Is Investment In REITs Simply An Investment In Property?

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By Greg Peel

Property has become the investment buzzword for 2013. Stock markets continue to rally on central bank stimulus yet the bulk of investors remain on the sidelines, still fearful of the volatility that has been a feature since the GFC. The assumed relative safety of “bricks and mortar” has become attractive to smaller investors in particular as falling interest rates render cash holdings unattractive.

In China, Beijing continues to apply measures to rein in that country’s property boom. In the US, the housing market has already staged a solid recovery from its post-GFC depths. In Japan, cheap finance provided through Abenomics is reinvigorating property prices. In Europe, a crawl-back out of recession is refocusing attention on beaten-down property values. In Australia, the first signs of a post-GFC property recovery are appearing, with house prices rising on investor-driven demand.

Direct investment in residential or commercial property has regained favour in Australia, particularly as the RBA cash rate has fallen. Yet single-asset investment at the low end of the scale will always be risky. Diversification reduces risk, and quality properties and tenants improve return potential, but the average investor can only ever dream of owning a suite of CBD office blocks, for example, and outlays are even too steep for institutional investors.

The role is instead filled by real estate investment trusts (REIT). REITs seek to raise funds from the market to acquire a portfolio of property assets typically in one particular class – retail, office or industrial for example – and usually in one particular geography. Resultant property funds can be unlisted, thus trading off lower volatility with less ease of secondary market transfers, or listed, which aligns REITs with shares in terms of price transparency and ease of transfer but opens the funds up to general market volatility.

The Australian REIT (A-REIT) market began to collapse in late 2007, a year before the GFC, long before an ultimate credit freeze spelt the demise of Lehman. The lead-up “credit crunch” exposed over-extended gearing and low quality portfolios among many a listed A-REIT and for some death came swiftly. Others suffered near-death experiences and even those with lower gearing and higher quality properties were dumped on suspicion.

The A-REIT market has since rationalised, deleveraged, and divested of lower quality assets. The survivors have seen unit (“stock”) prices recover and as rates on term deposits and other cash investments have fallen, yields offered by A-REITs have become ever more attractive to investors. Many funds fell to price levels inferring huge discounts to net asset values. As the property market has rationalised and the global economy has stabilised, asset valuations have become less fragile and those discount gaps have narrowed, providing for capital appreciation alongside yield.

The deleveraging of REIT balance sheets has reduced the risk of the funds themselves collapsing, irrespective of asset values and rental yields on offer. And this brings us to a very salient point.

Investment in a REIT is not simply an investment in property. Investment in a REIT is an investment in a company. In this instance, that company acquires and manages rental property. Property may offer “bricks and mortar” safety but just as any widget maker with a sought after product can mismanage the selling of that product, or just as any miner with high-grade deposits can mismanage the production of that resource, the management of properties can also be poorly executed.

A REIT investor does not buy property. A REIT investor buys shares in a company that buys and manages property. Resource Real Estate Global Property Securities believes the difference might be subtle but is fundamental, and overlooked by many a REIT investor.

Investors in A-REITs, and particularly smaller investors, are focused on comparing yield. If a term deposit is offering 4% and a REIT is offering 7% then the REIT looks like much better value. After all, it is backed by bricks and mortar. Banks, too, draw attention from investors on an almost exclusively yield basis. Yet bank analysts focus primarily on a bank’s earnings trajectory – that which is providing the cash to pay the dividends. Strong earnings growth means not only robust dividends but also capital appreciation. Analysts thus value banks on the basis of return on equity (ROE) – a combination of earnings and yield – rather than simply the yield itself. Strong earnings growth is indicative of successful management.

After having spent years in the property investment field, the fund managers behind Resource Real Estate have come to the conclusion that assessment of the value of a REIT based on yield alone is a shallow assessment, opening the investor up to mispriced risk. Even an investment in a REIT based on discount to net asset value is potentially an investment in a one-off opportunity as discount gaps close with an improving macroeconomic outlook. For the longer term investor, high yields and short term gains are not the goal. For the longer term investor, ROE is key.

Resource Real Estate has thus launched a fund with this alternative REIT investment objective in mind. RRE notes there have been no real new entrants into the REIT market since the GFC and certainly none with a different approach, such as RRE is adopting. The approach is to assemble a global portfolio of REITs based on assessment of management’s capacity to improve ROE over time, rather than a portfolio based simply on buildings and tenants providing an attractive yield at current price levels.

RRE invests in a REIT as a company. That is not to say the fund manager is ambivalent about what property is in the REIT portfolio. RRE remains fundamentally an investor in property and portfolio selection is fundamentally driven by underlying property value assessment. But also of great importance is the fund managers’ valuation of management itself.

RRE is bullish global property. The following graph provides an explanation as to why.
 

 

Phase One is now behind us. In the settling post-GFC dust, economic fundamentals have stabilised. As central banks have set about providing stimulus to economic recovery, interest rates have fallen. There may be plenty of freshly printed money about, but since the GFC capital has remained restrained on much tighter lending standards. And the GFC killed off any immediate thought of new construction.

We are now in Phase Two. Demand for property is improving and rents are rising. Lenders are beginning to ease back their tight restraints. Construction has returned, but to date remains limited.

It is this last point which RRE sees as fundamental to its bullish view.

Each of the five phases takes around 3-5 years to play out, the table suggests. If demand, rents and capital availability all improve ahead of rate of new construction, as will inevitably be the case, the only release valve is property prices. Thereafter it will take another 3-5 years for the market to mature before the final 3-5 will bring the cyclical downturn. Thus the “We are here”, as marked on the above table, is a very good place for an investor to be.

Not only is supply growth currently limited at this stage of the cycle, this particular cycle is unusual. Why? Because we didn’t just have a cycle downturn, we had a GFC. As the following graph suggests, supply growth currently remains below the normal rate of replacement for building obsolescence.
 

 

This lack of growth only serves to strengthen RRE’s bullish view.

Readers might be inclined to question the timing of such a view given an apparent stall in the globally influential US housing recovery, as recent industry data attest. Whereas rising house prices have unsurprisingly served to ease demand, the recovery has taken a clear hit in past months due to a sudden and sharp rise in US mortgage rates. This sharp rise was triggered by the Fed’s suggestion in May that it may soon be time to start tapering QE, and the subsequent jump in US bond yields. The majority of US mortgages are based off the US thirty-year Treasury yield.

Rising interest rates impact not only mortgages, but all property financing rates. The result has been a 20% reduction in US REIT returns since Ben Bernanke’s May bombshell. Tapering may not have subsequently been announced in September, as the market expected, and may now not start until at least well into 2014, as the market is assuming, but the impact on US interest rates has stuck. Tapering’s day will eventually come, bond markets assume. The benchmark US ten-year yield jumped to almost 3% ahead of the September Fed meeting from 1.6% before May. It has since settled back only to 2.5%, with little sign of returning to past depths.

If interest rates begin to once again rise across the globe, is RRE’s bullish view on REIT investment misplaced? Consider the next graph:
 

 

It’s a bit crowded, but note the blue line represents the rolling return on commercial property and the red line the ten-year bond yield. The grey bars represent periods of rising interest rates pre-GFC. For the most part, property returns rise rather than fall during periods of rising interest rates. The explanation is straightforward: interest rates rise when economies are strong. When economies are strong, property rents and values rise.

Post-GFC global monetary stimulus is unprecedented in history. Yet while expectations of short-term volatility following the eventual easing of stimulus are relatively universal, many assume all markets can begin to thereafter “normalise” as economies transition to self-feeding rather than central bank-fed. RRE invests in REITs as a longer term strategy.

RRE is nevertheless not bullish property indiscriminately be region or sector. The fund is currently overweight apartments and retail in North America and underweight office and large cap companies, overweight commercial real estate and landlords in Asia and underweight residential developers, and overweight London, Germany and Western European retail in Europe and underweight developers and companies with weak balance sheets. Geographically, the fund is overweight Europe and Australia and underweight Hong Kong, Singapore and Canada.

That’s the current top-down view. Thereafter, RRE assess its portfolio selections on a bottom-up approach, consistent with analysis of the value of any company. The investment team applies a quality screen to assess management, assets, business models and track records. A total qualifying universe of around 300 securities is thus reduced to an investable universe of around 200, before some 50-70 securities are finally chosen on the basis of high quality, attractive pricing and global diversity. And chosen on the basis of return on equity projections rather than simply today’s running yield.

RRE considers this a “next generation” investment process with regard to REIT investment.

The fund was established in September, but at this stage is intended for investment by institutional fund managers. High net worth sophisticated investors will also be on the radar if they can part with seven figures. For retail investors and average SMSFs, investment in Resource Real Estate’s REIT fund will require investment in a participating institutional fund offering. RRE will consider a retail-level entry fund once this first wholesale fund has achieved traction.

For the record, Resource Real Estate Global Property Securities currently includes two Australian REITs in its portfolio, being Goodman Group ((GMG)) and Charter Hall Group ((CHC)).
 

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