Virtus International Real Estate Securities Fund
3Q 2016 COMMENTARY
MARKET— International real estate equities posted positive returns in the third quarter, though mounting concerns surrounding global central bank monetary policy and the potential for a Fed rate hike later this year led the asset class to lag broader equities.
PERFORMANCE — The Fund underperformed the international real estate benchmark in the quarter. Security selection was the main detractor, primarily overweight exposure to a Japanese lodging/residential REIT and underweight exposure to a French office REIT, while country allocation made a position contribution, led by overweight exposures to the strong-performing real estate markets of Norway and Finland.
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 elevation of real estate to the eleventh sector under 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. As markets digested the vote outcome, the U.S. 10-year Treasury bond yield peaked intra-day on July 6.Two days later, a strong U.S. payroll report for June came in well above expectations. In the next week, 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.
In response, the markets exhibited 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 listed global real estate. As examples in the U.S., an increased appetite for risk was sourced from more defensive industry sectors such as utilities, consumer staples, and ultimately real estate, which had thus far been outperforming on the year. Conversely, financial shares, which had been year-to-date underperformers, began to outperform on a relative basis.
Another tone shift also became more evident during the quarter and came courtesy of major global central banks. Based on the rhetoric leading up to their respective September policy meetings and the meetings themselves, the Bank of Japan, European Central Bank, and FOMC to varying degrees seemed to be questioning the efficacy of current monetary policy to achieve their medium-term inflation goals. More than ever, the central banks appear to be indicating that it will be difficult to achieve their inflation goals without an assist from fiscal policy and structural economic reforms.
Additionally, there seems to be a greater recognition of some of the negative consequences of current monetary policy, particularly on the banking sector. Although no coordinated message has been announced, based on recent comments and policy actions it appears that all three major global central banks would like to see steeper yield curves. Not surprisingly, the yield curves in each respective market did steepen over the course of the third quarter. Moreover, while the FOMC did not raise rates at its September meeting, they did provide fairly clear guidance that the case for a rate increase was growing. As a result, the probability of a rate increase at the December FOMC meeting increased significantly.
INTERNATIONAL REAL ESTATE MARKET REVIEW
Given the change in tone in the markets during the quarter to a more risk-on environment and the shift in interest rate expectations, particularly post early July, we would expect international real estate shares to lag broader international equities and they did. While the performance of international real estate equities was positive during the quarter, they underperformed international equities, as demonstrated by the 2.4% increase in the FTSE EPRA NAREIT Developed Rental ex U.S. Index versus the 6.4% increase in the MSCI EAFE® Index (both in U.S. dollar). International real estate equities also trailed U.S equities during the quarter, as represented by the 3.9% rise in the S&P 500® Index during the quarter.
Currencies – The movement of the U.S. dollar during the quarter was rather benign and was a small tailwind for international real estate equity returns in U.S. dollars, given its 0.7% depreciation as measured by the U.S. Dollar Spot Index. Two notable currency moves to highlight would be the nearly 3% appreciation of the U.S. dollar relative to the U.K. pound and the 6% increase in the U.S. dollar relative to the Mexican peso, which has in recent months become highly correlated to the movement in presidential candidate Donald Trump’s poll numbers. As we go to print, the pound has continued to weaken and the peso has lifted.
Top 5 Countries – Within the FTSE EPRA NAREIT Developed Rental ex U.S. Index, the countries with the strongest total returns in the quarter (in U.S. dollars) included Norway, Finland, Austria, Hong Kong, and France. While Norway has a small representation in the benchmark with only two listed companies, they continued their winning ways, elevating Norway to the best performer on the year as well. The Norwegian economy and commercial real estate market have benefited from the improvement in the price of oil and the fiscal stimulus provided by the government. Additionally, the performance of one of the listed companies continues to benefit from a creeping takeover of the company by one of the wealthiest individuals in Norway. Hong Kong was one of the top performers for the second consecutive quarter as its real estate shares benefited from the growing exchange linkages with mainland China and the flow of capital into the Hong Kong equity market.
Bottom 5 Countries – The five bottom-performing countries during the third quarter were Italy, Canada, Australia, Switzerland, and Japan. Italian real estate shares came under pressure, not because of underlying property fundamentals, but because of growing concerns regarding the solvency of the Italian banking system. While initial steps have been taken to shore up capital at some of the banks, the markets have yet to be convinced that enough has been done at this point. Also weighing on the Italian market was uncertainty regarding the outcome of a referendum on economic reforms that is to be voted on during the fourth quarter and which could cause political turmoil depending on the results. Canada and Australia gave back some of their gains during the quarter, though remain outperformers on a year-to-date basis, as their markets digested the shifting interest rate environment.
Observations from Our Travels – During the quarter we traveled to the U.K. and France and attended the European Public Real Estate Association’s annual conference in Paris. During our time in London it was difficult to detect negative ramifications from the fallout of the Brexit vote. On the contrary, the anecdotal observations were positive as it related to tourist activity and retail spending, both of which have benefited from the dramatic fall in the U.K. pound since the June vote. However, based on the limited amount of commercial real estate transaction activity that occurred during the quarter, we know there has been a small negative impact to real estate values, particularly city-oriented offices, and that rental levels have softened a bit. Moreover, tenants are seeking shorter-lease terms and termination options to protect against future uncertainty.
Central Paris offices, on the other hand, are currently the highlight of the French commercial real estate market, demonstrating strong occupier demand and modestly growing rental levels, with limited new supply. While there was no evidence of a Brexit-related benefit yet, that could be an incremental demand driver in the future. However, Paris would have to compete with the likes of Frankfurt, Dublin, and New York for some of the possible relocations from London, depending on how the future Brexit negotiations shake out. As a whole, new development would be needed in any of the European cities to accommodate a significant move, were it to occur, from London.
The Fund underperformed the benchmark FTSE EPRA NAREIT Developed Rental ex U.S. Index in the quarter. Security selection was a detractor from performance, while country allocation made a positive contribution to performance.
What Helped Performance
Based on country allocation and security selection combined, the top contributors to the Fund’s performance in the quarter were exposures to the real estate markets of Norway, Finland, and Germany.
Country Allocation – The Fund’s overweight exposures to Norway and Finland were the most positive drivers of performance. The Norwegian economy and commercial real estate market have benefited from the improvement in the price of oil this year and the fiscal stimulus provided by the government. Additionally, the performance of one of the listed companies continues to benefit from a creeping takeover of the company by one of the wealthiest individuals in Norway. Finnish real estate shares reversed their negative performance from the prior quarter and may have been a beneficiary of capital reallocation following the Brexit vote.
Security Selection – The Fund’s overweight exposure to a Japanese industrial REIT was the largest positive contributor for the quarter. The company’s shares performed well following a September equity offering that helped fund the acquisition of additional properties that will support future cash flow and dividend growth. The next most positive contributor to security selection in the quarter was our overweight exposure to a French shopping center REIT. The company’s more neighborhood and convenience-oriented shopping centers continue to perform well and are benefiting from recent asset management activities.
What Hurt Performance
Based on country allocation and security selection combined, the largest detractors from performance in the quarter were the real estate markets of Japan, Sweden, and Hong Kong.
Country Allocation – The Fund’s underweight exposures to Sweden and Hong Kong were the largest allocation detractors. Although Sweden was not among the top-performing countries in the quarter, it did deliver better-than-benchmark performance, rebounding from its weak second quarter showing. Sweden’s economic and commercial real estate markets continue to deliver solid results and are among the best in Europe. Hong Kong was one of the top performers for the second consecutive quarter as its real estate shares benefited from the growing exchange linkages with mainland China and the flow of capital into the Hong Kong equity market.
Security Selection – Overweight exposure to a Japanese lodging/residential REIT that is focused on budget-oriented hotels and apartments primarily in the Tokyo area was the largest detractor. The company delivered disappointing earnings results and materially revised down its future hotel operating results guidance. At the margin it appears the strength of the Japanese yen is having a negative impact on lodging demand and new supply is impacting hotel pricing. The second largest detractor at the security level was our underweight exposure to a French office REIT that is focused on Central Paris office properties. The Central Paris office market is one of the bright spots of the French commercial real estate market and the company’s shares have benefited from the positive underlying fundamental dynamic and perceived potential relocations from London.
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. 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.
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 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) 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).