Fourth Quarter U.S. REIT Securities Portfolio Review
January 15, 2010
Author(s):
Market Environment
U.S. REITs and the Portfolio had a strong fourth quarter as the credit markets, capital availability, and macro-economic trends continued to improve. In addition, volatility continued to decline and is quite visible in the VIX® Index. The following chart represents the time period from December 31, 2007 through January 14th, 2010. It shows the VIX® Index has compressed to the lows over this time period, demonstrating a calmer environment.
Where Are We Now?
- Risk premiums have contracted significantly as measured by country risk premiums or corporate bond spreads and have been a significant driver behind the improvement in REIT equity prices over the last 12 months
- De-leveraging and capital preservation has been embraced by management teams and rewarded by the market, as more than $18 billion has been raised in over 50 equity issuances in the U.S. since late March 2009
- Over $8 billion of unsecured debt has been issued by listed REITs year-to-date, with nearly two-thirds of the issuance occurring during the third quarter of 2009
- Third quarter 2009 earnings reports were generally in line with expectations, with upside to expectations mostly driven by cost reductions and lower short-term interest rates
- Real estate fundamentals have a natural lag to the improvement in the broader economy.
- Real estate transaction volume, while still down significantly from prior years, is increasing and pricing is not showing the distress present earlier in the securities prices.
What Lies Ahead?
- We see the recapitalization of the global real estate securities industry, the majority of which has been completed, continuing to lower overall leverage, and positioning the industry to take advantage of external growth opportunities which will emerge over the next one to three years
- Commercial real estate debt maturities over the next few years will be a catalyst for increased transaction activity, as in many cases new equity will need to be injected to restore loan-to-value ratios to today’s more conservative levels
- Global real estate fundamentals will improve with a lag to the global economy but, once demand returns, relatively benign levels of existing supply will support a more robust recovery
- In the real estate downturn of the early ’90s, REITs bottomed in 4Q90, and rebounded by close to 60% before the private commercial real estate prices bottomed in 2Q93, something you would expect given the forward looking nature of equity markets
- The significant contraction in risk premiums over the last 12 months contributed to the out performance of higher beta, lower quality stocks, just as it has in previous cycles
- As the market shifts away from the recovery trade of 2009 to a focus on fundamentals in 2010, we believe companies with better positioned balance sheets and the capacity for growth will outperform
- No longer will the focus be on selling assets or equity to repair broken balance sheets, but rather on returning to the more virtuous cycle of issuing capital to make attractive acquisitions at positive spreads to underlying cost of capital and growing cash flow per share and ultimately dividends
- As long-term fundamental investors in real estate equities, with an emphasis on growth-at-a-reasonable-price, we anxiously await the emergence of this cycle and we believe our investment strategy is positioned to do well in this environment
REIT Portfolio Review
For the quarter, the Duff & Phelps U.S. REIT Composite returned 10.27% on a gross of fee basis (10.08% net of fee) vs. 9.39% for the Benchmark. For the year, the Composite returned 30.32% on a gross of fee basis (29.38% net of fee) vs. 27.99% for the Benchmark.
During the fourth quarter, the best performing property sectors were Regional Malls, Specialty, Manufactured Home sites, Health Care and Industrial. Lagging property sectors were Mixed Office/Industrial, Free Standing Retail, and Shopping Centers.
What helped and what hurt in the quarter? Shopping Centers (stock selection plus sector allocation), Regional Malls (sector allocation and stock selection), Office (stock selection), Industrial (stock selection), and Free Standing (sector allocation) were the primary drivers. From a sector perspective, two sectors detracted from performance, Health Care (stock selection) and Storage (stock selection).
Investment Outlook
- The recapitalization of global real estate security balance sheets has largely played out and many companies are now positioned for external growth opportunities
- Global real estate fundamentals will recover with a lag to the global economy
- Real estate transaction activity will increase as existing debt matures and equity needs to be injected
- Dividend yields remain attractive in today’s environment and are supported by historically low payout ratios
- The largest REITs paying dividends in stock, Simon Property Group and Vornado, have announced plans to pay them in cash going forward
- The recovery trade has likely run its course and low leverage companies, positioned for growth will likely outperform
- Long-term fundamental investors with a GARP focus, such as Duff & Phelps, should be well positioned in this environment
Past performance is no guarantee of future results. Returns are expressed 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 Benchmark is the FTSE NAREIT Equity REITs Index, a free-float market capitalization-weighted index measuring equity tax-qualified real estate investment trusts, which meet minimum size and liquidity criteria that are listed on the New York Stock Exchange, American Stock Exchange and the NASDAQ National Market System. The index is calculated on a total return basis with dividends reinvested.
The CBOE Volatility Index® (VIX®) is a key measure of market expectations of near-term volatility conveyed by S&P 500 stock index option prices.
FTSE® is a trade mark jointly owned by the London Stock Exchange Plc and The Financial Times Limited. NAREIT® is a trademark of the National Association of Real Estate Investment Trusts® (“NAREIT”).
CBOE Volatility Index® and VIX® are registered trademarks of the Chicago Board Options Exchange, Incorporated. S&P 500 is a registered trademark of McGraw-Hill Inc.
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