Despite a strong start to 2015, the global real estate sector has produced a flat return year to date through to the end of July. Such a return could indicate that the positive trend witnessed by the global listed property market over the last few years might be coming to an end. The success and popularity of the asset class was particularly evident in 2014, when the FTSE EPRA/NAREIT Developed real estate index delivered 15.9% in USD terms, meaningfully outperforming the broader equity and fixed income markets.
A number of factors have set the tone for the sector’s recent success. Demand for real estate investments has increased as the economies around the world improved. This strong trend has been buoyed to a large extent by central banks’ accommodative monetary policies. This was particularly illustrated by the Japanese government’s asset purchasing programme which started in 2013 and included not only government bonds, like the US central bank’s programme, but also real estate investment trusts.
This policy, part of a series of fiscal and monetary policies known as Abenomics, aimed to reduce the perceived risk premium associated with investing in risky assets and to boost investors’ demand for this asset class. As a result local market fundamentals have been improving - rents have gradually been rising, vacancy rates have dropped and the volume of transactions has been at an all-time high, which have propelled forward the J-REIT overall returns for the year and significantly outpacing the other REIT markets. Similarly, the Australian real estate market has also been a direct beneficiary of a growing economy and rising consumer confidence.
In addition, the sector strength has been driven by investors’ hunt for yield against the backdrop of a low interest rate environment and global bond yields at record lows. As at the end of July 2015, the yields on a 10-year US Treasury, German Bund and Japanese Government Bond were 2.18%, 0.64% and 0.42%, respectively.
Australian Property Offers Attractive Income
In contrast, the yield on the Australian REIT market, for example, is well above 5%. Thus, the combination of high yields and capital growth has led to compelling total returns over recent years. An obvious consequence of this has been the massive inflows recorded over the 2013-14 period and throughout the early part of this year. With these record inflows and the appealing characteristics of real estate investments, many global equity managers have gradually increased their allocation to this area of the market. Indeed, the average fund‘s exposure within the Morningstar Global Large-Cap Blend Equity Category has doubled over the same period.
Growing market expectations that the Federal Reserve will begin raising interest rates in 2015 have led to concerns among those investing in REITs, and some commentators have argued that their strong run may be nearing an end. Real estate consists of fixed assets and the conventional wisdom among market forecasters is that asset prices often decline with an interest rate hike, potentially leading to less attractive valuations.
This may explain some of the volatility seen in the second quarter of this year, with the Morningstar Property - Indirect Global Category tumbling by more than 5%, triggering significant outflows in June. While this is worrying, it remains to be seen whether this is a new downward trend or a one off event. It is also a reminder that in the short-term real estate investment trusts typically behave in a similar manner to traditional equities and as such remain a risky asset class for investors who may generally consider them as safe investments.
China Fears Drags on Global Economy
Recent ongoing fears around China's economic slowdown, which have been negatively impacting most markets, sectors and currencies, seem to have pushed back the probability of a September hike by the Fed. While an interest rate rise is a key risk monitored by the managers, many argue that REITs have moved through the recovery phase and are now in a much stronger position with solid balance sheets, lower interest expense and have selectively been sourcing accretive acquisitions. This seems to indicate that property fundamentals have improved across regions and sectors and continue to remain robust.
For example, rental prices in key markets have started rising and IPO activity has so far been very strong in 2015. Furthermore, rising interest rates is a function of an improving economy which will be ultimately a positive element in favour of equity markets and the demand for the real estate sector. Historically, higher interest rates driven by economic growth have generally been supportive of the demand for real estate, particularly commercial property, and consequently real estate equities have generated positive returns for investors. Despite the recent volatility, the combination of strong fundamentals and relatively high yields should continue to position the sector well for the next few years.
What Does this Mean for Investors?
From the investors’ perspective, the sector has meaningfully expanded over the last decade. Indeed, many countries have launched REITs over this period and it is also worth noting that UK investors, for example, have now a greater choice of REIT funds to choose from and use these funds where appropriate as mean of diversification within a broader portfolio. Moreover, there has been a large number of global REIT exchange traded funds (ETFs) launched in the last few years. This is owed to the many advantages offered by these passive vehicles over active ones, the main one being cost but also the difficulties faced by many active managers in outperforming the mainstream index, the FTSE EPRA/NAREIT Developed.
