The recent rally has seen equity markets recover dramatically from the downturn, but listed real estate trusts have lagged the broader market, writes Chris Bedingfield.
There have been a number of suggestions put forward for why this is the case. One argument is that real estate is highly exposed to sectors that may be particularly challenged in a post COVID-19 world. Retail and office, which make a significant proportion of the real estate investment trust (REIT) market, are two good examples.
However, just like the broader equity market, the real estate universe includes many sectors that are unlikely to be impacted solely by the virus, such as industrial property, single family homes, apartments, data storage and self-storage.
Certainly, if we are headed for a deep and protracted global recession, then the performance of REIT indices is justifiable. But the broader equity market is currently telling a different story. Either the recovery is extremely quick, or investors are willing to look past the downturn altogether.
Either way, there seem to be inconsistencies. In Australia, retailers such as JB Hi-Fi are down just -7% and Premier Investments -14%, while Scentre Group (a senior creditor to both these businesses) is down around -40%.
We think a better explanation for the underperformance of REITs is a strong recency bias against real estate.
During the Global Financial Crisis (GFC), real estate was one of the worst-performing asset classes – and for good reasons, including the fact that the GFC began as a real estate crisis in US housing before later morphing into a credit crisis.
Real estate relies on credit, and in 2008 many real estate companies were significantly levered (50-60% loan-to-value ratios (LVRs) were not uncommon). Further, since it was almost 80 years since the last major financial crisis, little value was placed on access to liquidity. So when the crisis hit and liquidity was needed, the cupboard was bare and, for many, the only alternative was to sell at painfully depressed prices. Big losses were locked in, and many investors today still remember those costs.
But the current climate is different.
Overall, across our coverage list, balance sheets are in much better shape than those prior to the GFC. We estimate the average LVR across our portfolio at 26% measured by debt to enterprise value, or 5.4 times measured by net debt/EBITDA. Additionally, all of our companies have significant access to liquidity.
And even if they were to fall short, central banks have taken the highly unusual step of buying investment (and sub-investment) grade credit, providing a credit backstop for all industries – including real estate. In our opinion, access to liquidity and credit is generally not a problem.
Furthermore, rents are (mostly) being paid, the cost of debt is falling, and the medium-term supply outlook has improved.
Therefore, it’s more about the economy, and it is hard not to conclude that either the equity market is wrong, or there is a significant opportunity in global real estate.
PAYING THE RENT
One of the initial concerns following the stay-at-home orders was that tenants would not be able (or willing) to pay rent. Under a worst-case scenario, lack of rent would squeeze the cashflows of real estate owners, which would lead to potential breaches of fixed-charge cover ratios within lending agreements.
However, the swift response of governments around the world, including payments to support wages and small businesses, has ensured rents continue to flow. Indeed, outside of retail, most US REITs have reported mid-90% cash rent collection, as shown in Chart 1 (with May collections generally better than April for apartments, healthcare and malls). Most of the rents not yet paid are on deferral agreements. Only slightly worse cash rent numbers were reported from Europe/UK.
Other elements that support REIT pricing in the medium term include interest rates and new supply.
It is almost certain interest rates will remain lower for much longer, which means many REITs will generate interest rate savings on future refinancing over time.
In addition, new supply (one of the biggest threats to real estate pricing) is likely to abate, leading to much tighter rental conditions over the next few years. Given most listed real estate asset values are now below the cost to build, less future supply should come as no surprise.
Just like the relationship between equities and real estate at the moment, it seems even within the real estate sector investors cannot decide whether we are having a recession or a recovery, and within the REIT sector itself there are anomalies.
During the last economic downturn, there were significant differences in what sectors outperformed and underperformed, as illustrated by Chart 2.
However, we are not seeing the same pattern in this downturn. Traditionally defensive sectors not directly affected by COVID-19, such as manufactured homes and apartments, are performing just as poorly or worse (when adjusted for leverage) than the more economically-sensitive sectors of office and industrial (see Chart 3). Given the high rate of rent collection to date, we see no reason why this should be the case.
The opportunity is to buy the sectors where there is a prolonged recession implied in the market price – this offers investors a skewed bet. If the worst-case economic scenario plays out, this should mostly be reflected in the price – if not, significant upside is potentially available.
Where to from here for the market is subject to much debate. While there seems to be a degree of enthusiasm reflected in equity market indices, listed real estate has been a significant underperformer.
Across most of our investees, we are seeing solid rent collection with robust balance sheets and good access to credit. Despite this, in some instances many years of share price gains have been erased and we believe this represents opportunity.
Chris Bedingfield is principal and portfolio manager at Quay Global Investors.