Property markets fell consistently around the world in February. The FTSE EPRA/NAREIT Developed Index (TR) was down 6.3% in USD terms. In local currency terms, Canada was the strongest property market despite losing 1.1%, while the US (-7.4%) was the weakest property market.

Market review

Property markets fell consistently around the world in February. The FTSE EPRA/NAREIT Developed Index (TR) was down 6.3% in USD terms. In local currency terms, Canada was the strongest property market despite losing 1.1%, while the US (-7.4%) was the weakest property market.

The FTSE EPRA/NAREIT Australia Index doubled its losses for this calendar year, falling -3.3% in February. Industrial A-REITs (1.5%) had a positive month, while Retail A-REITs (-4.3%) were by far the weakest performers of the sub-sectors.

US property markets suffered heavily, with the FTSE EPRA/NAREIT USA Index falling more than 7.4%. Rising bond yields have been a key driver since the start of 2018, with the 10-year Treasury yield up another 16 bps to 2.86%. Fed Chair Powell offered an upbeat perspective on economic growth in light of ongoing strong data and fiscal stimulus, raising the prospect that the Fed will move to a four hike baseline for this year in March. In Canada the property market was down 1.1%, performing reasonably well in the face of higher US interest rates. Canada continues to benefit from healthy domestic demand, stabilising energy prices, an expanding service sector, and better net exports.

The FTSE EPRA/NAREIT Developed Europe Index fell 4-.6%, with the UK index down 4.0%. Real Estate Investment Trusts (REITs) were weakest in the UK and France, while in Spain and Sweden they were relatively strong. Upwards revaluation of portfolios continues in markets with underlying rental growth, but the era of yield compression seems to be ending. Both the European Central Bank and the Bank of England’s Monetary Policy Committee left rates on hold this month, although the market has raised the probability of a rate hike in May to over 70%. Political uncertainty is back on the agenda in Europe with Italian elections resulting in a hung parliament, although in Germany the Social Democratic Party voted in favour of a new Grand Coalition after months of negotiations.

In Asia, the threat of rate rises from the US saw markets perform poorly, losing most of their gains from January. The correction was seen across the board, not just in high yield stocks such as REITs. Singapore was the next worst performing market after the US, with the FTSE EPRA/NAREIT Singapore down 5.9%. The Hong Kong index fell 4.9% despite the government announcing strong GDP growth, a generous budget including a HKD52bn relief package, and as-expected public housing supply production. In Japan, developers reported earnings mostly in-line with expectations.

Fund performance and activity

The Fund was down -3.4% in February1, 30 basis points above its benchmark index, the FTSE EPRA/NAREIT Developed Index.

Annual Performance (% in GBP) to 28 February 2018

 

 

These figures refer to the past. Past performance is not a reliable indicator of future results. For investors based in countries with currencies other than the share class currency, the return may increase or decrease as a result of currency fluctuations.

Performance figures have been calculated since the launch date. Performance data is calculated on a net basis by deducting fees incurred at fund level (e.g. the management and administration fee) and other costs charged to the fund (e.g. transaction and custody costs), save that it does not take account of initial charges or switching fees (if any). Income reinvested is included on a net of tax basis. Source: Lipper IM / First State Investments (UK) Limited. *The benchmark changed name from the UBS Global Real Estate Investors on 20 May 2013.

 

The Fund’s strongest contributors were US stocks Hudson Pacific Properties and Invitation Homes. Hudson Pacific’s fourth quarter earnings and 2018 outlook was well received, and the stock attracted a number of analyst upgrades. The company is expected to continue to show peer-leading rent spreads in 2018 and 2019 given its continued market strength in San Francisco, Seattle, and Los Angeles. Invitation Homes, the largest single family rental REIT in the US, continues to see market support following its merger with competitor Starwood Waypoint.

Mitsubishi Estate Logistics REIT in Japan and Kilroy Realty in the US also contributed. Mitsubishi Logistics outperformed on a relative basis post their recent Initial Public Offering. Kilroy’s fourth quarter earnings were solid, although asset sales continued to be a drag on 2018 earnings guidance. The market is more appreciative of the opportunity for value creation in 2019 with an active development pipeline of $1.4bn, of which approximately 50% is leased.

The comparatively strong performance of the Australian market helped self-storage company National Storage REIT add to performance for the month. National Storage is trading on an attractive distribution yield of ~6% and reaffirmed its full-year guidance despite an implied skew of 55% to the second half of the year, even assuming the bottom end of guidance.

As a result of the underperforming US market, seven of the top ten detractors for the month were US-listed companies. Two of these were our positions in data centre providers Equinix and CyrusOne. While neither announced any major underlying issues, they struggled along with the rest of the market. Other major detractors included US hotel companies DiamondRock Hospitality and Host Hotels & Resorts. DiamondRock faces headwinds in New York, and with the rebuilding and possible rebranding of some of its hotels. Host Hotels was the victim of profit taking after significant outperformance over the past four months, having risen almost 14%. Despite this, its fourth quarter results were in line with guidance.

In spite of good full year results from UK retail REIT Hammerson, the market remains sceptical about its acquisition of Intu. The major worry is Hammerson’s doubling of its UK exposure, in particular due to concerns about shopping centre valuations. This view is not helped by UK retail sales falling 2.7% during 2017, especially as more news of retailers entering administration emerges. Nevertheless, Hammerson operates a 98.3% occupied portfolio, with less than 1% of rent from retailers in administration.

Over the month we sold out of our position in Vornado Realty. Despite Vornado’s attractive valuation and solid internal growth from significant mark to market rents, the overall New York City office outlook is challenging with flat net effective rents and high tenant improvement costs. Vornado’s 30% exposure to New York City street retail is also an area of concern despite limited expirations, given the increase in store vacancies even in the 5th Avenue and upper Madison Avenue markets.

We also reduced our holdings in two US retail REITs, Kimco Realty and Simon Property Group, despite still attractive valuations. We decided to sell after a better than expected holiday season, as we anticipate still challenging retail news and an uphill 2018 outlook. For Kimco, we are increasingly concerned that greater than expected asset sales at lower than anticipated prices will be an area of investor concern and create a drag on 2018 earnings growth.

Following a run of strong performance, we took profit out of our position in Daiwa Office Investment. The market reacted positively on news of a large capital gain made on disposal of one of their properties, bringing the stock to a 12% return over just three months. We sold some of our position in Mapletree Commercial Trust, considering the narrowing leasing spreads and subdued outlook for suburban offices.

During the month we participated in an equity raising by GLP J-REIT (Japan Real Estate Investment Trust). The REIT raised 69bn Yen to acquire a portfolio of logistics assets (valued at 82bn Yen) on a 5.1% net operating income yield. The portfolio includes very high quality assets located in Tokyo and Osaka, and the stock offers a compelling valuation relative to its logistic peers. In order to fund this purchase, we marginally reduced our position in Activa Properties, despite remaining positive on the REIT in the medium term.

In the US we added to our overweight position in Prologis, the largest global industrial REIT. Its development activity should remain elevated and drive external growth, with an in-process pipeline of $3bn. We also added to our DiamondRock Hospitality position, given the slight pull-back it had on account of volatility. Current conservative forecasts do not factor in the backdrop of reaccelerating business demand as a result of tax reform, better sentiment, improved GDP forecasts, and better business investment spending. This combined with better market exposure for DiamondRock makes the company compelling at these levels.

In Australia we included Westfield into the portfolio, in light of the last fall in the share price post the takeover offer from Unibail-Rodamco.

Market outlook and Fund positioning

The Fund has exposure to very high quality assets in high barrier to entry urban locations in the world’s most bustling cities.

We expect 2018 to be another year of relative underperformance for the US real estate sector versus a more attractive broader equity market. REIT operating fundamentals are decelerating to more normalised levels. Fiscal stimulus from both corporate and individual tax cuts will add to corporate earnings growth in 2018 while real estate earnings growth is not expected to directly benefit. REIT valuations may continue to come under pressure if US 10-year Treasury yields increase materially, and we expect another 3-4 interest rate hikes in 2018. More significant current sector exposures include high quality data centres, single family rentals, West Coast office REITs, Class A regional malls, apartment REITs and an industrial REIT.

We expect the Canadian economy to generate approximately 2% Gross Domestic Product (GDP) growth in 2018, although this cannot be guaranteed. On the whole, Canadian REITs are trading at a modest discount to Net Asset Value, though most of the better quality names are trading closer to their underlying asset values. We view Canadian REITs as fairly valued overall at current levels given modest near-term earnings growth outlooks and the Bank of Canada’s move to higher rates.

In Europe and the UK, the potential for future increases in bond yields may lead to increased sector volatility. Our exposures include student accommodation in the UK, German residential, and office buildings in France and Spain. The A-REIT sector’s underperformance relative to the broader market in calendar year 2018 looks set to continue given the broader growth tilt favoured by equity investors. Bond yield volatility is expected to play through to the carrying value of real assets over the course of 2018, which could offer investment opportunities.

Within Asia, the overall strategy is to have a balanced portfolio with some quality defensive names, and some with strong growth potential in the region. We anticipate short-term volatility in the market which might present good investment opportunities in Asia and Japan, as with the retail tailwind recovery in Hong Kong and China. The pro-land supply policy of the Hong Kong Government particularly bodes well for developers with a cheap agricultural land bank. We continue to identify pricing anomalies within the J-REIT sector, currently targeting under-valued logistic names.

Performance is based on OEIC B share class, net of fees, expressed in GBP.

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