Property sector bounces back

What a difference a year can make. Yield-hungry investors of all descriptions have been pouring into pooled property funds. The latest figures from the UK’s Investment Management Association, for example, show that property was the best-selling sector in January – as it was in the final quarter of last year – attracting £373m (€422m).

“It was difficult, 18 months ago, to entice anyone into property; too many had had their fingers burned in the crisis,” says Rupert Robinson, chief executive at Schroders Private Bank. “NAVs had collapsed and illiquidity was firmly in the spotlight. Now we’re seeing a marked pick-up in demand for property investment, particularly from overseas investors because sterling has fallen against the euro and dollar.”

This time, however, asset management groups are taking a more moderate and tempered approach. “A number of open-ended funds have already put up the shutters to new money,” says Mr Robinson.

“This is a marked change of attitude from the approach in 2007 where asset managers became greedy and took more and more money, investing it into property that was already well priced – managers are now more circumspect about how much they take from investors and how much they are willing to pay for assets.”

Prime offices in central London have been leading the recovery, as companies compete for a dwindling amount of high-quality space. Financial institutions agreed new leases on more than 195,000m2 of offices in the City and the Docklands in the first quarter, a five-fold increase on 2009, according to New York-based property broker Cushman and Wakefield, and rentals rose 14 per cent in the first quarter compared with the final three months of 2009.

Arguably, however, the industrial sector is more attractive as it is linked to general economic activity rather than employment levels, particularly as the financial sector has not started to replenish staffing levels.

“Property fundamentals are still relatively weak – these flow from economic conditions – weak economic growth and weak or even negative employment growth depending on the locale,” says Bruce Eidelson, director, real estate securities at Russell Investments. “The office sector is heavily dependent on financial services, which has been adversely affected and continues to be under pressure,” he explains.

“Retail properties and the warehousing sector should also bounce back as consumers become less cautious and the recovery appears sustainable. The sector recovering most strongly, however, has been hotels as business travel budgets and leisure spending have ticked up. Much future growth is now priced in, but a case can still be made for further progress.

“One challenge the sector had was the high level of short-term interest in late 2008 and early 2009 from hedge funds and other speculators but that has now declined and we are seeing more price stability,” says Mr Eidelson.

“That was hot money but we’ve been seeing a stable level of commitment to the sector. Most institutions have stuck with their allocations, and a number of clients who did not have exposure have been coming back in.”

Some managers are taking the opportunity to arbitrage a valuation disparity of around 10 per cent between stocks in the development stage with greater gearing and stretched balance sheet, and more defensive mature stocks such as healthcare. For example, Steve Buller, portfolio manager of Fidelity Real Estate Portfolio, says he has been taking positions in stocks with valuation issues, that he thinks will come good.

The UK market’s recovery is lagging parts of Asia and Australia, and even the rest of Europe, with NAVs down 50 per cent from their peak. Funds such as MSMM Global Real Estate Securities fund have therefore taken an overweight position in the UK on the calculation that valuations will bounce back. UK stocks are traditionally more responsive to value adjustments than stocks elsewhere, particularly in continental Europe.

Buying property in South East Asia and China has become a gravy train for investors looking to ride the booming economic growth of emerging markets.

The younger economies have a chronic need of infrastructure; world grade offices are in very short supply in Rio and Sao Paulo, for example. Most of the focus in Asia is on the retail sector to capture the spending power of the new middle classes, but the threat remains that interest rates could rise and dampen prices, and that much of the good news is already in the price.

Just as many funds in the sector, such as the Russell, Robeco and Invesco funds included in the table, are overweight Asia Pacific and Australia, many are underweight North America. High foreclosure in the US is taking its toll on retail markets due to the higher correlation between the health of the housing market and retail activity.

Joe V. Rodriguez, Invesco

“Our portfolio is slightly underweight the US and slightly overweight Asia, particularly China and Hong Kong, where the overall theme is the huge potential in retail space,” says Folmer Pietersma, fund manager at Robeco Group. “Retail is the more resilient way to enter emerging countries, while offices are a more volatile boom/bust prospect. The key factor to consider is that a retail mall is built only when it is already three quarters pre-leased. In contrast, office space is more speculative with swings in supply and huge vacancies in bad times.” The Robeco fund’s holdings include BRMalls in Brazil and Singapore’s Capital Malls Asia.

The retail sector is also a way to play rising residential property ownership in emerging economies. There are particular opportunities in the mid-to-top end of the residential sector in Hong Kong which is seriously undersupplied.

Mr Pietersma also likes Turkey, and holds stocks such as Sinpas Gayrimenkul, because the nation’s macro outlook is improving, its financial system is sound and higher wealth levels and apartment ownership are creating positive momentum.

Direct route

One of the traditional debates around property is about the pros and cons of investing in property stocks or funds that invest directly in bricks and mortar. The advocates for Reits are vocal right now as liquidity is highly prized and good companies have repaired their balance sheets and are once again able to secure cash on favourable terms. This will allow them to take advantage of opportunities to buy distressed properties from banks and other forced sellers. Conversely, Reits have already discounted the economic uptick in their valuations, while direct property prices have yet to fully reflect the recovery.

“We feel stock funds benefit from liquidity, daily valuations and most importantly, the ability to move the portfolio around to achieve the best combination of fundamentals and valuation,” says Joe Harvey, president and CIO of New York boutique Cohen & Steers.

“Determining what looks good fundamentally is only one half of the equation. The other half is what is priced in and what is not. In contrast, the direct market needs a much longer time horizon, and the manager has to be prepared to live with his decisions for a long time. It is also harder to run a good diversification.”

Fidelity’s Mr Buller believes in companies that have the capacity for external growth in the UK, US, Japan and continental Europe. “Those will be in the forefront of buying property from forced sellers,” he says.

“The listed sector can profit from that, although opportunities are not now as good as they were a year ago. An example is British Land, which sold off some assets and repositioned its balance sheet so that it can be part of the repair process. Overall US, UK and Japan have had the most excessive lending and value degradation.”

Even Australia has experienced a substantial amount of company recapitalisation, a factor in its popularity along with its resilient economy, links to the powerhouse China and a lack of reliance on financial services.

Mr Buller believes that capital inflows can be as crucial as fundamental factors and points out that in 1998 the US Reit market had some of the best fundamental factors but negative returns as capital flowed out of the sector in that year; a situation that is similar in a reverse sense today as we have poor fundamentals but positive capital flows.

“If you go back to early 2009, the more highly levered a company, the more likely it would be to outperform its peers,” says Joe V. Rodriguez, managing director, real estate securities management at Invesco.

“But there is little room for error and these are the kind of stocks we tend to avoid. Looking ahead, we think this high beta rally is on its last legs and the next three to five years will be about companies with better quality mousetraps – that is, companies with better managements, better understanding, and better fundamentals. These may be the ones to produce the highest relative cash flow per growth over the long-term.”

Investors look to property for sustainable returns

Investors are choosing property primarily for an income that is significantly above gilt yields and over the long-term averages high single digits with a little less than half of that derived from dividends.

They are also using property to diversify and – increasingly – as a long-term hedge against inflation. This boom is also characterised by the speculative interest in the macro growth story in Asia.

“Many investors have a small underweight to property and have overlooked the sector in the last few years as it was hit by the crisis,” says Folmer Pietersma, whose Robeco fund has grown to €210m from €150m at the start of the year.

“There has been a discernable trend in flows from money market funds to high yield corporate bond funds and recently to property funds as bond spreads have tightened.” Investors are looking for value and Reits often pay a 4-5 per cent dividend yield which is looking sustainable and supported by earnings, he says.

Bill O’Neill, CIO at Merrill Lynch Wealth Management, advocates “a position in direct property as a way to play the revival, rather than a closed end investment trust, as most stocks have already discounted an upturn. In real bricks and mortar, the recovery is only just beginning. We have been an advocate of direct funds since December – the sector began to turn in mid to late autumn and is up 13 per cent from its bottom, according to IPD figures,” he says.

“Rent-led indicators such as voids suggest we may have hit bottom already and certainly will have done so by the end of the year. Prime offices have already rebounded and we believe the next stage will see commercial and retail moving [up]. As rates go up, banks will foreclose and will want to reduce their exposure to the sector, but they should be able to manage the pressure and there is appetite in the market to buy distressed properties,” says Mr O’Neill.

“The threat in emerging markets is that rates may go up too far too quickly but [we’re working on] the assumption that we’ll get a gradual and modest rise in rates.”

Pension provider Rowanmoor says the bulk of clients have been owner managers themselves and understand commercial property. “In the current climate we favour bricks and mortar funds that own vast estates of properties with good quality tenants, long leases and upward-only rent reviews,” agrees Neil Merryweather, director of consultancy, but the firm is not actively putting clients back into property just yet –the sector has been swamped by retail money and the resurgence may not be sustainable. They are looking to get back to fair value, and will re-evaluate once the UK election is over, probably in the third or fourth quarter of the year.