Virtus International Real Estate Securities Fund
2Q 2016 COMMENTARY
- 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 international REIT benchmark in the quarter. From a country allocation perspective, the portfolio’s overweight to Germany and slight underweight of the Netherlands were positive drivers of performance, and overweights to a U.K. self-storage REIT and a Japanese industrial REIT were the strongest contributors at the security level.
- 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.
INTERNATIONAL REAL ESTATE MARKET REVIEW
Given the shift in the interest rate environment during the second quarter, particularly post the Brexit vote, we would expect international real estate shares to perform well relative to broader international equities and they did. The performance of international real estate equities was positive during the quarter, outperforming international equities, as demonstrated by the 1.1% increase in the FTSE EPRA NAREIT Developed Rental ex U.S. Index versus the 1.5% decline in the MSCI EAFE® Index, both expressed in U.S. dollar terms. However, international real estate equities trailed 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.
Taking a closer look at the performance of the individual countries represented within the FTSE EPRA NAREIT Developed Rental ex U.S. 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 Australia. 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 for the second quarter. Japan’s return for the quarter 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 as investors continued to chase yield-oriented investments.
The five bottom-performing countries 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 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 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.
The Fund performed in line with the benchmark FTSE EPRA NAREIT Developed Rental ex U.S. Index during the quarter, with a return of 1.28% (Class A NAV) versus 1.07% for the Index. Security selection delivered a positive contribution to performance, while country allocation was a detractor.
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 during the quarter, and outperformed the benchmark. German apartment real estate companies 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 U.K. self-storage REIT which is one of the largest owners and operators of U.K. self-storage properties was the largest positive contributor. This company continues to deliver favorable results and deliver on their structural growth story. The next most positive contributor to security selection was the overweight exposure to a Japanese industrial REIT that is focused on long-term leased commercial real estate facilities primarily in the Tokyo area. Shares of this company underperformed during the first quarter over concerns regarding a large tenant departure. During the quarter, the market became more comfortable with the company’s ability to backfill the space following the tenant's departure, which drove the outperformance.
What Hurt Performance
From a country allocation viewpoint, our 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 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 underweight exposure to Japan was the second largest drag on country allocation performance. As noted, Japan delivered one of the better U.S. dollar-based returns in the quarter, as Japanese REIT shares benefited from a significant strengthening in the yen relative to the U.S. dollar.
At the security level, the Fund's overweight exposure to a Singapore-listed owner/operator of modern logistic warehouse real estate was the largest negative contributor. Given this company’s significant asset exposure to mainland China and the negative sentiment surrounding anything China related during the quarter, the company delivered a negative return during the quarter versus Singapore as a whole, which delivered a positive return. The second largest security detractor was our overweight exposure to a Japanese lodging/residential REIT focused on budget-oriented hotels and apartments primarily in the Tokyo area. The company’s shares suffered as the continued strengthening in the Japanese yen relative to the U.S. dollar caused investors to become concerned about a potential future slowdown in tourist arrivals, from mainland China in particular, given the less favorable exchange rate.
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 amount 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.
Class A operating expenses are 1.50% and gross operating expenses are 1.78%. Operating expenses reflect a contractual expense reimbursement in effect through 1/31/2017.
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 EPRA NAREIT Developed Rental ex U.S. Index (net) is a free-float market capitalization-weighted index measuring international real estate securities, which meet minimum size, liquidity and investment focus criteria. The index is a sub-set of the FTSE EPRA NAREIT Investment Focus Index Series, which separates the existing constituents into both Rental and Non-Rental Indices. A company is classified as Rental if the rental revenue from properties is greater than or equal to 70% of total revenue. The classification is based on revenue sources as disclosed in the latest published financial statement.
The MSCI EAFE Index (Europe, Australasia, Far East) (net) is a free float-adjusted market capitalization index that is designed to measure the equity market performance of developed markets, excluding the U.S. and Canada. The MSCI World Index (net) is a free float-adjusted market capitalization index that is designed to measure the equity market performance of global developed markets. The S&P 500® Index is a free-float market capitalization-weighted index of 500 of the largest U.S. stocks and is generally representative of the performance of larger companies in the U.S. The U.S. Dollar Spot Index is a broad-based, diversified index representing an investment in the U.S. dollar. The equity indexes are calculated on a total return basis with net dividends reinvested. The indexes are unmanaged and not available for direct investment.
The Global Industry Classification Standard (GICS) are developed by and 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).