leasing, and the market was reluctant to give it credit that the leasing pace had improved in the quarter; while the other announced its CEO was going to retire. Data centers continue to experience positive demand driven by the robust growth in IT infrastructure outsourcing and the rapid adoption of cloud computing.
From our perspective, the global real estate space market cycle still has room for further growth, as we expect overall space market demand to exceed supply across most property sectors and major cities. The private real estate asset market varies by property type and location, but is further along in the cycle in terms of valuations. However, we believe the global weight of capital looking for a home in high-quality, core real estate is meaningful enough to continue to support current real estate asset pricing. The year-to-date decline in interest rates is also supportive of current asset valuations. Nonetheless, we believe additional price appreciation will likely be driven largely by cash flow growth, as opposed to continued compression of capitalization rates. Given the significant number of overseas buyers and private real estate equity capital that has been raised but unspent, we expect M&A activity to continue for the balance of this year and into 2017.
In aggregate, we view a backdrop of low, but positive U.S. economic growth and manageable new real estate supply as positive fundamental tailwinds for U.S. REITs going forward. Should U.S. economic growth continue to improve, this would facilitate further increases in real estate operating cash flows and dividends through higher property occupancies and, in cases where occupancy has reached equilibrium, higher rents. In effect, higher rents represent pricing power, a hard-to-find attribute in today’s investment climate. Combined with the supportive tailwind to real estate asset pricing, our base case remains for another positive total return year for U.S. real estate securities in 2016.
Following the August 31 market close, real estate became the eleventh sector of the S&P Dow Jones Indices and MSCI’s Global Industry Classification System (GICS) – the first sector added since the classification system was created in 1999. Importantly, we believe this decision reflects the views of industry participants that real estate is a separate asset class with distinct investment characteristics, particularly relative to other financial companies. We believe there are some potential positive implications that investors should consider. First, we would expect the visibility of listed real estate, particularly among generalist equity investors, to increase from where it stands today. Second, the increased visibility of real estate as a standalone sector may lead to higher allocations to real estate by generalist investors than historically has been the case.