The first six months of 2016 were challenging for the quoted real estate sector, ending a fantastic run of out-performance against the wider equity markets.
Some would find this surprising given that real assets with predictable cash flows should continue to appeal in a world in which $9 trillion (£6.85 trillion) of liquid fixed-income investments now have a negative yield.
“Markets are constantly in a state of uncertainty and flux, and money is made by discounting the obvious and betting on the unexpected.” So said George Soros, and in many ways this perfectly describes the last six months.
According to research by KKR, in 2007, $20.1 trillion or 82% of the Barclays aggregate subsectors yielded over 3%. Today that number stands at $8.3 trillion or just 17%. Low interest rates that are increasingly negative tend to depress risk premia and stretch asset valuations.
This has become increasingly “obvious” and perhaps explains why the quoted real estate sector significantly under-performed in the first six months of 2016 relative to the wider equity markets. This under-performance commenced well before the Brexit vote.
Equity investors concluded that real estate asset valuations had reached a point at which further capital growth would be challenging. Hence the major discounting of the share prices of the majority of the quoted real estate sector. Indeed the discounting was severe with the FTSE 350 Real Estate Index delivering a negative 14.2% total shareholder return versus +4.3% for the FTSE All Share.
The real estate sector is not delivering sufficient income returns, at just over 1% in the first half. If the sector had delivered higher income returns then the decline in share prices would have been less.
The Brexit vote was a shock to the capital markets, representing the “unexpected” that George Soros referred to. The impact accelerated the decline in the share price performance of the quoted real estate sector. Companies with large London-focused portfolios and the development specialists were particularly hard-hit by the sector sell-off.
Within the real estate sector, however, the trends of outperformance of REITs over non-REITs and sector specialists over generalists continued during the first six months.
|Listed real estate companies ranked by total shareholder return, H1 2016 (REITs in blue)|
|Company||Return||Approx market cap (£m)|
|2||Secure Income REIT||8%||£489.60|
|4||LXB Retail Properties||7%||£104.80|
|6||FTSE ALL SHARE||4%|
|7||Tritax Big Box REIT||4%||£1,088.00|
|8||Primary Health Properties||1%||£644.90|
|12||Big Yellow Group||-2%||£1,160.10|
|15||Standard Life Investment Prop Inc Trust||-5%||£294.10|
|16||Picton Property Income||-5%||£361.80|
|24||Land Securities Group||-10%||£8,310.00|
|25||F&C UK Real Estate Investments||-11%||£205.30|
|28||Schroder Real Estate Investment Trust||-13%||£272.20|
|29||F&C Commercial Property Trust||-13%||£996.80|
|30||UK Commercial Property Trust||-13%||£1,014.20|
|31||FTSE 350 REAL ESTATE||-14%|
|32||Town Centre Securities||-15%||£151.50|
|33||Capital & Regional||-17%||£385.40|
|34||Conygar Investment Co||-19%||£103.90|
|35||A & J Mucklow Group||-20%||£251.30|
|37||British Land Company||-20%||£6,479.70|
|38||Great Portland Estates||-24%||£2,259.60|
|43||Capital & Counties Properties||-32%||£2,558.40|
|44||St. Modwen Properties||-35%||£597.50|
|Source: Bloomberg, 18 July 2016|
Equity capital markets have been very volatile and are likely to remain so. At my company, NewRiver, we have assessed volatility within the quoted real estate sector, and REITs have proven to be less volatile over the last three years than non-REITs. Furthermore, it is the sector-focused REITs that offer the lowest volatility, those being LondonMetric, Shaftesbury and NewRiver Retail.
Looking to the post Brexit era, it is too early to say how the UK quoted real estate sector will perform. Ultimately, real estate is about supply and demand, and that very much depends upon the performance of the UK economy.
The terms of Brexit are far from determined, and the uncertainty will affect investment decisions and create many challenges for companies that rent space from UK real estate companies.
Overlaying the difficulties of leaving the EU is falling global economic growth and exceptionally low interest rates, which ultimately reduce the strength of the financial system by eroding banks’ net interest margins and boosting the liabilities of pension funds.
Over time, low interest rates may affect the real economy as the impact on banks’ margins may reduce lending capacity and further build up debt.
So how can firms enhance performance in these uncertain times? Controlling operating costs, adopting prudent borrowing and the efficient allocation of capital should protect firms against the impact of Brexit and low interest rates. Moreover, a focus on income returns, as the main driver of total returns, is paramount and at NewRiver we focus on delivering an attractive and growing dividend yield for our shareholders.
Finally, in my Property Week article in January, I mentioned that we could have a real estate guy in the White House by the year’s end. That prospect is still possible. As George Soros said, bet on the unexpected!
Allan Lockhart is property director at NewRiver Retail