Despite a torrid 2022, investors would be remiss if they were to ignore the opportunities in listed real estate, as current valuations represent attractive entry points and they should benefit from a rebalancing away from private markets, market observers FSA spoke with said.
Last year was an abysmal year for all asset classes, although listed real estate fared poorly even by those standards with valuations for real estate investment trusts (REITs) falling by as much as 40% in some geographies, according to research from Janus Henderson.
At the same time, direct and private property market funds were actually up during the same period, primarily due to the slower-moving price discovery among private market funds, which market observers said should provide savvy investors with the opportunity to reallocate tactically to public funds.
“The region’s listed real estate looks attractively priced on a range of metrics including price to book, historic yields, or implied cap rates but also relative to pre-Covid levels,” said Daniel Fitzgerald, portfolio manager for the FTGF Martin Currie Asia Pacific Urban Trends Income fund at Franklin Templeton.
“Now we see listed property trading at a notable discount to book values, as compared to unlisted, which for us highlights the valuation opportunity of listed property now as compared to unlisted. Given the opportunity, we expect more outflows from unlisted property funds.”
Discrepancies in valuations
To take the US as an example, according to research from Janus Henderson, valuations for REITs were down about 16% last year, whereas direct and private market funds were up about 12% in the US, meaning a close to 30% performance differential for what is essentially the same asset class.
This naturally begs the question why is there such a large discrepancy in valuations between the two in the first place? One explanation would be that the fundamentals for private real estate funds are somehow stronger than those for REITs, although this is largely not borne out by the evidence.
Very little data is collected on private real estate, but anecdotally at least, the opposite appears to be the case as REITs typically own high quality assets concentrated in major urban centres, while private real estate funds also tend to be more exposed to the troubled office sector.
When it comes to their financial health, REITs also tend to be in a stronger position than private market funds. Several market observers told FSA that REIT sponsors largely learned their lessons from the global financial crisis and have since reduced their leverage and extended their debt maturities, whereas this has not been the case among private market funds.
“Now we see listed property trading at a notable discount to book values, as compared to unlisted, which for us highlights the valuation opportunity of listed property now as compared to unlisted. ”
Daniel Fitzgerald, franklin templeton
“Non-listed property has taken the complete opposite approach as regards how much debt they were prepared to take on. Because debt had been incredibly cheap, it’s been easy for them to get away with playing the cost of carry game,” said Tim Gibson, portfolio manager and co-head of global property equities at Janus Henderson.
“If I were to buy a property, which is yielding say 5% and I can borrow debt at 2%-3% then I have a positive cost of carry. And therefore the more debt that you can borrow then the greater the impact of that cost of carry, which has been precisely the approach a number of private real estate firms have taken. In the US today, we estimate private real estate has twice the leverage of public real estate – that’s why balance sheet risk is a key consideration.”
The most plausible explanation for the discrepancy in valuations between listed and non-listed real estate is the slower-moving price discovery in the case of the latter. Whereas public markets benefit from rapid price discovery via immediate trading liquidity, private markets rely instead on actual transactions and third-party revaluations, which inevitably leads to a lag of many months. Given the sell-off that has already occurred in public markets, this should mean that they stand to benefit in the event of a rebalancing between the two.
“We expect on that basis that there will likely be a reversion in valuations between the public and private markets, which should relatively benefit the public markets given the current valuation discounts that we do see. In fact, we’re already seeing this with global real estate securities showing a positive total return year to date,” said Jagdeep Ghuman, co-manager on the Nuveen Clean Energy Infrastructure Impact fund.
It’s the economy, stupid
Even if there is a reversion in valuations between public and non-listed real estate, this naturally begs the question as to whether this will take the form of a rally in the share prices of REITs or a substantial re-rating downward in the valuations of private real estate funds. Here, the omens look positive for any investor considering investing in listed real estate.
Market observers FSA spoke emphasised that it is likely that we should be able to draw a line under last year’s sell-off because of the nature of the state of the wider economy. Put simply, while listed real estate tends to struggle during periods when inflation is high and rising, it tends to do much better when inflation is high and falling.
“Essentially when inflation is high and rising, you’re going to need some sort of central bank response. That means higher rates. That’s painful for real estate but equity markets being forward looking took this pain last year in listed property markets. This pain is still to come in non-listed (or private) real estate” said Janus Henderson’s Gibson.
“Conversely, when inflation is high and falling, that’s probably going to lead to a situation where interest rates are going to have to be cut and historically that’s been positive for the valuation of real estate equities.”
Regardless of how many more rate hikes the Federal Reserve has planned, most commentators are expecting inflation to remain much higher than it has done in recent years and listed real estate tends to do well during periods of high inflation.
“For us the way we look at it is everything is to do with disruption. That’s the lens or the prism that we look through things because that will give you a sense of how the needs of the real estate market are going to change over time.
tim gibson, janus henderson
For one thing, many long-term leases have built-in rent escalators that protect income generation. At the same time, the higher costs for land, materials and labour increase replacement costs, reducing the potential profits of development, raising the economic barriers to new supply and thereby leading to higher prices.
All of this is not necessarily a fait accompli as there are a number of headwinds in the real estate sector, most notably in the office sector, which has been struggling due to low occupancy rates following a reshaping of work patterns post-Covid and dwindling bank liquidity, particularly following the collapse of Silicon Valley Bank.
Earlier this month, some of the largest US banks singled out commercial real estate as an area of growing concern. Wells Fargo, for example, set aside an additional $643m in the first quarter for credit losses, mainly driven by expectations of higher commercial real estate losses.
Market observers said that this underscored the need for active management and generally meant aligning investment decisions with long-term secular themes around things like demographic change, climate change and digitalisation.
“For us the way we look at real estate markets is through the prism of disruption. The reason we do this is because it gives us some sense of how the needs of the real estate markets are going to change over time. We’ve had some pretty obvious ones recently.
“E-commerce has been a positive driver for sectors like industrial/logistics and correspondingly retail has suffered. We are also beginning to see how ESG considerations are creating risks and opportunities as tenants needs evolve, particularly in the office sector.” said Janus Henderson’s Gibson.
