Virtus Real Estate Securities Fund
2Q 2016 COMMENTARY
- U.S. REITs outperformed broader U.S. equities in the second quarter. The U.K.’s surprising “Brexit” decision on June 23 triggered a decline in interest rates, which combined with diminishing expectations for future Fed rate hikes, served to ignite a further rally in yield-oriented equities, including REITs, late in the quarter.
- The Fund had a good quarter, with strong performance that was driven by overweight allocations to the industrial and data center property sectors, and at the security level by overweight positions in a mid-cap industrial REIT and a mid-cap office REIT with significant exposure to the West LA office market.
- Going forward, we expect a backdrop of low, but positive U.S. economic growth and manageable new real estate supply, combined with favorable real estate asset pricing trends, are positive tailwinds for U.S. 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.
U.S. REIT MARKET REVIEW
Given the shift in the interest rate environment during the second quarter, particularly post the Brexit vote, we would expect U.S. REIT shares to perform well relative to broader equities and they did. The performance of U.S. REITs was positive during the quarter, outperforming U.S. equities, as demonstrated by the 7.0% increase in the FTSE NAREIT Equity REITs Index versus the 2.5% increase in the S&P 500 Index. REIT first quarter earnings, which were reported in the second quarter, were very solid and reinforced our constructive view on the asset class. The REIT sector overall posted 5.7% same store net operating income growth which was higher than the prior cycle peak of 4.8% in the first quarter of 2012. These results reflect the REIT sector’s current pricing power that has resulted from several years of low supply growth.
Within the FTSE NAREIT Equity REITs Index, the top-performing property sectors during the quarter on a total return basis included single family homes, data centers, and industrial. Single family home rental company shares performed well on the back of positive first quarter 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. Data center companies continue to benefit from the positive demand being driven by the robust growth in IT infrastructure outsourcing and the rapid adoption of cloud computing. The performance of the industrial sector is benefiting from healthy demand for warehouses from companies who compete in the fast growing world of e-commerce.
The three bottom-performing property sectors during the quarter were self-storage, lodging/resorts, and apartments. The self-storage property sector, which has been one of the best performing sectors over the last five years, underperformed during the quarter on concerns regarding slowing market rent growth. The Lodging/Resorts sector is very sensitive to changes in the economic environment and lagged alongside some softer economic data and increasing levels of new supply in certain major markets. The Apartment sector was challenged during the quarter by growing concerns regarding new apartment supply in several urban markets on the East and West Coasts and its impact on operating fundamentals.
The Fund returned 6.71% (Class A NAV) in the quarter, compared with 6.96% for the benchmark FTSE NAREIT Equity REITs Index. Security selection contributed positively to the Fund’s performance, while the property sector allocation detracted from performance.
What Helped Performance
From a property sector allocation perspective, the Fund’s overweight exposures to the industrial and data center sectors were the most positive drivers of performance. We have been overweight the industrial property 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. The Fund’s overweight to data centers is more recent and is supported by the strong growth in IT infrastructure outsourcing and the rapid adoption of cloud computing. In particular, healthy demand is being driven by hyperscale users such as Amazon’s AWS and Microsoft’s Azure.
At the security level, the Fund's overweight exposure to a mid-cap industrial REIT was the largest positive contributor. The company’s performance has been positively impacted by the healthy industrial trends mentioned above and its prudent capital allocation track record. The second most positive security driver was our overweight exposure to a mid-cap office REIT with significant exposure to the West Los Angeles office market. The performance of this company has been positively impacted by the growth in office space demand by media and technology companies and the continued recovery in market rents in its core office locations.
What Hurt Performance
From a property sector allocation viewpoint, the Fund's underweight exposure to the health care sector was the largest detractor from performance, however the total negative impact was somewhat muted by positive security selection. Given its more defensive qualities, and in some cases longer lease durations, the health care property sector typically outperforms when interest rates are falling, as they were in the quarter. Nonetheless, we remain concerned regarding the elevated levels of new supply in assisted living properties and the ongoing operator challenges at some of the skilled nursing companies. Our lack of exposure to the specialty property sector was the second largest detractor from a sector allocation perspective. The specialty property sector consists of an eclectic range of REIT companies, with a focus as varied as gaming properties, prisons, billboard towers, and so forth. Given the longer lease durations embedded in a number of these REITs, their performance can also be positively influenced by a decline in interest rates.
At the security level, the Fund's overweight exposure to a mid-size office REIT with exposures to New York City, Washington D.C., and San Francisco was the largest negative contributor to security selection for the quarter. Despite the company’s solid execution on the leasing front for its own portfolio, negative sentiment towards its key markets weighed on performance. Nonetheless, we expect a nice acceleration in cash flow growth for this company over the next 12 months as recent leasing activity begins to pay off, and we believe the shares trade at a meaningful discount to private market values. The second largest security level detractor was the overweight exposure to a small-cap lodging REIT with coastal-oriented geographic exposures. Lodging REITs performed poorly in the quarter given growing concerns on the economic environment, and this negative sentiment was supported when this lodging REIT lowered its forecasts for second quarter earnings. However, the company also executed some timely sales of hotel assets during the quarter at favorable pricing, which highlighted the current disconnect between private real estate market values and the public market pricing of lodging REIT share prices.
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. 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 U.S. economic growth and manageable new real estate supply as 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.
In addition to our favorable fundamental outlook, we believe a 2016 specific issue 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, 2016, 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.
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.
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) 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).
Equity Securities: The market price of equity securities may be adversely affected by financial market, industry, or issuer-specific events. Focus on a particular style or on small or medium-sized companies may enhance that risk.
Real Estate: The fund may be negatively affected by factors specific to the real estate market, including interest rates, leverage, property, and management.
Industry/Sector Concentration: A fund that focuses its investments in a particular industry or sector will be more sensitive to conditions that affect that industry or sector than a non-concentrated fund.
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The commentary is the opinion of the subadviser. This material has been prepared using sources of information generally believed to be reliable; however, its accuracy is not guaranteed. Opinions represented are subject to change and should not be considered investment advice or an offer of securities.
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