Published November/December 2013
Brown talked with REIT magazine about a number of the most pressing topics in commercial real estate investment today, including interest rate policy, international markets and the diversification and hedging benefits of REITs.
REIT: In talking to REIT investors and fund managers about the market this year, the same two subjects come up over and over again: interest rates and job growth. Let’s start with the former. In recent months, some Federal Reserve officials, including Chairman Ben Bernanke, have discussed publicly how long the Fed’s quantitative easing program should continue, but so far, there has been more talk about tapering than any real steps to do so. What kind of impact is this having on the REIT market?
Steve Brown: The initial impact was negative. There was a strong sell-off in REITs from May to August of about 18 percent or so. The initial concern was that as the Fed wants to exit the tapering program and let long-term rates drift higher, investors sold income-oriented investments, such as REITs, in quite a dramatic fashion.
We think that the initial reaction to the concern about higher interest rates has run its course. REITs have bounced back somewhat from their lows of late August. If tapering is done in conjunction with improving employment and improving economic activity, that should be a supportive market for real estate fundamentals in the United States.
REIT: Is an environment of rising long-term interest rates a net positive or negative for REITs?
Brown: Near term, it would be a negative as investors move away from income-oriented investments.
Longer term, based on historical precedent, if the higher rates are accompanied by expanding economic activity and inflation, then REITs can deliver positive returns to investors based on their ability to generate higher rents from their tenants. That’s a process that has happened in the past, but it has been a long time since we’ve had any meaningful inflation. There may be a learning curve as investors learn that rising rates coupled with an expanding economy and high prices are good for a hard asset like commercial real estate.
Over the course of the complete cycle, I think investors will understand that real estate would benefit in that environment.
REIT: Employment has a pretty direct effect on the office sector, but are there any other sectors that have been affected by the lackluster job growth?
Brown: There would be concern that the apartment sector would be impacted if the job market remains lackluster. The weak job market impacts the younger age cohort, ages 22 to 30, the most. That would be the prime apartment-renting age group.
If the economy was not creating jobs at a reasonable clip, then you’d also have concerns about demand growth for apartments.
You’re seeing a reduction in the correlation of REITs with the equity market and the bond market. With the passage of time, the inherent characteristics of commercial real estate will drive performance.
REIT: Do you consider this a stock picker’s market for REITs?
Brown: That’s a good question. Except for some extreme examples, such as the hotel sector and maybe the storage sector, it has been a stock picker’s market this year in terms of looking for ways to outperform the index.
There has not been that much differentiation among the core eight or nine property sectors. In order to generate alpha, it has turned back into a bottom-up, fundamental research stock picking market.
We are able to focus more on the management teams and what they’re doing to take advantage of the current environment. There’s not a lot of distressed real estate for sale, so it’s not necessarily a buyer’s market for real estate. It’s more of a leasing market and redevelopment market, so REITs that have strength in those areas can demonstrate strong relative performance in this environment. It’s not necessarily a spread investing environment anymore.
REIT: Give us one REIT sector that you think investors could be underestimating.
Brown: Although the hotel sector has done well this year, I think the continued improvement in demand as the economic recovery spreads farther out to both business demand and vacation demand and the modest new supply growth paints an attractive picture there.
Many hotel markets are still below their peak RevPAR (revenue per available room) levels. If we do get into a period of higher rates coupled with expanding economic growth and inflation, hotels are going to outperform in that kind of environment.
REIT: Historically, REIT stocks have offered diversification and hedging benefits to investors. Is that still the case?
Brown: This comes up a lot. We continue to think that REITs remain an excellent investment class for investors who use asset allocation models. We also think the correlation with both the stock market and bond market is starting to deteriorate as we’ve come through a very volatile period where a lot of investment classes moved in tandem.
Now we’re getting away from that. There’s more discrimination among the asset classes and how they perform. You’re seeing a reduction in the correlation of REITs with the equity market and the bond market. With the passage of time, the inherent characteristics of commercial real estate will drive performance.
Over a 12- to 36-month holding period, investors will benefit from the diversification and hedging benefits of having real estate as part of their asset portfolio.
REIT: In terms of trying to capture value in international markets, would you be more inclined to invest in U.S. REITs that are expanding abroad or in native companies? Does that even make a difference to you?
Brown: We generally prefer to invest in native companies because of the home field advantage and knowledge that they bring to it. That would be our first preference.
REIT: In your discussions with management teams, is there one particular corner of the world that is garnering more interest than expected?
Brown: Japan and Japanese property stocks have garnered an incredible amount of interest this year as a result of the new economic policies put in place by [Prime Minister Shinzo] Abe’s economic team.
The very aggressive approach to stimulating economic growth through currency devaluation, as well as lower interest rates, has had a dramatic impact on expectations for Japan. They also announced the awarding of the 2020 Summer Olympics to Tokyo.
REIT: How do you see declining growth in the economy changing commercial real estate companies’ strategies in China, if at all?
Brown: When we think of China, we think of the impact of government policies on the real estate market there, as well as changes in economic activity. If we continue to see maturation in the growth rate of the Chinese economy and concerns about the depth of the luxury condo market in China, we would expect to see commercial real estate companies adopting a more cautious approach to expansion in China.
REIT: How do you think real estate investors will look back at this year?
Brown: It looks like the S&P is going to outperform the REIT index for the first time in a couple of years. It’s important to recall that REITs have delivered strong results for the last five years for investors.
As we look forward, while the stock market appears to be poised to deliver good returns as a result of the currently low inflation environment we’re in, I think investors will be pleasantly surprised when they see the long-term impact of very modest supply growth in commercial real estate and its impact on REITs’ ability to deliver above inflation same-store net operating income growth.
Steve Brown is a senior vice president and senior portfolio manager with American Century Investments. Prior to joining American Century in 2008, he spent six years at Neuberger Berman, most recently serving as global head of real estate securities. He has a bachelor’s degree in economics and an MBA in finance from New York University.