How to assess listed real estate holdings post Brexit
The UK referendum has hit the UK listed real estate sector hard. For June, it was down 9.5% in local currency terms and down 16.7% in USD terms, taking into account the steep fall in sterling. Despite the UK referendum, global listed real estate returned 3.7% in June, outperforming global equities which registered a 1.2% loss (MSCI World in Local Currencies). Japanese real estate also had a bad month, falling 5.9%, as its stock market fell 8% due to the strength of the yen, a consequence of investors’ demand for haven currencies.
How should international investors with UK listed real estate exposure react to the referendum?
First, count your blessings if you are invested in REITs. Three major UK open-ended funds have suspended trading in the last week. REITs are a source of permanent capital for real estate and will not be forced to sell holdings. They may decline in value, but investors can sell them if they need to. Our Real Assets fund does not invest in open-ended funds for this very reason.
Second, hedge the foreign exchange risk. Quaero’s Real Asset Fund systematically hedges all FX risk, and we are currently 100% hedged against the GBP. Since investors often buy listed real estate for yield, it seems foolhardy to put a 3.5% yield at risk with a 10% fall in exchange rates, which has been the case for sterling since the referendum. We see GBP/USD at 1.20 at year-end 2017, a drop of 8.7% from here, so it is not too late to hedge.
Third, consider the impact Brexit might have on UK GDP and interest rates. Swiss bank UBS, whose Real Estate Research opinions we acknowledge for this report, has cut its UK GDP estimates to 1.3% from 2% for 2016, and to 0.5% (from 2.2%) for 2017, with a downside of minus 0.2%. We think the Bank of England will cut rates twice this year, by 25bp each time.
Fourth, consider cap rates. These have now increased to 4.9%, 400bp above gilt levels, implying a 20% fall in property values from the end of December 2015 to the end of March 2016 appraised values. In Japan, with a long history of no growth and deflation, the cap rate to JGB yield is also 400bp. It is possible that the move in UK cap rates already reflects an efficient repricing.
The UK referendum creates new risks for UK real estate investors. The current uncertainty may lead occupiers and investors to put decisions on hold. A slowdown in the economy may see reduced hiring intentions or even redundancies. Property transaction activity is likely to be soft, especially if open-ended funds begin to sell real estate to meet redemptions, which may have a knock-on effect of causing UK valuers to adjust down asset values by year end.
We expect sell-side downgrades of earnings and NAVs. Economic uncertainty is likely to unsettle consumers, leading to a slowdown in UK retail sales. Relocation from the City of London is a possibility. The most vulnerable segment of the market is likely to be London office, which represents 32% of the value of the larger UK REITs.
Not surprisingly, the UK is now the best value on a NAV basis, trading at a discount of 26.7% with an average 2016e dividend yield of 3.1%. Given the vast uncertainty surrounding Brexit, based on the current state of play, we would conclude that UK REIT prices have been efficiently adjusted downwards, and we are planning a neutral allocation from here (market weight, roughly 5% of global developed market REITs). That said, on 22 June we remained confident that reason would prevail and the UK would remain in the EU, and so we were overweight post-referendum.
To which countries have we reallocated?
Globally, we see 10 year government yields moving lower for longer in the face of an increased risk profile for global markets, and therefore REITs remain well placed to benefit from renewed investment flows seeking yield. Our focus is on quality sources of yield in those markets which are likely to demonstrate the highest degree of stability.
Europe looks expensive, and has been for some time, trading at a premium to NAV of 11.9%. 2016e dividend yields average 4%. Finland stands out with its two largest REITs trading at a 30% discount to NAV. We think many investors are overweight Europe, and will eventually shift their focus from UK REITs to the UK referendum’s impact on European property companies, which may result in a correction. REITs and funds owning property with a high exposure to British buyers and tourists (Canary Islands hotels, for example) have a new risk profile. However, we will hold our heavy overweight in German residential. Vacancy rates there are low, demand exceeds supply, current market values are around half of replacement costs and current share prices reflect values well below recent transaction values.
Amongst developed markets, Australia has been the best performing property market this this year, up 18% year to date, substantially outperforming the ASX 200 equity index which is up 1%. Although property companies there are still trading at a discount to NAV, REITs are priced at a 10.4% premium, and yield 4.3%. Australian rates also look set to remain lower for longer. The UK referendum increases the likelihood of the RBA cutting rates by 25bp in August to a record low of 1.5%. However we think Australian GDP growth will remain at 2.7%, as growth in healthcare, education, construction and tourism offset the slowdown in mining and resources.
Fears of an overheated housing sector continue to look overblown, with moderation rather than a downturn the most likely scenario. Another rate cut will delay a correction, although this may lead to a worsening outlook if housing supply continues to advance. Retail sales growth is a bright spot at 3.6%. We already have significant exposure to housing and retail in Australia, and so we will be allocating to Sydney office, where vacancy rates are trending downward to 5%, and supply remains muted. Weakness in the AUD may continue if there is a further rate cut. We will be fully FX hedged.
The US has had the second best performance this year, up 12.5% YTD, outperforming equities which are up 3.9%. Like Australia, US REITs are trading at a healthy premium to NAV of 15.5% and yield 3.5%. Investor attention there is already moving away from Brexit back to the US elections. Years where restive moods prevailed (such as 1960 and 2008) evidenced choppy markets, with positive returns the following year. We think ‘lower for longer’ will also play out in the US, with perhaps one rate hike this year in December and 50bps in 2017 (to 1.125%), and we think US 10 year treasury yields may end up at 1.5% at year-end 2017. REITs in the US remain well placed to benefit from renewed investment flows seeking yield.
US REITs have minimal direct exposure to the US and Europe, and provided that spreads and liquidity in the bond market hold up, the US REIT market should benefit. However, there may be a high divergence in performance by sector in the US, with central business district offices (especially New York) underperforming in the face of a weaker global financial sector and decreased business spending. This may not be felt until the autumn when leasing activity normally picks up. On the other hand, we think apartments might offer upside as supply threats decrease in the face of a more difficult construction lending market. Grocery-anchored shopping centres are also interesting on valuation grounds and because they represent an alternative retail play to the mainstream retail landscape, which is vulnerable to trends towards internet and off-mall value retail.
Mark Ebert, manager of the Quaero Real Assets fund