Virtus Real Estate Securities Fund
4Q 2016 COMMENTARY
MARKET — After a slow start, REITs ended the year with a strong finish, rising 4.69% in December. Although REITs lagged broader equities for the fourth quarter, the positive performance of REITs alongside rising U.S. Treasury yields late in the quarter effectively demonstrated how REITs can generate positive returns in a rising rate environment.
PORTFOLIO — The Fund outperformed its benchmark during the quarter, though both had negative returns. Both property sector allocations and stock selection contributed to performance, with health care, office, and data center REITs the leading contributors, while lodging, specialty, and shopping centers were the largest detractors.
OUTLOOK — We view moderate and potentially accelerating U.S. economic growth, combined with manageable new real estate supply and favorable asset pricing, as positive tailwinds for the U.S. real estate market, and we expect another positive total return year for U.S. REITs in 2017.
Several of the major market shifts that began to take root during the third quarter more fully blossomed during the fourth quarter, particularly post the November U.S. presidential election. Long-term interest rates, which broadly bottomed during the third quarter, continued their march higher. Alongside this increase in interest rates, the U.S. dollar resumed its upward trajectory after its largely flattish move during the last quarter. Conversely, global equities moved lower to start the quarter as risk premiums appeared to increase ahead of the election, but found their second-half lows just days before the election.
The broad U.S. election results were clearly the defining events of the quarter. Defying the odds and most political prognosticators and market strategists, Donald Trump was elected president and global equity markets rallied. Much like with the U.K. Brexit vote, prominent forecasters and news outlets missed the outcome as none seemed to call for the House, Senate, and White House to end up in control of the Republican Party under Trump. The strong results for the GOP surprised the market and drove a global equity rally as the potential for more market friendly, reflationist policies and higher economic growth were taken into account. Some of President-elect Trump’s less market-friendly policy prescriptions were dismissed for the time being.
As market expectations for global growth and inflation increased, interest rates leapt higher. This had a knock-on effect on the U.S. dollar and financial-oriented equities, which were turbo-charged into the year-end. Financial stocks led the post-election rally in the S&P 500® Index, as the possibilities of a friendlier regulatory environment and rising net interest margins were embraced. Oil prices also resumed their rally following production agreements between OPEC and non-OPEC members.
On the global monetary policy front, the U.S. FOMC increased the federal funds target range by 25 basis points as was widely expected and signaled that several more rate increases are likely in 2017. The European Central Bank (ECB) extended its quantitative easing program past its previous March 2017 expiration until the end of 2017. However, beginning in April 2017, the ECB will reduce its targeted asset purchase amount by 20 billion euros to 60 billion euros per month. The divergence in monetary policy between the major central banks that began in December 2015 looks set to potentially widen further in 2017.
U.S. REIT MARKET REVIEW
REITs finished the quarter and year with solid returns, gaining 4.69% in December and 8.52% for the full year, as measured by the benchmark FTSE NAREIT Equity REITs Index.
During the quarter, the market realized that REITs had been too oversold into the beginning of November, after hitting an intra-year high in August. Interestingly enough, and supportive of how REITs can generate positive returns in environments when interest rates rise, REITs put up a 6.9% return from the day the 10-Year Treasury hit an intra-month low yield of 1.78% on November 4, just days before the election, through the end of the year. During the same window the 10-Year Treasury yield rose to 2.44%. In comparison to REITs’ 6.9% return in this intra-quarter window, the S&P 500 put up a 7.8% return. For the quarter, the initial lag caused REITs to trail with a -2.89% return versus the 3.82% return of the S&P 500.
Third quarter REIT earnings, which were reported in the fourth quarter, were solid and reinforced our constructive view on the asset class. For both REITs and the broader market, the post-election read was positive.
The REIT sector, as measured by Evercore ISI, overall posted 4.0% same-store net operating income growth in 3Q16 which was healthy, yet a bit of a continued 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.
Taking a closer look at the fourth quarter performance of the individual property sectors represented within the FTSE NAREIT Equity REITs Index, lodging was the top-performing property sector on a total return basis, and in a league of its own with a return of 20.39%. Returns for the next five property sectors ranged from 2.14% to 0.16%, and were led by the specialty sector, as prison REITs rallied post the election, and apartments, as they rallied on the expectations that increased job growth would help absorb a higher level of new supply and mortgage rates would rise. Data centers, office, and self-storage rounded out the other property sectors delivering positive returns in the quarter.
The three bottom-performing property sectors during the quarter were those with longer lease duration: freestanding retail, regional malls, and health care. Freestanding retail and health care often benefit during periods of declining interest rates when investors seek more defensive investment options.
The Fund outperformed the benchmark in the quarter, with a return of -2.49% (Class A NAV) compared with -2.89% for the FTSE NAREIT Equity REITs Index. Both security selection and property sector allocation contributed to the Fund’s outperformance.
What Helped Q4 Performance
Taking into consideration both the Fund’s allocations to property sectors and security selection, health care, office, and data center REITs were the largest contributors to performance in the quarter.
Health care benefited from our underweight allocation as the sector lagged, and from our security selection. The office sector outperformed and our overweight allocation and security selection helped. Data centers also benefited, both from our overweight allocation as it outperformed, as well as from security selection.
From a pure allocation perspective, our underweight in health care, underweight in regional malls, underweight in freestanding retail, and overweight in data centers were the largest positive contributors. The strong growth in IT infrastructure outsourcing and the rapid adoption of cloud computing continued to lift data center demand. In particular, healthy demand has been driven by hyperscale users such as Amazon’s AWS and Microsoft’s Azure.
At the security level, the largest positive contributors included our overweight exposure to an office REIT which outperformed both the office sector and the benchmark, overweight exposure to a diversified REIT which outperformed both the diversified sector and the benchmark, and our zero weight to a diversified REIT that lagged both the diversified sector and the benchmark.
What Hurt Q4 Performance
Considering both property sector allocation and security selection, lodging, specialty, and shopping centers were the largest detractors.
From a pure allocation perspective, the largest detractors were our underweights to lodging and specialty given their aforementioned outperformance, and our overweight to shopping centers as it underperformed.
At the security level, the largest detractors were our overweight exposure to a lodging REIT which outperformed the benchmark but lagged its peers, and our zero-weight to a regional mall REIT which lagged the benchmark in the year, but outperformed its peers in the quarter.
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 and has continued to support current real estate asset pricing. Nonetheless, we believe additional price appreciation will likely be driven largely by cash flow growth, as opposed to continued cap rate compression. With the significant amount of overseas buyers and private real estate equity capital that has been raised but unspent, we expect M&A activity to continue in 2017.
In aggregate, we view moderate and potentially accelerating U.S. economic growth, combined with 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 2017.
2017 GLOBAL REAL ESTATE
Total Return Drivers
- Estimated 2017 global cash flow growth of approximately 5-6%
- Dividend yield of approximately 4.0%, with above-average growth expected in the U.S. given lower payout ratios
- Healthy demand and moderate new supply driving cash flow and dividend growth
- On a country basis, real estate fundamentals remain more attractive in Ireland, Spain, the Nordics, Germany, and the U.S.
- Greater-than-expected global economic growth leading to more robust employment and income growth are key drivers of higher occupancies and rents at company-owned properties
- Inflow on rotation from bonds to listed real estate
- Increased potential for M&A and privatization given listed discounts to private real estate market prices, robust bids, and the ongoing appetite for high quality, core real estate among institutional investors
- Cessation of real estate capitalization rate compression and potential expansion
- An acceleration in the pace of new commercial real estate supply
- Increases in interest rates at a faster pace than a lift in net operating income growth and replacement costs
Global Macro Risks
- Diverging monetary and fiscal policies and ongoing political risks, particularly in Europe with a number of high profile elections taking place in 2017 and the U.K. still sorting through Brexit