Leading real estate fund managers reflect on the challenges and opportunities ahead for 2019.
3/20/2019 | By Beth Mattson-Teig
REIT magazine: March/April 2019
REITs were not immune to the challenges that swept across securities markets in 2018. Although the FTSE Nareit All REITs Index fell 4.1 percent last year, performance was choppy, with some sectors posting returns as high as 14 percent. The S&P 500 also struggled in 2018, dropping 4.38 percent. Investors enjoyed a strong start to the new year as REIT returns topped 11 percent in January, while the S&P 500 returned 8 percent.
REIT magazine recently talked with some of the leading real estate investment fund managers to discover how they navigated 2018 and the opportunities and challenges they see ahead for 2019.
What did you see as some of the biggest challenges impacting REIT performance in 2018?
Tony Kenkel: Despite generally healthy macro real estate conditions for the year, rapidly changing sentiment led to a choppy return profile for real estate stocks in 2018. REITs lagged the broader markets when investors exhibited more optimism for growth prospects or when interest rates moved higher.
Mathew Kirschner: REITs initially had to contend with rising interest rates associated with accelerating economic growth, but later in the year we saw a shift to concerns about a slowdown in growth. In addition, increasing expenses in the form of higher interest rates, real estate taxes, and wages created concerns regarding REITs’ ability to drive stronger cash flow growth.
There were a lot of cross currents at the sector level as well, as investors focused on marginal changes in the outlooks for supply and demand across property types.
What were some of the keys to generating positive returns for your real estate funds in 2018?
Guy Barnard: Remaining disciplined, looking at the volatility in equity markets as an opportunity as much as a frustration, and taking a longer-term view towards areas of structural growth. Our focus on sectors of the market with secular tailwinds, like industrial and logistics and alternative parts of the market, such as cell towers, single-family residential rentals, and student accommodation, really helped us to navigate choppy waters.
Burland East: We tend to invest in niche areas and not as broadly as some other managers. So, our results in 2018 were not representative of the indexes as a whole.
Geoffrey Dybas: U.S. REIT returns were anchored by their attractive dividend yield, steady cash flows and dividend growth, a strong private market bid and selective M&A, and attractive valuations in the face of increased economic uncertainty. Global macro-political volatility added to broader market defensiveness and helped more defensive sectors outperform, including the less cyclical freestanding retail, manufactured homes, and healthcare property sectors.
What are some of main issues that you are focusing on as you position your real estate funds for 2019?
Dybas: We expect continued variance in the global economic growth picture and regional real estate fundamentals. Regionally, we are looking to Ireland, Australia, and the U.S. for economic growth leadership. We expect the variance in global growth trajectories to create opportunities for active managers to deliver outperformance versus the broader REIT market. Overall, we expect cash flow and dividend growth for global real estate securities to be solid once again in 2019.
Kenkel: We seek to diversify our sources of alpha with bottom-up stock selection and not concentrate our portfolio positioning on one or a few specific investment themes or ideas. We are more bullish on stocks with reasonable or discounted valuations and structural drivers for growth in a slowing macro environment. We believe this would support industrial, tower, data center, and residential REITs.
East: I am focused on the state of the Federal Reserve’s ability to balance growth with inflation, as well as the state of trade between the China and the U.S. We think a global recession is a real possibility if the U.S. and China don’t settle their differences.
Kirschner: We are highly cognizant of the potential risks related to the overall domestic economy, monetary and fiscal policy, tariffs and trade, and growth outside the U.S. But at the same time, rising construction costs and disciplined financing have led to a moderation in new supply in many property sectors, creating the backdrop for a stabilization and potential improvement in fundamentals.
There are secular stories at play as well, in towers and data centers on the positive side and in retail on the negative side. With costs increasing and the economic cycle now entering its tenth year, we are investing in REITs that have the financial flexibility to continue to grow their earnings and cash flow in a variety of economic and capital market environments.
Barnard: Investing in real estate is going to be more difficult over the next three to five years than it has been in the last three to five, in terms of the returns you’re going to be able to generate. Against that backdrop, it is increasingly important to be active. We think the spread of returns at the underlying property level between different cities and different property types is going to be much wider—that is where the opportunity sits for us as active managers.
We are expecting more volatility. Something that we have re-emphasized as a team in our valuation approach in the past six months has been to try to tilt the portfolio towards companies with stronger balance sheets.
What can we expect to see regarding movement in REIT valuations in the coming year?
Kirschner: Economic growth and changes in the capital markets will continue to have a significant influence on REIT valuations. We believe the backdrop remains supportive for continued growth in values consistent with positive internal growth, accretive investment activity, and rising cash flow and dividends.
Kenkel: We could see REIT valuations, and most risk assets, come under more pressure should growth expectations fall sharply again. Most likely, interest rates are likely to be low and range bound. If so, investors will have increased confidence that long-term interest rates will not spike higher, removing a potential headwind for the group.
There were several large entity-level acquisitions last year.
Do you think we will continue to see more of those types of deals in 2019?
Dybas: Yes, we see an increased potential for M&A and privatizations given the listed discounts to private real estate market prices, robust bids, and the ongoing appetite for high-quality, core real estate among institutional investors.
Kirschner: Buyers increasingly include private equity investors, who currently hold nearly $300 billion of uninvested capital earmarked for real estate investment. This “dry powder” is largely a function of the investors’ search for income, total return potential, inﬂation protection, and diversification. Investors are looking increasingly to public listed real estate, where they can deploy capital on a large scale, often buying companies that are trading at discounts to underlying asset values.
East: We don’t think there were more large deals than normal in 2018. There are piles of cash sitting on the sidelines in private real estate funds waiting to be deployed and to the extent REITs trade at meaningful discounts, private equity shops will be tempted to privatize public companies.
As you assess your investment decisions, what are specific priorities you want to see REIT management teams address?
Kenkel: Strong balance sheet management, smart capital allocation, and “doing right” by shareholders. These are always top-of-mind items but become even more important the later we get in the cycle. Companies need to make sure that they have leverage in check and a diverse set of funding options available at all times.
On the capital allocation front, we’re big proponents of taking advantage of the cost of capital signal provided by net asset value. Finally, to the extent that a takeout offer is received, we advocate for companies taking a fresh, serious look.
Barnard: One of the things that we spend a lot of time discussing with management teams is longer-term strategic vision. How this change in technology, how this change in lifestyle is going to impact REITs and the use of real estate going forward. We want to see companies that don’t have their head in the sand around some of these changes that are taking place.
In the short term, a focus for us is on balance sheets. Cost of capital is going to change. So, we want companies to be focused on more defensive aspects of making sure their balance sheet is robust and they can live with any volatility in capital markets in the shorter term.
How will the pattern of volatility in the broader stock market impact REIT investing in 2019?
Kirschner: We need to be forward looking and focus on where we think the right investments will be over the next one to two years, blocking out short-term noise in the process. That said, volatility can create opportunities during temporary dislocations, and we want to be able to act when that occurs.
With regard to real estate compared with other stocks, REITs could see less volatility thanks to their healthy and growing dividend yields and more stable earnings growth profiles.
Kenkel: It will create opportunities for active managers as volatility often creates disconnects between fundamentals and share prices that a skilled manager can exploit. Our base case calls for an environment of elevated volatility caused by low macroeconomic visibility and high anxiety regarding future Fed policy.
While this outlook is uncomfortable, we believe REIT stocks are likely to be in favor as investors show preference for largely domestic, highly predictable income streams amidst the uncertainty.
Do you anticipate that the REIT outperformers of 2018 will continue their run in 2019?
East: Not necessarily. We are focused on companies with sustainable same store NOI growth and some of 2018’s drivers are cyclical and will wane.
Barnard: In the U.S. in particular, we saw defensive parts of the market outperforming, including sectors like health care and net lease. We’re actually pretty cautious on health care. We see issues in terms of the oversupply in retirement properties and structural issues around some of the operators of skilled nursing facilities. Otherwise, some of the structural dynamics that are playing out will have industrial outperforming retail again. That is something that is likely to persist until we get clarity on where rents are going in the retail space and when we get back to a stage where there is a stronger growth story.
Kenkel: The macro backdrop could support increased investor appetite for more defensive segments of the REIT market, such as health care and net lease, yet we are mindful that relative valuations for many of these stocks are full already. We are more bullish on stocks with reasonable or discounted valuations and structural drivers for growth in a slowing macro environment. We believe this would support industrial, tower, data center, and residential REITs.
Are there any “off the radar” or underappreciated property sectors that could get more attention in 2019?
East: We are looking at specialty industrial sectors such as cold storage and others that we think have long-term appeal but underperformed in 2018, like data centers.
Kirschner: One I would cite is cell towers, which is a large sector with positive cyclical and secular fundamental trends, and which has made inroads into the REIT space from infrastructure in the past few years.
Barnard: In the U.S., one area that we like is the gaming REITs. There are very few players, and therefore these companies are able to consolidate to continue to grow their platforms, which is very accretive to earnings and also the overall value of the business.
Kenkel: The industrial sector is clearly not off the radar, but we continue to believe it is under appreciated. Industrial remains our favorite property type in the U.S. and globally.
Lastly, what is one big issue you are watching for 2019?
Kirschner: As we head further into prolonged economic and real estate up cycles, we believe the key is to be correct in where our views differ from market expectations, whether they involve the economy, property sectors, or individual stocks. Our research is devoted to getting ahead of incremental changes in supply and/or demand that can alter the trajectory of forward growth.
East: Primarily 2019 should be about rates, GNP growth, and global trade. These items are inherently difficult to predict and run game theory on. It’s a lot easier to simply visit with companies and tour assets to develop a strategy, but the more ethereal rate drivers like government and politics seem to be at play.
Kenkel: Credit spreads. We’ve seen widening spreads recently, which indicates concern over the economy and makes capital more expensive. We will be monitoring how trends develop in 2019 and watching for deviations in the normal relationships between credit and equity performance. Depending on the moves, it may influence our appetite for more offensive or defensive positioning.
Barnard: We have to be conscious of those parts of the market where we have seen elevated levels of new supply in recent years and where that may continue, such as some of the coastal apartment markets, self-storage, and senior living.
The big issue is on the demand side. In recent years, we have seen pretty healthy levels of demand for space in the U.S. and globally. That demand has driven rental growth. If business confidence and consumer confidence take a hit, then that demand risk is more of a concern for us than supply risk.
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