Sector Watch: Interest rates weigh on real estate

“In the U.K. and U.S., you’ve had strong returns, although they’re a little uneven in other parts of the world,” says Wolf. “The fundamentals are very good in certain places, and capital flows for investment have been very good. But [the strength of each market is] difficult to generalize. Each market is a micro-market.”

All eyes are on the U.S., though, as its rising interest rate environment is weighing upon markets. Indeed, rising 10-year bond yields have put pressure on real estate investment trusts (REITs) in the U.S.

“People are concerned about a higher rate environment,” says Wolf, noting that REIT unit prices are down by about 12% from January’s peak.

Ironically, Wolf also argues that valuations are still high: “But I’m not saying everything is overvalued. There are plenty of individual stocks that are attractively priced.”

A value-oriented investor, Wolf suggests that there are ways to minimize the impact of rising rates, such as avoiding dividend-only securities and favouring companies with shorter lease terms that are less vulnerable to rising rates.

Meanwhile, Wolf notes that REITs are trading at a slight discount to net asset value (NAV), compared with a 7%-8% premium in mid-2014.

“At this stage of the market, at which you have large companies trading at better valuations than smaller, mid-cap companies, that allows [larger firms] to do some accretive mergers and acquisitions. There is good potential that the smaller REITs will be acquired. That’s one of the ways you will be able to make money in the REIT market over the next couple of years.”

From a geographical standpoint, the Manulife fund’s portfolio managers have allocated about 45% of the fund’s assets under management (AUM) to the U.S., 16% to Asia (ex-Japan), 10% to the U.K., 8% to Europe and 5% to Australia. The fund also holds about 14% in cash. The portfolio is split between 60% real estate operating firms and 40% REITs.

Running a fund with about 40 names, Wolf continues to like Weyerhauser Co., a leading forest-products provider. Weyerhauser stock is trading at about US$30.65 ($38.45) a share and pays a 3.8% dividend. The stock trades at a 15%-20% discount to NAV. However, depending upon the U.S. housing market returning to 1.5 million starts a year, the stock may be worth US$38-US$42 within three to five years.

“It could happen by the middle of 2016 or 2017,” says Wolf. “No one knows when. But the prospects look very good.”

the fundamentals for real estate are reasonably good, mainly because demand exceeds supply in most markets, says Steve Buller, vice-president at Boston-based FMR LLC (a.k.a. Fidelity Investments) and portfolio manager of Fidelity Global Real Estate Fund: “There are some exceptions. But occupancies continue to tick up and the ability to push rental increases exists in more markets.”

Yet, there is a worry that “the cost of capital is a little higher than a year ago,” says Buller. “Interest rates and property stocks go through a tug of war. If interest rates are rising, that usually portends good economic growth, which should be good for real estate stocks. On the flip side, rising rates mean that the cost of capital is going up – and that’s a negative. So, we have seen a tug of war, historically, between the fundamentals and interest rates.”

Although Buller argues that the fundamentals eventually will win, he acknowledges that stocks may revert to historical return patterns. “The ownership of buildings or a portfolio of real estate stocks lends itself, especially in this interest rate environment, to more of a high single-digit per annum total return,” says Buller, noting that recent double-digit returns can be attributed to stocks coming off a low base in 2009.

Buller compares real estate stocks to a three-legged stool with the fundamentals, cost of capital and valuations comprising the legs. He also believes that real estate equities are trading at a 5% discount to NAV.

“The NAV has been going up across the world. You’ve had growing operating income and cash flows. So, NAVs have been increasing, although stocks have been OK lately; valuations are better. But you’ve given up a bit on the capital cost side.”

From a portfolio perspective, 51% of the Fidelity fund’s AUM is in the U.S., 30% is in continental Europe, 8% is in Japan, 5% is in Hong Kong, with smaller weightings in Canada and Singapore.

The largest portion of AUM – 30% – is in diversified firms, 23% is in office space, 20% is in residential and 18% is in retail, with small holdings in hotels and industrials. The fund is split between stocks (78%) and REITs (22%).

One top holding in the 67-name portfolio is British Land Co. PLC, a U.K.-based REIT that focuses on the London office market. “[British Land] has exposure to London offices, one of the best fundamentals stories in the world. We continue to see demand for space and sizable rental increases,” says Buller, adding that he believes the REIT trades at a 10% discount to its intrinsic value.

The REIT is trading at about £8.40 a unit ($16.40) and pays a 3% dividend. There is no stated target.

The real estate sector is in the middle of its cycle, with property fundamentals healthy and rents rising in most global markets, says Paul Curbo, portfolio manager with Dallas-based Invesco Real Estate, a unit of Invesco Ltd., and portfolio co-manager of Invesco Global Real Estate Fund. He works on a six-person portfolio-management team led by Joe Rodriguez, head of the real estate unit in Dallas.

“From a fundamental perspective, we are fairly positive,” says Curbo. “However, we are cautious with respect to rising interest rates. It may present some volatility for the listed securities and we’ve seen some of that this year.”

If the U.S. was regarded in isolation, a decision to raise rates would reflect stronger economic fundamentals. But that decision is held back by a host of unknowns, such as slowing growth in China. “There are various impacts in terms of the Fed’s pace in raising rates,” says Curbo, adding that his firm prefers to take a longer-term view and focus on the fundamentals rather than short-term changes in interest rates.

On a global basis, Curbo argues that the real estate sector is attractive, as it trades at about a 6% discount to NAV. Yet, the discount is as high as 20% in Hong Kong and 10% in Singapore, which are affected by the slowdown in China.

“In certain cases, real estate looks more attractive, given the pullback in shares,” says Curbo. “We don’t see signs of overbuilding at this point, but we continue to monitor it. The longer this cycle goes on, that will be the key risk for investors to monitor.”

From a portfolio standpoint, 50% of the Invesco fund’s AUM is in the U.S., 30% is in greater Asia and 15% is in Europe. Diversified firms represent the largest portion of the fund at 28% of AUM, followed by 22% in retail, 13% in office, 12% in residential and smaller holdings in segments such as health care.

One of the top holdings in the 100-name Invesco fund is Federal Realty Investment Trust, a REIT that specializes in shopping malls on both U.S. coasts. Says Curbo: “[Federal Realty] has the highest-quality portfolio, from a rent perspective or sales [per square foot] perspective. Retailers can choose to be in the best centres and concentrate on the best locations. Federal benefits from this trend.”

Federal stock is trading at about US$135.25 ($169) a share, or 21 times cash flow. Adds Curbo: “That may appear rich, but we think it actually trades at a discount to its NAV.”

There is no stated target.

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