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Global Real Estate Securities
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March 31, 2008
We are pleased to share with you our review and outlook for the global real estate securities markets as of March 31, 2008. For the quarter, the FTSE EPRA/NAREIT Global Real Estate Index had a total return of –5.6% in U.S. dollars. In local currencies, the total return was –8.3%.
Investment Review
Global real estate securities declined in the first quarter, with weakness in Asian markets overcoming positive returns elsewhere. The best performer in 2007, in the fourth quarter Asia began to succumb to the economic and credit concerns that weighed on other markets, and the impact of a slower global outlook carried over into 2008. The United States and Europe both had gains in local currency terms; for dollar-based investors, euro zone returns were boosted by a strengthening euro. Asian currencies, in particular the Japanese yen, also appreciated against the dollar, while the British pound was relatively flat.
The U.S. was aided by Federal Reserve actions
U.S. real estate securities advanced 1.4% despite a decidedly negative period for U.S. equities (the S&P 500 Index had a total return of –9.5%). REITs benefited from relatively attractive valuations, better-than-expected 2007 earnings results and Federal Reserve easing. The Fed lowered interest rates from 4.25% at the start of the quarter to 2.25% by mid-March in an aggressive response to weak economic reports and instability in global financial markets.
To that end, the Fed also announced new lending programs to investment banks as well as commercial banks, aimed at easing the persistent credit crunch. Late in the period the Fed’s role in the proposed acquisition of Bear Stearns by JPMorgan Chase eased financial market concerns somewhat.
Self storage and apartment companies had significant gains
Self storage was the best-performing U.S. property sector, aided by favorable earnings and generally strong balance sheets. Apartments also outperformed, with share prices validated by recent sales. The health care sector benefited from its defensive characteristics. The office sector, however, struggled on employment concerns.
Mixed performance in Europe
The United Kingdom had a total return of 1.2% in the quarter. After posting one of their best months on record in January, U.K. property stocks sold off in late February when credit market volatility increased. A 25-basis point interest-rate cut by the Bank of England (BOE) in February, to 5.25%, failed to provide a sustained lift.
The U.K. economy remained strong, but concerns that financial sector layoffs will dampen demand for office space weighed on office REITs with holdings in the City; we believe that capital markets are starting to price that into the stocks.
France (+6.0%) outperformed, paced by shopping center stocks, which are considered safe havens. Office property stocks with central business district holdings, largely in Paris, also performed well during the quarter, benefiting from strong demand and a diverse tenant base.
Germany (–8.9%) underperformed within Europe due to concerns over high leverage in the market and weakness in certain stocks, including IVG Immobilien, which reported lackluster results. One good performer was Alstria, an office company—and Germany’s only REIT. Its holdings are in attractive markets and the company’s debt level is relatively low.
The Netherlands (+2.7%) and Belgium (+4.3%) were strong performers, as investors were attracted to their defensive characteristics: minimal development, high occupancies, rising rents and conservative financing.
Norway (–33.8%) lagged, due primarily to the performance of Norwegian Property ASA. The company has above-average leverage and still needs to finalize its acquisition of Norgani, one of Europe’s largest hotel companies.
Asia declined across the board
Hong Kong, one of the strongest global markets in 2007, had a total return of –24.3% in the quarter. Concerns over the U.S. credit markets and the global economy, along with expectations of further tightening measures in China, hindered stocks. Investors were also concerned that Hong Kong interest rates have little room left to fall.
Japan (–19.8%) struggled amid signs of a slowing U.S. economy and a weakening dollar, trends that could stall Japan’s economic recovery. Fundamentals remained firm, however, with vacancy rates in Tokyo’s central office market below 2%.
Singapore (–7.2%) outperformed within Asia, although returns were negative. Property developers were the poorest performers amid concerns over Singapore’s slowing housing market. Singapore REITs performed relatively well due to their defensive characteristics.
A confluence of negative factors weighed on Australia (–18.5%). Concerns from Centro’s fund management crisis in December lingered. While a company-specific event, it caused investors to question the defensive nature of Australian listed property trusts. In February, the Reserve Bank of Australia raised its benchmark interest rate to 7% in an attempt to rein in inflation.
Outperformance aided by Asia stock selection
Our portfolios outperformed their benchmarks in the quarter, aided by our underweight and stock selection in Australia and Japan. Stock selection was also favorable in Hong Kong, more than offsetting the negative effect of our overweight.
Our overweight and stock selection in the United Kingdom helped performance, although our underweight in the Netherlands and absence from Switzerland hindered performance. Our U.S. allocation did not have a meaningful impact on relative returns; we were slightly overweight and stock selection was neutral.
Investment Outlook
While the U.S. economy is slowing and we are likely to see a softening in demand for commercial space across property sectors, fundamentals should benefit from high initial occupancies, along with limited new supply due to the decreased availability of construction loans and high construction costs. We expect this to provide some stability for REITs until the economy re-accelerates in response to fiscal and monetary stimulus. We believe that may begin in the end of 2008.
Europe’s defensive markets could outperform
Europe’s first-quarter outperformance may be threatened by credit and inflation concerns. If the U.K. economy slows, as expected, all property companies are likely to experience declining values and rising capitalization rates. To date, the West End has been resilient due to a more diversified tenant base than the City; but it is unlikely that the two London neighborhoods would completely decouple during a prolonged economic slowdown.
Similarly, France faces economic headwinds, which could put upward pressure on capitalization rates and spreads. A number of office buildings slated to come on the market in Paris’s La Défense business district beginning in 2011 may be delayed or cancelled if the credit crunch persists.
Germany’s economy is expected to slow on the back of the euro’s appreciation against the dollar. Although most of the country’s GDP centers on exports to the rest of Europe, it will not be immune to the effect of declining European exports to the United States. If uneasy consumers retrench, Germany will likely experience an economic slowdown.
Property markets considered defensive and that provide attractive dividend yields are likely to receive the most investor attention—notably the Netherlands, Belgium, Sweden and Finland.
Japan is cheap but economic concerns remain
Japan’s real estate securities market is now the cheapest in the world, with discounts to net asset values in excess of 40%. Investors are clearly concerned that weak consumer spending, a strong yen and the rising cost of raw materials will weigh on the economy and, ultimately, property values. We believe that even in a slow-growth environment, low supply and tight occupancies in Tokyo should continue to support rental growth.
Recent performance notwithstanding, Hong Kong in our view stands to benefit from increased demand for space in a growing economy, limited new supply and materially negative real interest rates (adjusted for inflation). We are relatively cautious toward Singapore, particularly its residential market, although we expect the hotel sector to be strong, with incentives in place to boost tourism. Our allocation to Australia is tempered by relatively high valuations, monetary policy headwinds and higher borrowing costs for Australian property companies.
The views and opinions in the preceding commentary are as of the date of publication and are subject to change. This material represents an assessment of the market environment at a specific point in time, should not be relied upon as investment advice and is not intended to predict or depict performance of any investment.
(1) All returns in local currencies as measured by FTSE EPRA/NAREIT Global Real Estate Index. |
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