- A shift in the interest rate environment during the second quarter, particularly post the U.K.’s June 23 “Brexit” vote to leave the European Union, ignited a rally in yield-oriented equities, including global real estate equities, which went on to outperform the broader global equity market for the quarter.
- The Fund outperformed the global REIT benchmark in the quarter, with positive security selection behind all of the outperformance. Overweight positions in a mid-cap industrial REIT and a U.S. data center REIT made the most significant contributions to performance.
- Going forward, we expect a backdrop of low, but positive global economic growth and manageable new real estate supply, combined with favorable real estate asset pricing trends, will be positive tailwinds for global real estate securities in 2016. In addition, the fact that real estate will become a standalone Global Industry Classification Standard (GICS) sector in September is also a positive development for the asset class.
Following the significant choppiness of the first quarter, the second quarter was relatively benign from an equity markets’ perspective, but by no means was it a quiet quarter. U.S. equity markets, as measured by the S&P 500® Index, rose 2.5% and oil prices carried forward the positive momentum from the middle of the first quarter to gain 26.1% during the quarter. However, the relative calm that was experienced for most of the quarter began to shift in early June.
When the advanced estimate of first quarter U.S. GDP growth was released in late April, many market participants shrugged off the disappointingly low growth rate of 0.5%, given similar weakness experienced in the first quarter of the last two years. Moreover, there was an expectation that the number would subsequently be revised higher. This was ultimately the case as the final estimate of first quarter GDP was revised up to 1.1%. More concerning to the markets was the May employment report released in early June, which registered an anemic 11,000 jobs (revised lower from an initial 38,000 estimate) — the lowest monthly job creation in nearly six years. The weakness of this report led the Fed to keep policy rates steady at its June meeting and dramatically lowered the markets’ expectations for future interest rate increases over the balance of 2016.
However the real surprise for the quarter was the shocking result delivered by voters in the U.K. on June 23 to leave the European Union. Despite polls indicating that the result would be close, very few observers actually believed that the “Leave” camp would carry the day. In the days following the vote, volatility in the global equity and currency markets spiked dramatically, with the U.K. pound falling 11.1% in the first two days post the results. The U.K political situation also became more uncertain as Prime Minister Cameron announced his resignation and the race to succeed him began. The ultimate implications of Brexit on the U.K. and the broader European Union remain very uncertain at the moment and it will likely take months, if not years, to gain greater clarity. In the meantime, it is fair to say that U.K. risk premiums have clearly increased.
As it relates to the U.S., most observers expect limited impact to the U.S. economy from the Brexit vote. The most immediate impact was to interest rates, with 10-year Treasury yields falling by nearly 30 basis points post the vote to the end of June. The markets’ expectations for future Fed rate increases were also further diminished. Additionally, the decline in rates ignited a further rally in yield-oriented equities, such as utilities and REITs, which outperformed broader equities into the end of the quarter.
GLOBAL REAL ESTATE MARKET REVIEW
Given the shift in the interest rate environment during the second quarter, particularly post the Brexit vote, we would expect global real estate shares to perform well relative to broader equities and they did. The performance of global real estate equities was positive during the quarter, outperforming global equities, as demonstrated by the 4.2% increase in the FTSE EPRA NAREIT Developed Rental Index versus the 1.0% rise in the MSCI World Index, both expressed in U.S. dollar terms. Global real estate equities also nicely led U.S equities during the quarter, as represented by the 2.5% rise in the S&P 500 Index during the quarter.
The movement of the U.S. dollar during the quarter was a small headwind for international real estate equity returns in U.S. dollar terms, given its 1.6% appreciation, as measured by the U.S. Dollar Spot Index. While the headline index showed slight appreciation for the quarter, as is typical, the underlying currency relationships showed a greater degree of volatility. Specifically, the Brexit vote provided further momentum to two trends that were already firmly in place, with the Japanese yen further appreciating by 9.1% and the British pound further depreciating by 7.3% during the quarter.
Within the FTSE EPRA NAREIT Developed Rental Index, the top-performing countries during the quarter on a total return basis measured in U.S. dollars, included Hong Kong, Canada, New Zealand, Japan, and the United States. Hong Kong was a weaker performer in the first quarter due to the broader concerns surrounding mainland China as well as weaker local real estate fundamentals. However, receding China fears and very solid earnings results from the largest Hong Kong index constituent powered the gains delivered by the country in the second quarter. Japan’s return was completely driven by the increase in the Japanese yen relative to the U.S. dollar as the country delivered a negative return on a local basis. Falling interest rates, particularly post the Brexit vote, helped propel the returns for the other top countries during the quarter as investors continued to chase yield-oriented investments.
The five bottom-performing countries in the Index during the quarter were the U.K., Austria, Italy, Spain, and the Netherlands. Following the Brexit vote, real estate shares in the U.K were pummeled alongside the declines in the British pound as investors concluded that real estate would be one of the larger losers of the vote to “Leave.” The concerns are most focused on financial services companies and how their access to the European Union might change in a post Brexit world. If U.K.-based financial services companies have more restricted access to the European Union in the future, this may necessitate moving jobs from cities like London to other European cities, which would imply less demand for London office space in the future — a clear negative. In the meantime, given the high degree of uncertainty surrounding issues like this, companies will likely at a minimum be more cautious regarding their U.K. real estate decisions.
As is typical, our travels during the quarter brought us to many different cities and countries. Early in the quarter we visited several cities across Norway, Denmark, and Sweden. Sweden has been a standout economic performer in recent years as its export industries have benefited from a weaker currency and local consumption has benefited from the wealth effect of rising house prices. Stockholm in particular has been rather robust and this is evident within the commercial real estate sector as well as demonstrated by falling vacancy rates and rising rents across retail, office, and industrial property. On the other end of the spectrum, we also visited the Asia Pacific region, spending time in Singapore, Hong Kong, and mainland China. China’s slowing economic growth rate has clearly had a negative impact on the region and combined with select oversupply of commercial real estate in some markets, has made for more challenging real estate fundamentals.
During the quarter, the Fund outperformed the benchmark FTSE EPRA NAREIT Developed Rental Index, 4.73% (Class A NAV) versus 4.21%. Positive security selection drove all of the quarter’s outperformance as country allocation detracted from performance.
What Helped Performance
From a country allocation perspective, the Fund’s overweight exposure to Germany and slight underweight of the Netherlands were the most positive drivers of performance. Germany as a whole delivered positive performance, which was roughly in line with the benchmark. German apartment real estate companies however, continue to be well bid as investors remain attracted to the stable growth profiles these companies offer in an overall low yield environment. The Netherlands was one of the weaker performing countries during the quarter, delivering a negative return.
At the security level, the Fund’s overweight exposure to a mid-cap industrial REIT was the largest positive contributor. The company’s performance has been positively impacted by the healthy industrial trends mentioned above and its prudent capital allocation track record. The next most positive security driver was the Fund’s overweight exposure to a mid-cap U.S. data center REIT with significant exposure to the Los Angeles, San Francisco, and Northern Virginia data center markets. The performance of this company is being driven by the strong growth in IT infrastructure outsourcing and the rapid adoption of cloud computing.
What Hurt Performance
From a country allocation viewpoint, the Fund's overweight exposure to the U.K. was the largest detractor from performance. However the negative allocation impact was eliminated by positive security selection, which drove an overall relative positive total contribution from the U.K for the quarter. The U.K. delivered the worst country performance during the quarter, driven by the falloff in U.K. REIT shares and the drop in the British pound following the surprising vote to “Leave” the European Union. Our overweight exposure to Finland was the second largest detractor from a country perspective, and negative security selection added to the negative country impact.
At the security level, the Fund’s overweight exposure to a large-cap U.S. apartment REIT with exposures concentrated on the West Coast was the largest negative contributor to security selection for the quarter. Despite delivering best-in-class same-store net operating income growth during the first quarter, negative sentiment towards one of its key markets weighed on the shares’ performance. The second largest security level detractor during the quarter was our overweight exposure to a small-cap lodging REIT with coastal-oriented geographic exposures. U.S. lodging REITs performed poorly in the quarter given growing concerns on the economic environment, and this negative sentiment was supported when this lodging REIT lowered its forecasts for second quarter earnings. However, the company also executed some timely sales of hotel assets during the quarter at favorable pricing, which highlighted the current disconnect between private real estate market values and the public market pricing of lodging REIT share prices.
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. With 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, if not accelerate, during 2016.
In aggregate, we view a backdrop of low, but positive global economic growth and manageable new real estate supply as fundamental tailwinds for global real estate securities going forward. Should global 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 global real estate securities in 2016.
In addition to our positive fundamental outlook, we believe a forthcoming event later this summer is worth highlighting. Back in November 2014, S&P Dow Jones Indices and MSCI Inc. announced that following their annual review of the Global Industry Classification System (GICS) structure, it was decided that a new real estate sector would be created, elevating real estate from its current position under the financials sector and bringing the number of GICS sectors to 11. The implementation of this decision is expected to occur after the market close on August 31, and represents the first time an additional sector has been added to the GICS structure 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.
While it is too soon to know the ultimate impact this decision will have on the global listed real estate industry, 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.