Managing Changing Trends in Real Estate

REIT magazine: May/June 2018

An experienced investor with her eyes on both the domestic and international real estate markets, Nora Creedon sees a lot of positive signs in the U.S. REIT market. Creedon is the co-lead portfolio manager of the REITs and Global Infrastructure Strategies at Goldman Sachs Asset Management Division. Creedon spoke with REIT magazine about the evolution of retail, best practices in capital allocation, global real estate investing, and disruptive trends in real estate.

How are you interpreting the current volatility in the market, and how does that impact your management decisions going forward?

With the selloff in REIT equities thus far this year, we now calculate implied cap rates of north of 6 percent. This is a very attractive spread to that risk-free rate. 

Secondly, it appears rising inflation expectations have been a big driver behind higher rates. While real estate generally benefits from rising inflation, we believe there are sectors and specific companies that especially benefit. 

So, bottom line, we are looking to take advantage of the volatility in the market this year to position our portfolio for inflation beneficiaries and where we have a large margin of safety in our implied cap rate to own real estate. This volatility should produce a much more favorable environment for stock picking and alpha, in our view. 

Which of your strategies provided the most active returns for investors last year, and why? 

Our best performing strategy over the last year was our U.S. REIT Income Strategy, which has outperformed the U.S. REIT benchmark by about 660 basis points on a trailing one-year basis. This strategy focuses on common stocks with stable and growing dividends and preferred securities that have been very attractive to yield-starved investors. 

What are some of the strategies being employed to deliver consistent ROI for your investors in these mercurial times? 

The market tends to put the highest value on organic, same property growth that requires a minimum of new capital investment to sustain that growth. This is why many REITs have shed “commodity” assets in recent years in favor of class A assets with pricing power and expensive alternatives. 

For companies operating in sectors not friendly to new supply (retail for example), the best ROI opportunities may very well be in investing free cash flow in the REITs’ own properties to make them stronger and more dominant. We look for management with a demonstrated history of successful capital allocation, armed with a strong balance sheet to take advantage of opportunities at the right time. 

In your global real estate strategies, which are highly diversified, which sectors are you most enthusiastic about?

Our strategy is relatively sector neutral, and instead sources our alpha at the stock level. In the global strategies, there’s the potential additional opportunity to pick stocks within a given sector across the globe, and therefore capture valuation discrepancies and opportunities between say, for example, class A malls in Europe, Asia/Australia and the U.S.

That said, within the various sectors, there are certainly some opportunities emerging that are worth mentioning. In retail, we believe there’s insufficient differentiation between high-quality and low-quality assets. We believe it’s an evolution of retail, not the death of retail and that negative sentiment has made valuations very attractive for high-quality retail REITs. 

In multifamily, we have grown more constructive since the sector is not a direct victim of disruption (such as online spending with retail, and millennial and sharing economy effects in hotels and office). Supply concerns have subsided and demand trends are improving.  The newest positive development is tax reform, which should drive incremental demand for “for rent” housing (which REITs represent) relative to “for sale” housing since it makes the latter more expensive. 

Hotels stand to benefit from the newly passed U.S. tax reform, which will lower the tax burden for both companies and individuals. This should translate to increased business and leisure travel, thus driving demand upwards. Balance sheets (the aggregate level of debt and complexion of the leverage) are the healthiest we’ve seen in over a decade. 

Lastly, on towers and data storage, we continue to have a positive outlook on this sector due to compelling secular trends. They are direct beneficiaries of the exponential growth in global mobile data and stand to benefit from the development of autonomous vehicles and push toward 5G networks.

What countries or regions of the world are you bullish about for real estate investment?

We have been overweight Japan and continental Europe in our global strategies. In Japan, we perceived an opportunity in the Japanese developers some time ago, and as economic growth began to improve there we saw significant lifts to both earnings power and valuation. In Europe, we saw growth re-emerging in Spain and France in particular, and good spreads to local bond yields.

On the flip side, what countries or regions concern you?

U.K. office is an area of concern for us until we get more clarity around Brexit and what the ultimate job migration to the Continent might look like. When Brexit occurred, there was quite a bit of new product being built and we know tenant incentives are up significantly, hurting net effective rents as this supply will take time to be absorbed. There were some very strong trophy asset sales over the last year or two, but much of that was driven by foreign buyers, so we are a little skeptical on using them in our NAV models. 

We are also underweight Australia, where the benchmark is retail real estate heavy, and we perceive some complacency about what e-commerce could do in that market.

How do rising interest rates impact investing in real estate versus the bond markets?

It’s common to compare investing in REITs to investing in fixed income securities, but remember with real estate you will have the added factor of cash flow growth or contraction. So, if you’re reasonably bullish about economic growth, de-regulation and tax reform, you should have the added benefit of cash flow growth with almost all real estate sectors (although certainly to different degrees depending on the asset class and its lease duration).  

Additionally, unlike broader equities, REIT balance sheets are stronger than in 2007 (in terms of leverage being lower and complexion of debt mostly being fixed) which means that it will take longer than it has historically for the rate increase to filter into rising cost of capital. That, along with the higher starting yield in real estate versus most fixed income securities, makes us more constructive on real estate as an asset class. 

There’s been a tremendous amount of money flowing into fixed income in the last several years, particularly high yield funds. To the extent that capital starts looking for a new home, we think real estate could offer a good fit. 

How do you think the outcome of tax reform will impact U.S. real estate investment in general?

Overall, real estate came through tax reform in good shape, in our opinion. Real estate was eliminated from the debt limits imposed for interest deductibility, and the 1031 tax exchange program was kept intact. Both of these should support the private market for real estate, which of course, feeds public market valuations. 

We also believe REIT shareholders will benefit from the new 20 percent deduction in pass through dividend income, and 260 basis point reduction in the top marginal individual tax rate. This could result in a 14 percent increase in after-tax income on REIT dividends for some shareholders. 

And lastly, we believe putting more dollars in corporate America’s after-tax profit pool is good for real estate demand overall. It could drive more hiring, more travel, more capex for industrial purposes, and higher wages, all of which could benefit demand for different real estate sectors. 

What REIT sectors do you expect to outperform? 

Over the last year, the best performing REITs in the U.S. were industrial REITs and data center REITs. Both are in favorable parts of their respective real estate cycles, where demand is exceeding supply. 

For industrial, much of this is being driven by the growth in e-commerce and all the related logistics chain changes that are occurring with the rise of this channel; and for data centers much of it is being driven by the growth in hyper-scale cloud players, as well as the growth in data overall. 

Other sectors in real estate are further along in their cycle, and therefore contending with supply that is greater than demand, and still other sectors are facing more secular threats (such as commodity retail and commodity suburban office).

With some fairly low initial investment thresholds in some of your real estate strategies, what advice do you provide institutional and individual investors alike when it comes to investing in these types of strategies versus ETFs or individual stocks?

We believe most investors will be better served by investing in a diversified real estate strategy, with exposures to multiple different asset classes and geographies, versus individual stocks. In terms of active versus passive, we believe the challenges active investors faced in the past decade are subsiding and will ultimately prove to be more cyclical in nature.  

The unprecedented monetary and fiscal stimulus in the system since 2008 (in terms of both magnitude and degree of synchronization) created an environment defined by high correlations and low dispersion which made it difficult for active managers to outperform net of fees even if they made the right decisions. Now that this is reversing and disruption trends are accelerating, we believe the set up is quite attractive for active investors. 

What do you see as the next disruptors fort global real estate?

The beginnings of using artificial intelligence, driverless cars and applications we can’t even envision are sure to guarantee more change. 

But, you also still need a place to live, a place to eat and be entertained, a place to work and so on, and as a result great brick-and-mortar real estate is also going to thrive in our view. Technology has also brought entirely new sectors to our opportunity set, such as data centers and communications towers. We believe there is still a lot of growth to those sectors globally. 

Why are real estate strategies good for income-oriented investors? 

Income investors are generally looking for a yield premium and stability to that yield—REITs offer both. REIT dividends are at a premium to many fixed income securities, carry low payout ratios in a historical context (therefore have room to increase), will grow with cash flows as demand could increase in a stronger economic environment and carry less risk than the last cycle thanks to de-leveraging that occurred in the financial crisis. 

Nora Creedon is the co-lead portfolio manager of the REITs and Global Infrastructure Strategies at Goldman Sachs Asset Management Division. She first joined Goldman Sachs in the Global Investment Research Division in 2000 and rejoined the firm in 2010 in her current role. She was named a managing director in 2013.

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