Virtus International Real Estate Securities Fund
4Q 2016 COMMENTARY
MARKET — International real estate equities lagged the broader international equity market during the fourth quarter, particularly following the U.S. presidential election, as further appreciation of the U.S. dollar proved a large headwind for international markets (in U.S. dollar terms).
PORTFOLIO — The Fund outperformed its benchmark during the quarter, though both had negative returns. Looking at country allocation and stock selection combined, the top contributors to portfolio performance were Singapore, Spain, and Finland, while the largest detractors to performance were the United Kingdom, Canada, and Germany.
OUTLOOK — In our view, the global real estate space market cycle has room for further growth as we expect overall space market demand to exceed supply across most property sectors and major cities. Combined with a supportive tailwind to real estate asset pricing, we expect another positive total return year for global real estate securities 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 U.S. election, but found their second-half lows just days before the election.
The election results were clearly the defining events of the quarter. Defying the odds and most political prognosticators and market strategists, Donald Trump was elected the U.S. 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 the 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 they will reduce the 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.
INTERNATIONAL REAL ESTATE MARKET REVIEW
Given the ongoing momentum shift in the broader markets, particularly post the U.S. presidential election, we would expect international real estate equities to continue their underperformance relative to international equities and they did. While the performance of international real estate and broader international equities were both negative during the quarter, international real estate meaningfully trailed, as demonstrated by the 8.8% decline in the benchmark FTSE EPRA NAREIT Developed Rental ex U.S. Index versus the 0.7% decline in the MSCI EAFE® Index, both expressed in U.S. dollar terms. International real estate equities also trailed U.S equities during the quarter, as represented by the 3.8% rise in the S&P 500® Index during the quarter.
The movement of the U.S. dollar during the quarter was a rather large headwind for international real estate equity returns in U.S. dollar terms, given its 7.1% appreciation as measured by the U.S. Dollar Spot Index. One notable currency move to highlight would be the 15.4% appreciation of the U.S. dollar relative to the Japanese yen during the quarter. Given the Bank of Japan’s current yield curve control policy, the movement in long-term interest rates in Japan remained relatively muted.
Taking a closer look at the performance of the countries represented within the FTSE EPRA NAREIT Developed Rental ex U.S. Index, the top performers during the fourth quarter on a total return basis measured in U.S. dollars included Canada, Italy, Austria, the U.K., and Spain. Following underperformance during the third quarter, Canada and Italy were the top-performing countries for the fourth quarter and Canada was the second best performing country for the year. Quarterly performance likely benefited from a healthy jump in oil prices during the quarter following a production agreement between several oil-producing nations. Italy, the U.K., and Spain were all bottom-performing countries on the year, with the fallout post the Brexit vote driving the U.K. into last place. Quarterly performance for Italy was likely helped by the announcement of government financial support for the country’s struggling banking sector and in Spain by the formation of a government after months of political uncertainty.
The five bottom-performing countries during the fourth quarter were Germany, Singapore, Sweden, France, and Ireland. Given the sensitivity of some of these countries to changes in long-term interest rates, the significant movement in rates across many global markets during the quarter had a meaningful impact on the performance of their real estate shares.
Our global travels during the quarter brought us to Tokyo to attend a Japanese REIT conference and to conduct individual management meetings and property tours. Tokyo is one of the few places in Japan that is experiencing positive in-migration against a backdrop of overall population decline in the country. The real estate market in Tokyo remains very vibrant with many large-scale urban redevelopment projects underway across many of the key wards of the city. Additionally, there will be some significant infrastructure projects executed upon leading up to the 2020 Tokyo Olympics. Most of the commercial real estate space markets are stable to healthy. Since our trip a year ago, lodging demand and supply has become somewhat unbalanced, particularly in certain pockets of Tokyo. Concern regarding upcoming modern industrial supply remains, but demand for this type of space remains robust. Office vacancies remain low and office rents have achieved healthy gains over the last 12 months. However, concerns regarding future office supply post 2018 have increased. The real estate asset market in Tokyo remains robust with a significant amount of domestic and foreign capital continuing to be put to work in high-quality Tokyo real estate.
For the fourth quarter, the Fund returned -8.71% (Class A NAV), compared with -8.82% for the FTSE EPTRA NAREIT Developed Rental ex U.S. Index. Country allocation and security selection both positively contributed to relative performance for the quarter, however country allocation had a greater impact.
What Helped Q4 Performance
Combining country allocation and security selection, the top positive contributors to performance for the quarter were Singapore, Spain, and Finland.
From a country allocation perspective, our underweight exposure to Singapore and our overweight exposure to Spain were the most positive drivers of performance. Despite a soft economic environment and rather tepid underlying commercial real estate fundamentals, Singapore outperformed on a country basis during 2016 as investors were attracted to the country’s high relative dividend yields. However, during the fourth quarter, Singapore underperformed on a country basis as a rise in global interest rates, particularly following the U.S. presidential election, caused the shares to underperform. Conversely, Spain was a mirror image of Singapore as it underperformed on the year despite a solid economic and commercial real estate environment, but outperformed during the quarter. After months of political paralysis, Spain was able to form a government during the fourth quarter, which likely helped performance.
At the security level, our out-of-benchmark exposure to a Singapore-listed owner/operator of modern logistic warehouse real estate was the largest positive contributor for the quarter. The company’s shares performed well following a news story in early November that stated that a consortium, led by the China Investment Corporation, was interested in making a bid for the company. In early December the company announced to the market that it was undertaking a strategic review to enhance shareholder value at the request of its largest shareholder, the Government of Singapore Investment Corporation. This announcement also benefited the performance of the shares. The next most positive contributor to security selection for the quarter was our overweight exposure to a small-cap Spanish office/industrial owner/operator with a focus on Madrid. The performance of the company’s shares benefited from an announcement in October that one of its larger listed real estate peers had taken a 15% ownership in the company at a premium to the then trading price of the shares.
What Hurt Q4 Performance
Combining country allocation and security selection, the largest detractors to performance for the quarter were the United Kingdom, Canada, and Germany.
From a country allocation viewpoint, our overweight exposure to Germany and our underweight exposure to Canada were the largest detractors from performance. While Germany outperformed on a country basis for the year, it was the worst performing country in the benchmark for the quarter. Though German interest rates remain very low on an absolute basis, on a percentage basis they increased rather significantly during the quarter, which contributed meaningfully to the negative performance of the shares. Canada was one of the top-performing developed markets during 2016 and following its underperformance during the third quarter, it bounced back on a relative basis to be the top performing country for the fourth quarter. Country performance likely benefited from the 11.4% move in the price of oil during the quarter.
At the security level, our overweight exposures to two U.K.-based self-storage REITs, were the largest negative contributors to performance for the quarter. Although both companies continue to deliver favorable business results and deliver on their structural earnings growth stories, the shares meaningfully underperformed the broader U.K. market during the quarter. Ongoing challenges in the U.K. residential market and a general market preference for value over growth during the quarter may have contributed to the underperformance. The next largest security level detractor during the quarter was our overweight exposure to a U.K.-based student housing owner/operator. Similar to the U.K. self-storage companies, this company continues to deliver solid operating performance. However, potential future changes to the university admission levels of foreign students in the U.K. negatively weighed on sentiment towards the shares.
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. 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 private real estate equity capital that has been raised but unspent, we expect M&A activity to continue in 2017.
In aggregate, we view a backdrop of low, but positive global economic growth and manageable new real estate supply as positive 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 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