This article was first published in the second-quarter 2015 edition of Personal Finance magazine.
A listed property fund can be a great diversifier in your investment portfolio, and a global listed property fund even more so, because it gives you access to a greater variety of listed property companies and sectors than you would have through a local fund. A recent survey by PlexCrown Fund Ratings identified a global real estate fund managed by local manager Catalyst as a top performer in the global and worldwide sector.
The Catalyst Global Real Estate PSG Feeder Fund collected two certificates at this year’s Raging Bull Awards and was among the top five performers of the rand-denominated global and worldwide funds based on risk-adjusted returns over five years to the end of December 2014, as measured by the PlexCrown ratings. Over five years, the fund returned 21.47 percent a year.
As a feeder fund, the Catalyst fund enables you to invest in rands in a fund denominated in a foreign currency; in this case, the United States dollar. The Catalyst fund invests in the Irish-based Catalyst Global Real Estate UCITS Fund. The managers of the Irish fund are Cape Town-based Jamie Boyes and Andre Stadler.
According to ProfileData, there are seven funds in the global real estate general sector. These funds must invest a minimum of 80 percent outside of South Africa, and must ensure that at least 80 percent of the portfolio is invested in listed property and related property investments.
Over the five years to December 31, 2014, the funds in the global real estate general sector produced an average return of 20.6 percent a year, while the benchmark index, the MSCI World Index, returned an annual average of 18.05 percent. Over the same period, funds in the global equity general sub-category returned 17.86 percent on average a year, while global interest-bearing variable-term funds produced an average annual return of 12.5 percent.
The returns by global real estate funds have been remarkable; usually, the total returns from property range between those of interest-bearing/bond funds and general equity funds, but over the past five years real estate funds have out-performed equities.
Does your fund have a narrower internal mandate than investing 80 percent in property and 80 percent offshore?
Jamie Boyes: Yes. For one thing, we never take a view on cash, so the fund is generally over 95 percent invested in listed property. Our investors give us money to invest in property, so that is what we do. We don’t invest in other income-generating investments, although, in terms of the fund’s classification, we are allowed to do this.
Second, although the fund has a global mandate, most of the listed properties are in developed countries. For example, the Asian investments are in Singapore, Hong Kong and Japan, not emerging markets such as Indonesia. There are a few instances where our underlying property companies have emerging-market exposure, but this is limited. Our fund isn’t suitable for investors looking for exposure to property opportunities in emerging markets.
Third, our fund is classified as a UCITS (Undertakings for Collective Investments in Transferable Securities) fund, which means that we comply with further (offshore) European regulatory and investor protection requirements. The fact that the fund is compliant in more than one environment provides further comfort for both European and South African investors.
Why should a South African who wants to invest offshore invest in a real estate fund, rather than a general equity fund?
I don’t think these two options should compete with one another; global property deserves a place in any diversified portfolio. Property as an asset class is considered a hybrid of equity and interest-earning investments. On both the returns and the risk in the sector, it should fall between equity and income funds. Property produces both a yield and capital appreciation. So from the investor’s point of view, we are mandated to search for opportunities where we see the best potential total returns (yield and capital return) measured on a risk-adjusted basis.
Do you agree that global listed property is a suitable asset for an investor looking for diversification away from South Africa and for returns that are less volatile than equity returns and higher than fixed income?
I am not really happy with property returns being described as less volatile than equity returns, because property is not less volatile through all cycles. However, excluding anomalies, such as the global financial crisis, we would expect the longer-term volatility to be below that of equities.
The endearing feature of property is the lack of volatility in the earnings. This is generally underpinned by long-term contractual leases, and earnings can grow in line with inflation over long periods. Even during the 2008/9 crisis, income streams were level and did not decline.
What proportion of the return over three years, measured in rands, can be attributed to a weakening rand?
Probably between seven and eight percent a year.
Describe the size and location of the listed property markets that are part of your investment universe.
The favoured global listed property vehicle is the real estate investment trust (Reit). About 80 percent of listed property companies are structured as Reits; the balance are listed property companies; we invest in both. Reits receive special tax considerations and typically offer investors high yields. They also provide an easy, quick way to buy and sell real estate.
Both Reits and listed property companies own and, in most cases, operate income-producing real estate. Examples are commercial real estate, ranging from office and apartment buildings to warehouses, shopping centres to retirement estates. Both pay out a high proportion of their taxable income in the form of dividends to shareholders, which is why people invest in this sector. The US listed property market is the most mature and makes up about 50 percent of the total investment universe. Other markets are in Western Europe, Canada, Sweden, Hong Kong, Japan, Australia and Singapore.
Divided by sector, the biggest sector is retail, at about 30 percent, followed by a range of other sectors, including offices (20 percent), residential, (15 percent), health care (hospitals and retirement estates – about 10 percent), industrial (five percent), and hotels (about two percent). We monitor about 250 companies; we pay close attention to about 150 and select about 80 for our portfolio.
How has the listed global real estate sector fared over the past 10 years or so?
Like many listed companies, property investments took a knock in 2007/8. Many property companies had borrowed lots of money for new developments and some were leveraged to 50 or 60 percent, so the 2007/8 period was very painful. However, both investors and developers learnt to be more cautious and to pay more attention to balance sheets.
Since the low point for markets in March 2009, one of the drivers of out-performance has been high demand for existing property, because fewer new properties were built. Looking forward, muted supply remains a feature of the listed property sector, which bodes well.
What are the key risks that could upset the performance of global listed property?
The main one is when, and by how much, interest rates will increase. The consensus is that, globally, rates will remain lower for longer, which is positive for real estate. Generally, property prices move up as government bond yields move down. But the reverse (property prices go down when government bond yields go up) doesn’t necessarily follow, because rising bond yields indicate economic growth, which is also good for property.
But there are two mitigating factors to consider. The first is that investors generally are pricing in the interest rate increase, so we have a buffer, and the second is that when interest rates do go up, different property sub-sectors will respond differently. Broadly speaking, if government bond yields go up, this a vote of confidence in economic growth. So those sectors with shorter lease and rental cycles, such as hotels and storage, will do better.
Other risks are more difficult to quantify: property managers can try to avoid high vacancy rates, or tenant risk, by investing in high-grade properties. We are aware of the impact of remote-computing/work-from-home trends on the demand for office space; this trend has definitely affected more vulnerable city centres in the US. In the same way, the increase in online sales of consumer goods may well have an impact on the more vulnerable retail properties.
However, we can take comfort from knowing that most institutional investors, such as pension funds, will go for the easy pickings: the low-management-intensive property investments, such as office space in major cities around the world. We, however, have a greater appetite for hunting down more niche opportunities with more of a hassle factor.
We have to remain alert to changing trends; as some property investments become moribund, others emerge. To our mind, there are interesting opportunities in the high-quality retail (mall and high street) space. There has been a shift in spending patterns that has not been fully priced in; online shopping companies have expanded at the expense of traditional retailers, and traditional retailers have captured some of the customers of lesser-quality retail outlets.
Where do you get your investment ideas?
We travel. Conferences are a great way to keep in touch with the market. There are some wonderful international property conferences, where you get “speed dating” type access to leading property chief executives and chief financial officers. We speak to our colleagues in the industry. Our past experience in property has provided us with invaluable, expanding networks that provide us with on-the-ground insight into how different types of properties behave in different economic environments.
What indicators or measures do you use when selecting your companies?
We are a specialist property investment firm that chooses listed property shares based on a company’s earnings and prospects. We invest for the long term and go far beyond simply checking the yield and growth prospects of selected property investments. We scratch hard to understand the risks associated with different investments. We evaluate management teams, we look at the capital structure and pull apart the balance sheets of our target investments.
We are prepared to take risks, if there is commensurate return. The real estate sector consists of listed companies classified as “developers” and listed companies classified as “investors”. Investors are companies that derive more than 70 percent of their income from rent. While we research all opportunities that meet our requirements, we generally prefer the “investors”, because we have found that there is greater transparency, which we value highly.
Could you give us some insight into your thinking by telling us what made you choose three of the shares in your portfolio?
Equity Residential is a US-listed company that has responded to a massive pent-up demand for good quality, easy-come, easy-go, short-lease housing. There is no equivalent in the South African market, but we are sure that in time there will be. The relative under-development of this sector here is partly explained by the historically high yield differentials between the residential sector and the commercial sector: four to five percent, compared with eight to nine percent. In our view, this difference will become more muted in the future, which will encourage property companies to seek new opportunities.
We expect South African property companies to follow the lead of US companies for similar reasons: general wariness of property ownership, reluctance to sign long leases due to the possibility of transfer and the desire to live close to work to avoid traffic congestion. In South Africa, rented accommodation has received a further boost, because the National Credit Act has put property ownership out of reach of many buyers.
Prologis: This US company is the leading owner, operator and developer of industrial real estate and has a US$30 billion global industrial portfolio. Although real estate is generally a local business, industrial is one of the few sub-sectors where it is beneficial to deal with one landlord across a range of geographic jurisdictions.
Prologis has invested in more or less every sector of the industrial/commercial sector. Industrial fundamentals are very healthy, with the increase in online shopping a big driver for suitable property. Prologis has been proactive in responding to delivery companies’ need for distribution centres close to their customers. The company has a significant development pipeline that should create shareholder value over the next few years, plus they still own large tracts of undeveloped land that can be developed in the future if demand remains strong.
Derwent: This is a specialist London-based property company with a focus on the office market. They have an enviable track record of creating shareholder value through refurbishments and developments. Not only are the fundamentals in their niche sector extremely good at the moment, but they have redevelopment opportunities in their portfolio that should deliver great returns over the next couple of years. They also have a very sound balance sheet, with a loan-to-value ratio in the mid-20s that will give them reserves if real estate values do come under pressure.
Despite your mandate to produce a yield for your clients, your fact sheets do not record the yield your fund has delivered.
It is a condition of investing in our fund that the yields generated by the underlying holdings are automatically reinvested into the portfolios. If investors plan to live off the income generated, they must sell the underlying units.
Given the good fundamental environment for real estate and the risk profile of listed property, why did the fund lose 9.64 percent of its value in one particular month during the past three years? This type of volatility is normally associated with equity funds.
What must be remembered is that investors are getting exposure to the listed equity of real estate companies, and these equities are traded daily on stock exchanges around the world. Although this makes investments very easy to buy and sell, it also increases the volatility of listed property relative to bricks and mortar. Listed real estate companies can react immediately to changes in bond markets, whereas the reaction to the ownership of physical real estate is more gradual. During the period of that loss, the yield on the US 10-year Government Bond went from about 1.6 percent to three percent within about four months. This had a short-term negative effect on listed property.
If we use surfing as a metaphor, an interest rate change is like a big wave in an otherwise calm sea; you can see it coming, you can prepare for it, and some surfers even get out of the water. But then it passes on and everyone carries on surfing, albeit a bit more carefully. By contrast, the volatility of equity funds is more like surfing in a rough sea at high tide. Every wave has the potential to dump you. So a loss of 9.64 percent can and does happen, but it is a once-in-blue-moon event, as opposed to a twice-a-day, high-tide event.
The market is likely to be volatile if and when bonds are re-priced, but we feel that the listed real estate sector has largely priced in this change. The sector is also enjoying very high growth, which will help to buffer some of the interest rate changes. Right now, listed real estate is trading at yields that are very attractive for long-term investors.