Fourth Quarter International Real Estate Securities Strategy
January 15, 2010
Author(s):
Market Environment
During the fourth quarter financial markets received a not so subtle reminder that the road to recovery will continue to be a bumpy one when Dubai World, a government controlled investment conglomerate with significant global real estate exposures, sought a standstill agreement from its lenders regarding billions of dollars of debt that was coming due in the next six months. While the total debt obligations of Dubai World are small in relation to the overall global financial system, the announcement and the immediate negative market reaction did highlight that the global financial recovery remains fragile and highly susceptible to extraneous events.
Notwithstanding this short-lived market scare, global equity markets ended the year on a positive note, closing the year out with some of the best annual total returns in market history. As it pertains to global equity market returns, in many ways 2009 was a mirror image of 2008 as some of the hardest hit asset classes and industry sectors in 2008 were the return leaders in 2009. Such was the case for international real estate securities as highlighted in the following charti.
International Real Estate Securities Market Review
Following strong performance in the second and third quarters, international real estate securities consolidated their gains during the fourth quarter generating slightly positive total returns. For the quarter international real estate equities trailed international equities as highlighted by the 1.50% increase in the FTSE EPRA NAREIT Developed Rental ex U.S. Index (“the Benchmark”) versus the 2.25% increase in the MSCI EAFE Index, both expressed in U.S. dollar terms.ii Total returns for international real estate and international equities fell short of U.S. equities during the quarter when compared to the 6.04% increase in the S&P 500 Index, in part due to the strengthening of the U.S. Dollar, which increased by 1.6% as measured by the U.S. Dollar Spot Index.iii
With the recapitalization of global real estate company balance sheets having largely run its course, many companies are now positioned for external growth opportunities. In fact, during the quarter we witnessed the emerging return to the virtuous cycle of global real estate companies issuing capital to consummate acquisitions at positive spreads to their underlying cost of capital. Because real estate fundamentals will improve at a lag to the global economy, internal growth driven by improvements in rents and occupancy will be marginal at best in the near-term. Thus, for many global real estate companies the primary driver of cash flow and dividend growth in the short-term will be the extent to which they can source and execute on attractive acquisition opportunities.
Taking a closer look at the individual countries that are represented within the FTSE EPRA NAREIT Developed Rental ex U.S. Index, the top five performing countries during the fourth quarter on a total return basis measured in U.S. Dollars were Norway, Hong Kong, Singapore, Canada and the U.K.iv The economies of Asia-ex. Japan continue to show positive momentum relative to the overall global picture, which should translate into better demand side real estate fundamentals in the near-term, benefiting the local real estate markets and the companies with investments there. Canada continued its year-to-date out- performance during the quarter as the local financial and real estate markets remained relatively calm compared to the volatility witnessed globally and as investors continued to find the dividend yields offered by local real estate companies attractive compared to other yield alternatives.
Conversely, the bottom five performing countries during the quarter were Japan, Germany, Greece, Austria and Australiaiv. Among the bottom performing countries, Japan was a real disappointment as it was one of only two countries to finish the year with a negative total return in U.S. dollar terms, in an otherwise very strong return year. Returns were weak during the fourth quarter as a large amount of equity issuance by financial firms weighed on the market. A few Japanese REITs participated in the equity issuance wave during the quarter and for the most part the deals were poorly received. In addition, the Japanese Yen weakened significantly against the U.S. dollar during December, which dragged returns down as well.
Portfolio Review
For the quarter the performance of our international real estate securities strategy out-performed its Benchmark on both a gross and net of fee basis.
Performance was positively impacted by stock selection more so than country allocation, although both were positive contributors in the quarter. The three countries that had the greatest positive impact were France (stock selection), Australia (stock selection) and Hong Kong (country allocation).
The most meaningful detractors from performance during the quarter were Japan (stock selection and country allocation), Norway (country allocation) and Canada (country allocation).
We increased our exposure to Australia during the quarter, moving from neutral weight to overweight as the economy continues to be the best performer across our investment universe, which should drive an improvement in real estate fundamentals in the coming year. We also marginally increased our exposure to the U.K. by adding to two of our more economically sensitive holdings within the country, which should benefit as the economy improves.
Our underweight to Canada grew during the quarter as a couple of new companies were added to the Benchmark and we sold out of one of our positions. Having just added exposure to Brazil during the third quarter, we reduced our position during the fourth quarter following strong investment performance of our one holding in the country.
Investment Outlook
While the outlook for international real estate securities remains positive for the next twelve months, assuming a continued recovery in the global economy, we expect total return performance to be more muted in 2010. Although global real estate fundamentals weakened during 2009, the securities performed strongly as risk premiums, and in turn cost of capital, compressed rather dramatically. Importantly, global real estate companies did not complacently watch this improvement in capital markets, but rather actively sought to take advantage of this environment to put their financial house in order and better position their balance sheets for the next phase of the real estate cycle.
With their improved capital costs and cost of capital advantage over private real estate players, global real estate companies that have spent the past year enhancing their liquidity and financial capacity, will look to put this capital to work in 2010 and beyond. This desire to put capital to work by the public companies, together with growing distress in the private real estate markets, points to a continued pick-up in transaction activity over the next year. Ultimately the big question will be: How much volume and at what price? The answer to this question will go a long way to understanding what the cash flow growth outlook will be for global real estate companies in 2010 - 2011. Given soft real estate fundamentals that will improve with a lag to the overall global economy, the current outlook is for negative to slightly positive cash flow growth depending on the country. However, growth in cash flow and potentially dividends and total returns, may prove to be more robust if acquisition opportunities at attractive going in returns become more plentiful.
Past performance is no guarantee of future results. Returns are calculated in US dollars and include the reinvestment of dividends and other earnings. Indices are not available for direct investment and index returns do not reflect the deduction of any fees. Gross composite returns are net of trading costs. Net composite returns are calculated by subtracting our highest separate account investment management fee from gross composite results on a quarterly basis in arrears. Investment advisory fees are described in Part II of our Form ADV. This material has been prepared using sources of information generally believed to be reliable; however, its accuracy is not guaranteed. Opinions represented are subject to change and should not be considered investment advice or an offer of securities.
The FTSE EPRA/NAREIT Developed Rental ex U.S. Index is a free-float market capitalization index measuring developed market international real estate securities that meet minimum size, liquidity and investment focus criteria. The Index is a sub-set of the FTSE EPRA/NAREIT Investment Focus Index Series, which separates the existing constituents into both Rental and Non-Rental Indices. It is a custom index, as the Rental Index utilized is ex U.S.
All indices, trademarks and copyrights are the property of their respective owners
iU.S. REITs as measured by the FTSE NAREIT Equity REITs Index
International Real Estate as measured by the FTSE EPRA NAREIT Developed ex US
Index
iiSource: FTSE, Bloomberg Finance L.P.
iiiSource: Bloomberg Finance L.P.
ivSource: FTSE
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