With US interest rates rising, and investors in real estate investment trusts wondering what the direction of the market heralds, Gillian Tiltman, portfolio manager on the Neuberger Berman Global Real Estate Securities Fund, and Thomas Bohjalian, executive vice president, Cohen & Steers, give their view.
“The global Reit market has experienced a bumpy ride during the latter part of this year,” says Tiltman.
“But in 2017, we expect real estate fundamentals to remain positive. Indeed, we think fundamentals, rather than interest rates, will be the long-term driver of Reit performance next year.
“In the US, while there continues to be uncertainty around some of President-elect Donald Trump’s policies – namely healthcare, immigration, global trade, infrastructure and defence spending – the equity market has performed better than expected since the election. Lower taxes and a pro-business environment should bode well for economic growth. Higher interest rates will likely be a short-term headwind for real estate securities, but over the longer term an improvement in the economy and job market should be good for property owners. Modest inflation could be supportive to rental rate and cash flow growth.
“Europe ex-UK has been a strong performer over the last three years. In the near term, however, there are likely to be headwinds as a result of rising bond yields and the likelihood that the European Central Bank will start to taper its bond buying program next year. There’s also increased political uncertainty over the results of the impending French and German elections.
“In the UK, there has already been a significant price correction in the listed property market, driven by the outcome of the Brexit referendum. The market is currently pricing in a 20% decline in asset value. However, we do not think this is likely and, as a result, believe the asset class is starting to look attractive.
“In the Asia Pacific region, the outlook is likely to be mixed. Property developers in Hong Kong and Japan will likely outperform as their valuations are already discounting a hefty decline in real estate values while Reits’ valuations remain somewhat elevated relative to Net Asset Values. However, Australian Reits could prove more resilient in light of attractive yields and their low level of financial leverage.”
Trump changes everything
Bohjalian says: “Proposed policy changes under the upcoming Trump administration could speed up US economic growth and drive higher inflation, potentially improving real estate fundamentals at a critical time.”
“Trump’s key policy pillars have included more infrastructure spending, lower corporate and individual tax rates, a reduction of regulatory burdens and protections for low income workers through higher trade and immigration barriers. With Republicans in control of both chambers of Congress, there is a strong chance many of Trump’s legislative priorities will be implemented in some form.
“The details of how these policies are enacted will be critical in determining the ultimate economic impact. In particular, questions about Trump’s global trade policy and geopolitical strategy are likely to remain unanswered until he takes office. But gauging from the post-election spike in US treasury yields, markets are already anticipating higher inflation and growth.
“After two years of compression in earnings multiples, we believe Reits could perform well in such an environment. Although real estate fundamentals are still strong, the cycle appears to be in its later stages, with increased supply beginning to pressure some markets and external growth opportunities becoming scarcer. However, we believe higher growth and inflation rates could essentially reset the cycle through accelerating demand and slowing new supply.
“On the demand side, more fiscal spending and lower taxes could drive job growth, corporate profits and increased consumption through wage inflation. On the supply side, higher inflation may pressure the environment for construction. Higher costs for labour, raw materials and financing would, in turn, mean a higher cost to replace aging real estate, raising the value of existing properties. With occupancy rates in the US already at high levels, a tailwind of demand amid reduced supply growth could be an important driver of Reit fundamentals in the long run.
“The absolute and relative valuations of Reits have improved significantly since the sell-off over in recent months. The market is trading at roughly the same level as it did two years ago, despite achieving cash flow growth in the high single digits. Investors are also now able to buy real estate through Reits at a lower price than in the private or open-ended market.
“While bond yields change quickly, changes in real estate fundamentals take time to work through the system. This is the challenge for investors in respect to interest rates. However, as long as the rise in long-term rates is commensurate with improvement in growth, Reits can perform well.
“In fact, Reits have historically delivered strong returns in periods of rising yields, as these periods are generally characterised by accelerating economic growth. When the economy is improving and fundamentals are strong, yield-driven corrections are often a time to consider adding allocations to real estate securities.
“While Reit prices may be sensitive to changes in interest rates in the short term, long-term performance depends more on real estate fundamentals and the strength of the overall economy. We believe investors who are aligned to take advantage of temporary dislocations resulting from rising interest rates may be rewarded in the long term.”
Gillian Tiltman (left), portfolio manager on the Neuberger Berman Global Real Estate Securities Fund, and Thomas Bohjalian (right), executive vice president, Cohen & Steers