While investors shied away from real estate securities in the latter half of 2016, analysts believe that an improving economic backdrop and an enhanced outlook may benefit the real estate sector. Stanley Kraska, Head of Global Securities at LaSalle, talks to Giada Vercelli about whether now it is a good time to invest in real estate securities, with an eye on growing demand for Sharia compliant investment tools.
Giada Vercelli: What is your assessment of the global real estate sector currently? What is happening to real estate fundamentals?
Stanley Kraska: Looking across the globe today, real estate fundamentals remain healthy and broadly supportive of the real estate sector. Moderate economic growth has continued to spur demand for space, occupancy levels are ﬁrm or improving and rental rates are still growing in many markets around the world. We have seen vacancy rates decline dramatically over the past few years. As a result of these progressing fundamentals, we have seen an increased level of supply in some markets, but generally only to average historic norms. While we expect fundamentals to remain healthy, the increased supply level may moderate the pace of improvement. Many companies are seeing the benefit from these healthy conditions through growth in income from their properties and value creation opportunities from new developments and re-developments.
GV: Tell us about recent performance in GRES (global real estate securities) markets.
SK: In 2016, global real estate companies produced solid absolute total returns, as the FTSE EPRA/NAREIT Developed Index gained +5.0% in the full year, in USD terms. The FTSE EPRA/NAREIT Developed Index is a widely referenced benchmark when referring to global real estate securities. Real estate securities outperformed global bonds, but mildly underperformed the broader equity market in 2016.
In the first half of the year, real estate securities benefitted from a period of declining interest rates, safe-haven flows and a healthy real estate fundamental backdrop. However, after this period of strong performance, real estate securities were impacted by a rotation in the broader market away from market segments perceived to be more defensive and towards more economically sensitive sectors.
This rotation began in the third quarter of 2016, as growth expectations firmed and were accompanied by a corresponding increase in interest rates. The unexpected U.S. election result and the potential impact of President Trumps pro-growth agenda enhanced the economic outlook further. Subsequently, investors continued a shift towards more economically sensitive sectors, as well as towards market segments which may benefit more immediately from the potential of lower regulation and increased fiscal stimulus.
While investors shied away from real estate securities in the latter half of 2016, an improving economic backdrop and enhanced outlook may benefit the real estate sector. We believe the longer-term performance of real estate securities is driven by underlying fundamentals, not movements in interest rates. What really matters is improvement in the broader economy - which includes increased consumer spending, business and leisure travel, and demand for office and warehouse space as these factors are what drive real estate fundamentals, and the performance of the real estate sector.
GV: How do rising interest rates impact REITs?
SK: In the short run, rising interest rates do not have a material impact on real estate fundamentals and companies earnings. While increases in interest rates may cause short-term volatility for global real estate securities, we believe the longer-term performance of real estate securities is more directly inﬂuenced by changes in underlying real estate fundamentals and real estate values than by changes in interest rates. Changes to real estate fundamentals and property values are driven by several factors, some of which include demographic and economic growth, inflation, interest rates and government regulation. While a sharp rise in interest rates can negatively impact real estate securities, as evidenced in the second half of 2016, longer-term performance should depend on what has contributed to such an increase. When rising rates are accompanied by or a result of an improved economic growth outlook, this changing environment may lead to an improvement in real estate fundamentals, resulting in higher operating cash flows and growth expectations for real estate securities, which mitigate the negative impact of an increase in rates.
GV: How are public real estate companies positioned at this point in RE cycle?
SK: Broadly speaking, we have moved into a later, more mature stage of the business and real estate property cycles in certain markets across the globe. At the same time, part of the attractiveness of an investment in public real estate companies is that it enables exposure to multiple markets around the world. Markets across the globe can be at different stages in terms of their fundamentals, capital markets and other cyclical factors, which can provide diversification benefits to an investor, as well as the potential for an investment manager to seek attractive investment opportunities.
Looking at individual companies specifically, we believe most public companies are well positioned for the current market environment. Most companies have set out to improve their portfolios and aim to own higher quality assets which allows them the ability compete for tenants in tighter or developing markets. The companies we invest in tend to have strong balance sheets, which should provide financial flexibility to be defensive if needed or take advantage of available opportunities.
GV: Is now a good time to invest in real estate securities?
SK: At LaSalle, we believe that investing in real estate is an asset allocation decision and an investor should always have an allocation to the global real estate securities market. The beauty of a global real estate allocation is that an investor gains exposure to multiple regions, which can be at differing stages of the business and real estate property cycles.
At this time, real estate fundamentals remain broadly healthy across the globe and companies continue to experience income growth from their properties and value creation opportunities which should continue to produce a strong profit picture for the sector. Global real estate companies also currently offer an attractive and well supported cash dividend yield compared to government bond alternatives. For reference, the FTSE EPRA/NAREIT Developed Index offers a dividend yield close to 4%, which is about a 2% spread above the average of 10-year government bond yields around the globe.
In recent months, real estate securities share prices have been negatively impacted by firming growth expectations and a fast-paced increase in interest rates which occurred in the latter half of the year. We believe a re-acceleration of economic growth could benefit the real estate sector and provide the sector the backdrop to produce healthy earnings growth. With values holding and share prices declining, global real estate securities are trading at moderate discounts to our assessment of their Net Asset Value (NAV). Over the longer-term, global real estate securities have traded at modest premiums to NAV.
GV: Should investors look to public or private RE in order to get RE exposure in their portfolios?
SK: We believe both public (real estate securities) and private real estate (physical real estate asset) investments are a good way to gain exposure to the real estate asset class. Real estate is attractive to investors as it can be an effective income generator as an individual asset class, has a relatively lower correlation to other asset classes, and allows asset value appreciation over time. Public and private real estate offer a large universe of potential investments, strong historical performance and diversification benefits to other asset classes. These investments can be owned individually or as a complement to one another.
An allocation to public real estate allows an investor enhanced diversification and exposure to institutional quality assets across the world, with the added bonus of daily liquidity. An investment in public real estate enables an investor to access traditional property types as well as newer, specialty sectors. In addition to the attractive dividend yield of public real estate, investors also benefit from the alignment of their own interests with those of public real estate management teams and gain insight into real estate market trends and information.
While an institutional investor can utilize public real estate to supplement their real estate allocation, for an individual investor, a public real estate investment may be the only option to gain exposure to global real estate markets. Global real estate securities offer a high-quality, liquid and diverse allocation opportunity for an investor with a minimal initial cash outlay.
The second half of this interview will appear on the blog on Monday 27th February.
Hear more on this topic at the upcoming Euromoney Executive Briefing: REITs in the KSA, which will take place in Riyadh on Monday 1st May. For more information, please visit the event webpage.
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