Virtus Real Estate Securities Fund
3Q 2016 COMMENTARY
MARKET — U.S. REITs started out in the third quarter strongly positioned, however, performance ebbed amid rising Fed rate concerns. Although REITs posted negative returns for the quarter, lagging the broader U.S. equity market, REITs have produced strong positive returns and outperformed broader U.S. equities year to date.
PERFORMANCE — The Fund underperformed its benchmark during the quarter driven by a combination of allocations to, and stock selection within, the health care, data centers, and self-storage property sectors.
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 on a bounce for both global equities and bonds following the U.K.’s surprise Brexit vote in late June to leave the European Union and the ensuing market sell-off. The lift in equities included listed real estate and continued into August. In the case of U.S. Treasuries, their rally peaked intra-day on July 6, two days before strong payrolls were released for the month of June. On July 11, 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. The markets responded accordingly with 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 the REIT market.
By mid-August, the S&P 500® Index peaked at 2,190, ending the quarter at 2,168, for a return of 3.85%. By comparison, the S&P Utilities Index peaked in early July and returned -5.91% for the quarter. As equities were lifting into August, the opposite could be said for oil. However, an OPEC accord in Algiers became a possibility by quarter-end. As we go to print, the price of oil, as measured by the current contract for West Texas Intermediate crude, has returned to its high of the year, at just under $52 per barrel.
The most significant piece of news late in the quarter was the cluster of hawkish comments relative to interest rates, quantitative easing, and associated asset purchases or curtailment thereof, whether by ECB President Mario Draghi, the Bank of Japan, or the FOMC, along with dovish Fed presidents becoming hawkish. By September 13, the U.S. 10-Year Treasury yield lifted to 1.75% — a level not reached since June 23, the last day of trading before the Brexit vote — and finished the quarter at 1.60%.
U.S. REIT MARKET REVIEW
Performance – REITs, as measured by the FTSE NAREIT Equity REITs Index, peaked on August 1, and ended up posting a -1.43% return for the quarter amid rising interest rate concerns. While the Index lagged the S&P 500 during the quarter, returns remained strong year to date, at 11.75% compared to 7.84% for the S&P 500.
Sector Classification – In September, the widely anticipated breakout of the real estate sector within MSCI and Standard & Poor’s Global Industry Classification Standard (GICs®) became effective — appropriate recognition of real estate as its own asset class.
Fundamentals – REIT second quarter earnings (reported in the third quarter) were solid and reinforced our constructive view on the asset class. The REIT sector, as measured by Evercore ISI, overall posted 4.6% same-store net operating income growth in 2Q16, which was healthy yet a bit of a deceleration from the current cycle high of 5.7% experienced in 1Q16. These results reflect the REIT sector’s current pricing power which has resulted from several years of low supply growth and solid tenant demand.
Top 3 Property Sectors – Industrial, office, and single family homes were the top-performing sectors for the quarter within the FTSE NAREIT Equity REITs Index on a total-return basis. The industrial sector is benefiting from healthy demand for warehouses from companies who compete in the fast growing world of e-commerce. Office sector outperformance commenced with strong June payrolls data and an ensuing increased risk-on appetite. Lodging did the same but faded in September, more than any other sector. Two single family home rental company shares performed well on the back of positive earnings reports, which demonstrated continued growth in occupancies and rents and the well-managed integration of recent company acquisitions by two of the larger public players.
Bottom 3 Property Sectors – Self-storage, specialty, and data centers were the weakest performing sectors in the quarter. Self-storage, which has been one of the best performing sectors over the last five years, underperformed during the quarter on concerns over slowing market rent growth. Same-store net operating income growth slowed to 8.7%, which was still the highest level of any property sector, and over 400 basis points above the average REIT sector, as measured by Evercore ISI. One year ago, 2Q15 same-store net operating income was 9.4%. The specialty sector was adversely impacted by the underperformance of two prison REITs after contract risk loss became a real issue. 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 the larger companies in the space experienced lumpiness in leasing, and the market was reluctant to give it credit as to whether the pace had improved in the third quarter. Another company 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.
During the quarter, the Fund lagged its benchmark, the FTSE NAREIT Equity REITs Index. A combination of security selection and property sector allocation detracted from performance.
What Helped Performance
Considering both property sector allocation and security selection, the largest contributors to performance were the specialty, office, single family homes, and lodging sectors.
Sector Allocation – The specialty sector, at a zero weight in the portfolio, benefited from a lack of exposure to poor performing prison REITs. The office sector benefited from our overweight allocation, while losing a few basis points on security selection, as one of our outperforming names in the first half lagged during the risk-on window in the third quarter, yet still outperformed the benchmark. Single family homes benefited from both our overweight allocation and security selection.
From a pure allocation perspective, the largest contributors to performance were the zero allocation to the specialty sector and the overweight allocations to the industrial and office sectors. We have been overweight the industrial sector for some time given our positive view on the cyclical recovery of industrial real estate fundamentals and the secular demand for warehouse space that is being driven by the growth in e-commerce retail sales. These dynamics continue to be positive for occupancies and rental rate growth.
Security Selection – The largest positive contributors were the Fund’s overweight exposure to a shopping center REIT which outperformed both shopping centers and the benchmark, and our zero exposure to a multi-family REIT.
What Hurt Performance
Considering both property sector allocation and security selection, the health care, data centers, and self-storage sectors were the largest detractors from performance.
Sector Allocation – Based on allocation alone, the Fund’s overweight to the data centers and self-storage sectors and underweight to health care were the largest detractors from performance. Last quarter we wrote how our overweight allocation to data centers was a contributor, supported by the strong growth in IT infrastructure outsourcing and the rapid adoption of cloud computing. Healthy demand was driven in particular by hyperscale users such as Amazon’s AWS and Microsoft’s Azure. In the third quarter, data centers became a detractor from performance.
Security Selection – Health care and data centers also detracted at the security level. After a significant period of underperformance by a health care company that we did not own relative to its peers and benchmark, the CEO resigned, which was followed by strong performance versus its peers and the benchmark. In another case, outperformance at the start of the quarter turned for one holding, first as a source of funds in a risk-on environment, and then as its CEO announced retirement. Both events more than offset an earnings beat and guidance raise in the short term as one would expect.
Also at the security level, our overweight exposure to a mid-cap industrial REIT was the largest detractor, reversing its role as the largest positive contributor to performance in the prior quarter. While its performance exceeded the benchmark and it has been positively impacted by the healthy industrial trends mentioned above, as well as a prudent capital allocation track record, it lagged its industrial peers.
From our perspective, the U.S. 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.
Benchmark since inception performance is reported from 2/28/1995.
Class A operating expenses are 1.36%.
Average annual total returns reflect the change in share price and the reinvestment of all dividends and capital gains. Net Asset Value (NAV) returns do not reflect the deduction of any sales charges. POP (Public Offering Price) performance reflects the deduction of the maximum sales charge of 5.75%. A contingent deferred sales charge of 1% may be imposed on certain redemptions within 18 months on purchases on which a finder’s fee has been paid.
Performance data quoted represents past results. Past performance is no guarantee of future results and current performance may be higher or lower than the performance shown. Investment return and principal value will fluctuate so your shares, when redeemed, may be worth more or less than their original cost. Please visit Virtus.com for performance data current to the most recent month-end.
Index: The FTSE NAREIT Equity REITs Index is a free-float market capitalization-weighted index measuring equity tax-qualified real estate investment trusts, which meet minimum size and liquidity criteria that are listed on the New York Stock Exchange, American Stock Exchange, and the NASDAQ National Market System. The index is calculated on a total return basis with dividends reinvested, and is unavailable for direct investment.
The S&P 500® Index is a free-float market capitalization-weighted index of 500 of the largest U.S. companies. The index is calculated on a total return basis with dividends reinvested.
FTSE® is a trade mark jointly owned by the London Stock Exchange Plc and The Financial Times Limited. NAREIT® is a trademark of the National Association of Real Estate Investment Trusts® (“NAREIT”).
The Global Industry Classification Standard (GICS) was developed by and is the exclusive property and a service mark of MSCI Inc. (MSCI) and Standard & Poor’s, a division of the McGraw-Hill Companies, Inc. (S&P).