Real Estate Fund Managers Discuss Challenging Year Ahead

Leading real estate fund managers reflect on gains made in 2019 and assess the outlook for REITs and listed real estate in 2020.

REIT magazine: March/April 2020

EDITOR’S NOTE: Interviews were conducted in February 2020.

REITs enjoyed a surge in performance last year, along with a broader rally in the stock market. Total returns for the FTSE Nareit All REITs Index gained 28.1% in 2019, the largest gain for the index since 2006. REIT magazine recently talked with some of the top-performing real estate investment fund managers to discover how they navigated 2019 and the opportunities and challenges they see ahead for 2020.

Generally, 2019 was a bullish year in the U.S. stock market. What were some of the keys to generating positive returns?

Guy Barnard: We remained focused on those sectors benefiting from technological and demographic tailwinds, which are providing a supportive backdrop for landlords even as economic growth has slowed. Investments in areas such as logistics and manufactured housing have seen stellar returns. Investing globally has also boosted returns, with Europe the strongest region in 2019, highlighting that it’s important to look through the macro noise.

Steven Brown: Demand for industrial real estate was strong as a result of continued growth in e-commerce. In addition, the increased market share of online wireless activity increased the demand for data centers, which was a positive for us. We also benefitted from our position in residential housing as the job market was strong. Toward the end of the year, as we continued to see interest rates drop, we invested in timber REITs, which were a beneficiary of increased housing demand.

Rick Gable: Overall, the key was to be invested in property types experiencing real cash flow growth, whether from pricing power in rents or accretive external growth. Companies that showed signs that their earnings were on the cusp of returning to a period of growth also performed well. The starting multiple almost did not matter, as long as companies were able to meet or exceed expectations. We had meaningful contributions from companies in warehouses/logistics, manufactured housing, data centers, office space for tech and lab use, and strip centers.

Todd Kellenberger: Our funds benefitted from a lot of stock selection decisions that focused on what we call structural growers. With many traditional cyclical areas of the real estate markets experiencing decelerating growth late in the cycle, we found compelling opportunities in niche areas of the market or companies benefiting from structural demand trends, which would include single-family rentals, manufactured housing, industrial, data centers, life science office, and tower REITs.

Rick Romano: We had a big overweight on last-mile warehouse landlords, as we saw them benefit from e-commerce demand and deliver accelerating cash flow growth. M&A activity also provided support for industrial valuations. Related to industrial, we also had a big overweight in cold storage. Another big theme for us in 2019 was the lack of affordable or mid-level housing, and we benefitted from a big overweight in manufactured housing. One of the things we avoided in 2019 was regional malls, with a significant underweight in that sector.

Do you think REITs will be able to maintain their strong momentum in 2020?

Kellenberger: We do think the backdrop is favorable. But, no, we don’t think it is likely that they will maintain that level of performance in 2020. We don’t think the drop in interest rates will be as big of a tailwind in 2020, which caused some of the outsized returns in REITs.

Gable: As long as the growth outlook for REITs remain competitive versus broad market equities, I think certain REITs can still generate competitive total returns. We think that REITs can generally produce a solid total return with a low degree of difficulty due to the mostly recurring nature of their cash flows. In fact, the strong performance of REITs in the last few years reflects a growing appreciation of their business models and the durability of the cash flows.

Romano: Slow U.S. and global economic growth are positives for REITs, and that still seems to be in place. Some of the macro overhangs that had clouded 2019 are not necessarily removed, but there is a bit more clarity around things like the trade war and Brexit. Interest rates remain low and the supply and demand picture still looks attractive across most property types and most areas of the country.

Lipper Ratings for Total Return reflect fund historic total return (income from dividends and interest as well as capital appreciation) performance relative to peers. The ratings are on a scaleof 1 to 5, with 5 the highest.

What do you think are some of the biggest near-term risks or potential headwinds to REIT performance in 2020?

Gable: One headwind could just be valuation. Many REITs have re-rated substantially higher, and while some of that move can be justified, we do have some concerns with how the absolute level of valuation will be viewed by generalists in a downturn.

Barnard: The biggest concern for us fundamentally is around the demand picture in 2020 and beyond, which will depend on overall global growth. Conversely, if growth does accelerate more meaningfully (not our base case) and we see bond yields and interest rate expectations take a hawkish shift, then listed real estate is likely to lag other asset classes.

Kellenberger: It could be the reacceleration of prospects for economic growth, which may cause a rise in interest rates. Should that happen, we could see investors rotate away from REITs in the short term. Other concerns we are watching for REITs in 2020 would be an acceleration of retail bankruptcies. We’re also closely watching new supply in certain segments, like senior housing, self-storage, and apartments. Right now, that seems like it is well-contained, but it is an issue that we are watching.

How do you view the potential impact of the coronavirus at this time?

Gable: As a long term investor, we try to look past the uncertainty and focus on the companies we own and their ability to continue to generate good free cash flows. That being said, the impact is spreading. Should central banks need to step in with lower interest rates to stimulate markets to offset the impact, real estate values would probably receive some positive support. Real estate companies have already started granting some rent relief to tenants impacted by the virus, but overall, the combination of current income and the relative stability of earnings has not been impacted dramatically for most companies, and we don’t expect that to change at this point.

Barnard: Beyond the more obvious direct impact on hotel and retail, there may be medium or longer-term implications for the property sector. Across Asia, the outbreak has led many companies to roll out different forms of remote working plans, highlighting the viability of flexible workspace solutions which could change the way businesses think about their physical office space requirements in the future. The surge in online shopping and data connectivity, as people stay and work from home also supports continued demand for underlying infrastructure such as logistics space and data centers.

Barnard: The risk of a global pandemic has clearly increased and markets have traded down sharply on fears of the negative economic fallout. Potential Fed rate cuts and policy initiatives can help restore confidence, but won’t contain a virus.  The depth and duration of the impact is very much uncertain.  We expect more economically sensitive REIT sectors around the world will feel the negative effects while more defensive REITs should hold up relatively well.

Romano: From an earnings perspective, hotel and retail REITs globally will sustain the most negative impact.  The impact is likely to be temporary ( a few quarters or so) and hotels in particular could be set up for a sharp price recovery at some point in 2020. We’re also seeing high quality REITs with defensive earnings streams being negatively impacted due to indiscriminate selling, particularly of “winners”.

Brown: The coronavirus continues to unfold and will have a material impact on economic growth measures in many ASEAN countries.  Tourism and retail stand out among the most impacted. The expected ramp up in government stimulus to offset these concerns will likely impact interest rates for the balance of the year.

How, if at all, is your team adjusting its investment strategy for the coming year?

Barnard: We remain focused on areas of structural growth and alternative sectors, but not at any price. On the flip side there are markets where fundamentals are weak, but shares may be more than discounting this. Recently, more of our marginal dollar has gone into markets like Hong Kong, the U.K., and Manhattan office, where we see the prospect for some positive re-pricing in 2020.

Romano: We’re keeping an eye on New York office. It’s been a big laggard for several years now and valuations are starting to look attractive. We are starting to see some traction in lease-up, and we would like to see capital market transactions where some of the bigger private equity players get more involved on the acquisition front to where we could potentially see cap rates stabilize and cap rate compression. Other themes we are keeping an eye on are rent control, both globally and in the U.S.

Brown: We’re looking at names that underperformed last year that look cheap but have okay fundamentals. That would include some names in the office and hotel sectors. Certainly, central business district office in the New York and the Washington, D.C. area underperformed last year, and there are a number of names there that are trading at discounts to net asset value (NAV). While they do have issues with high operating costs, the demand picture has improved because of the technology companies that are expanding away from California.

What are some of the ways that you are assessing ESG strategy?

Gable: We are paying more attention than ever to ESG topics. To properly assess any company’s overall ESG strategy, it is best to embed the analysis into the full investment process, from the bottom-up analysis and stock picking all the way through to portfolio construction and proxy voting. Now that ESG is fully integrated into the MFS global research platform, we can assess each company’s progress, not just the presence of an ESG goal or strategy.

Romano: We have always evaluated governance in our process with our proprietary scoring. We are also evaluating the environmental and the social aspects. The disclosure is not great yet, although companies are getting better at that. We are working on some proprietary scoring around those measures and look to more fully incorporate them into our process at some point in 2020.

Which sectors do you think are positioned to be the biggest outperformers this year?

Brown: We think data centers are well-positioned. We also remain positive on industrial REITs, where the demand profile remains among the strongest of any property sector. Within the office sector, some of the New York and Washington, D.C.-based REITs look attractive on a NAV basis, as well as because of marginal demand for their properties. We continue to think the lodging space is one of the cheapest around in terms of a discount to NAV, and if GDP growth comes in higher than expected in 2020 it would be one of the leading beneficiaries of that trend.

Kellenberger: We continue to be favorable on single-family home rentals and industrial warehouse. For single-family rentals, we are seeing robust demand growth driven by lifestyle choices and affordability issues and manageable supply within that sector. We also like the industrial sector where fundamentals remain in great shape with high occupancy levels and strong pricing power and downward pressure on cap rates. While trade remains a risk for this sector, the recent de-escalation of tensions with China should be a positive.

Romano: Based on our overweights, we look for industrial, single-family rental, and manufactured housing to be the biggest outperformers based on strong fundamentals and cash flow growth prospects. We also like net lease and West Coast office markets. West Coast office companies trade at a large discount to NAV, which seems to be disconnected from their strong supply and demand fundamentals.

What sectors do you see facing the biggest challenges in the coming year?

Barnard: While it’s not new, the pressure on traditional retail property is likely to continue. This year may provide the first true valuation points in the mall space for some time, highlighting the magnitude of value declines. Another area that we must be mindful of is the impact of politics and populism within the [multifamily] sector. Last year surprised us with new restrictive residential rent control proposals in Berlin, New York, California, and more recently Dublin.

Gable: Overall, the underperformers will come from companies and sectors with a lack of pricing power, a lack of demand, the inability to make accretive investments, decelerating growth, and deteriorating returns. This generally includes commodity office space, poorly located retail, U.S. student housing, and lodging.

Brown: One that we have concerns with would be the triple net lease space as a result of higher expectations for growth through acquisitions. If they run into an issue of not being able to raise capital for acquisitions, their growth rates would slow down.

Lastly, what is one BIG macro issue that you are watching closely for 2020?

Barnard: Market dynamics between “growth and value” have continued to stretch, and it will be interesting to see how this trend plays out in 2020. More broadly, it will be the “unknown unknowns” which will have the biggest impact on stock prices, and we can’t claim to have any insight on these. This is why we highlight that REITs should be used as a building block within a balanced portfolio.

Brown: Once we see who the Democratic presidential candidate is, the question will be what type of policies they will pursue. If the candidate is advocating for a higher tax, higher spend environment, that could be problematic for investments in general, and it would be viewed as a headwind in general for REITs if higher taxes led to higher interest rates.

Gable: We think the overall level of corporate debt should be monitored closely as it could become very damaging to the global economy if deleveraging becomes necessary and it cannot be supported by cash flow. Our concern is that companies will be forced to protect their margins with cost cutting programs that result in a negative spiral of economic impacts and higher credit spreads and borrowing costs.

Kellenberger: We do see the upcoming presidential election getting a lot of attention. Another issue is California’s vote on a proposal known as the split roll, which will be on its November 2020 ballot. That proposal would repeal Proposition 13, which has limited property tax increases to no more than 2% per year as long as the property wasn’t sold. If successful, commercial property owners would see increased tax bills that may not be fully offset from tenant reimbursement.

Romano: Aside from all the geopolitical and macro concerns discussed, one big issue is how REITs address technology. I think we’re going to start to see some separation in results for those companies that can embrace technology, utilize it in their platforms, and add value as a result of that.