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International Real Estate
Securities
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March 31, 2008
We are pleased to share with you our review and outlook for the international real estate markets as of March 31, 2007. In the first quarter, the S&P/Citigroup World (ex-U.S.) Property Broad Market Index had a total return of –10.0% in U.S. dollars. In local currencies, the total return was –14.3%. By comparison, U.S. REITs, as measured by the FTSE NAREIT Equity REIT Index, had a total return of 1.4%. The MSCI EAFE Index, a broad measure of all international equities, had a total return of -8.8% in U.S. dollars for the quarter.
Investment Review
International real estate securities declined in the first quarter due largely to weakness in the Asia Pacific region. The best performer in 2007, Asia began to succumb in the fourth quarter to the economic and credit concerns that weighed on other markets, and the impact of a slower global outlook carried over into 2008. In a reversal of roles, the United Kingdom and Continental Europe outperformed Asia, with a modest gain for the U.K. and a modest decline for the continent, in local currencies.
For dollar-based investors, returns from the euro zone were boosted by a strengthening euro. Asian currencies, in particular the Japanese yen, also appreciated, while the British pound was relatively flat versus the dollar.
The U.K. cooled after a strong start
The United Kingdom had a total return of 1.8% 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.
Continental Europe has mixed performance
France (+4.2%) was boosted 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 (–9.0%) 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 (+2.3%) and Belgium (+3.6%) 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 (up nearly 60%), declined 22.8% during the quarter. Performance was hindered by concerns about the U.S. credit markets, the slowing global economy and expectations of further tightening in China. Investors were also concerned that Hong Kong interest rates have limited room left to fall.
Japan (–21.1%) 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 (–10.8%) 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 in a period of volatility.
A confluence of negative factors weighed on Australia (–20.4%). 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 as economic growth picked up.
Outperformance was aided by Australia and U.K. stock selection
Our portfolios declined during the quarter but outperformed the benchmark. Factors that aided performance included our overweight and stock selection in the United Kingdom and France and our underweight and stock selection in Australia. Stock selection in Japan was relatively favorable as well.
Performance was hindered by our overweight in Hong Kong, which more than countered relatively good stock selection. Our underweight and stock selection in Singapore detracted from performance, as did our underweights in the Netherlands and our absence from Belgium and Switzerland.
Investment Outlook
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, in which case, capitalization rates are likely to rise and spreads widen. 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 German 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 rising raw materials costs 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, combined with limited new supply and materially negative interest rates. 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 S&P/Citigroup World (Ex-U.S.) Index.
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