10 January 2017
Portfolio Manager / Analyst, Global Listed Real Estate
In the last five years, those clients who were invested in the listed real estate sector have benefited from strong total returns. Notably, global listed real estate has outperformed the majority of other asset classes for eleven of the last 15 years and has significantly outperformed global equities since the height of the GFC in March 2009.The economic recovery following the Global Financial Crisis (GFC) naturally boosted demand for real estate, whilst at the same time, the reluctance of banks to fund speculative development has generally kept new supply in check. This demand/supply dynamic helped to drive capital growth. Meanwhile, regular rental income which supports the yield component of global listed real estate has proven to be attractive for investors, particularly against the backdrop of very low interest rates.And yet, if global listed real estate is indeed correlated to the performance of the global economy, conventional wisdom would suggest that it should underperform in the event that the bear case of a global economic slowdown does come to pass – as the sector did during the Financial Crisis.
Has the sector learned from its previous painful mistakes?
We believe that the sector is much better prepared and has heeded the bitter lessons learnt during the last global economic slowdown.
There are four key factors that support the notion that global listed real estate offers resilience.
1. Financial leverage is much more disciplined
Leverage was clearly a significant factor in the relative underperformance of listed real estate during the GFC. In many cases, real estate companies were over-levered and exposed to an economic downturn.
At the start of 2008, US REITs had an average leverage ratio of around 60 per cent. Debt to EBITDA multiples were around 7.5 times, rising to 8 times in late 2008 to 2009.
When debt markets effectively closed during the GFC, many listed real estate companies were close to breaching debt covenants and faced difficulty refinancing near-term debt. They were forced to either raise equity at deep discounts or offload assets.
In contrast, the average leverage ratio of US REITs today is around 30 per cent – roughly half what it was at the peak of the GFC. The debt to EBITDA multiple has also been cut by 25 per cent, falling from around 8 during the GFC to 6 today.
We believe that leverage is likely to stay in check or even trend lower as asset values continue to grow and companies sell into a very strong capital market.
This all suggests that the sector is much better positioned with respect to leverage and would be unlikely to suffer the same level of distress as previously experienced during the GFC.
A recent example supports this thesis – in the immediate aftermath following the UK’s decision to leave the European Union in June 2016, the UK REITs declined by around 20% per cent. However, once it became clear that the REITs would not necessarily be forced sellers of assets nor be forced to raise equity, most of those losses were regained.
2. Reduction in development risk
The magnitude of development exposure (or risk) on the balance sheets of listed real estate companies is also lower today than prior to the GFC. In addition, the nature of this exposure has changed with a reduction in the higher risk, so-called “speculative” development component of the overall development book.
Since the depths of the GFC, banks have been less willing to lend for development, particularly speculative development. That has had the effect of holding the supply of global real estate in check. Whilst supply is expected to pick up over the medium term, it is from a relatively low base and considerably below the long-term average.
3. Payout ratio headroom
The third factor underscoring the defensive positioning of global listed real estate today is that of payout ratios. Prior to the GFC, payout ratios in the US were around 85 per cent. In contrast, the present payout ratios in the US are at near historic lows of around 72 per cent.
This is important for two reasons. Firstly, a lower payout ratio reflects a greater focus on financial discipline including strengthened balance sheets and cutting the heavy reliance on debt to finance acquisitions and capital expenditures.
Secondly, headroom in the payout ratio also suggests that current dividend yields are sustainable, and that listed real estate is in a healthier position than has been the case in the past, particularly in the lead up to the GFC.
4. A new pillar of demand with the emergence of sovereign wealth funds
Sovereign wealth funds are playing an increasingly important role in global real estate.
The representation of sovereign wealth funds in global commercial real estate transactions has grown from less than 1 per cent in 2011 to 6 per cent in 2015. The proportion of the funds investing in the asset class has increased by almost 10 per cent in the past two years alone, a trend likely to continue given that on average, these funds remain underinvested relative to strategic targets.
Sovereign wealth funds are long-term oriented, patient capital, and most importantly, are driven by equity rather than debt. The mandates of these funds often restrict the use of leverage and as a result, these investors are relatively insulated from the type of stress in credit markets that exacerbated the fall in real estate values during the GFC.
In the event of a global economic slowdown, listed real estate companies will not be completely immune. However, we believe that the sector has taken important steps to insulate itself to a far higher degree compared to the period prior to the GFC. This is manifest is greater financial discipline, less speculative development, more headroom in payout ratios, and new pillars of long term demand for real estate from sovereign wealth funds.
The end result is an investment class that is positioned to deliver what is expected of it: real estate-like returns over the long term, with the benefit of both liquidity and diversification.
Important note: While every care has been taken in the preparation of this document, AMP Capital Investors Limited (ABN 59 001 777 591, AFSL 232497) and AMP Capital Funds Management Limited (ABN 15 159 557 721, AFSL 426455) make no representations or warranties as to the accuracy or completeness of any statement in it including, without limitation, any forecasts. Past performance is not a reliable indicator of future performance. This document has been prepared for the purpose of providing general information, without taking account of any particular investor’s objectives, financial situation or needs. An investor should, before making any investment decisions, consider the appropriateness of the information in this document, and seek professional advice, having regard to the investor’s objectives, financial situation and needs. This document is solely for the use of the party to whom it is provided