Part 2: Assessing the resilience of global listed real estate and lessons learned by the sector
This is the second part of a two part article series that explores global listed real estate as an asset class SMSF investors might consider.
Global listed real state as an asset class suffered following the financial crises of 2007/2008. Since then, the sector has undertaken considerable work to help protect it should another significant market dislocation occur.
This is the second part of a two part article series that explores global listed real estate as an asset class SMSF investors might consider. Part one explored its investment characteristics. Part two examines the four factors that support the notion global listed real estate offers resilience for investors.
Given its size and transparency the following discussion will concentrate on the US listed real estate market.
1. Financial leverage
Leverage was one of the most important factors contributing to the relative underperformance of listed real estate during the financial crisis. Like many financial institutions, global listed real estate companies became over-levered in the years preceding the crisis, reducing their resilience to a possible change in financial conditions.
At the onset of 2008, US REITs had an average leverage ratio of around 60% and a debt-to-EBITDA multiple of around 7.5 times, which grew to around 8 times during late 2008 to 2009. During the crisis the majority of short-term debt markets effectively closed, forcing both investors and CEOs to look closely at company balance sheets. With no end in sight to the fall in capital values, it became apparent many listed real estate companies were on the verge of breaching their debt covenants or would have difficulty refinancing near-term debt maturities or credit facilities.
These companies were forced to raise equity at deep discounts to net asset value (NAV) as well as complete asset disposals to provide adequate headroom to their covenants and/or meet their refinancing requirements. This was not the optimal time to be seeking capital and most importantly, as sellers, these companies were unable to take advantage of distressed asset sales at the peak of the crisis.
An examination of the US listed real estate sector today shows these companies now have an average leverage ratio of around 30%; roughly half of what it was at the peak of the financial crisis1. With asset values expected to continue to grow (due to both further yield compression and rental growth) and with companies continuing to sell assets in a strong capital market, this ratio will trend even lower in the near term.
Given the reduced leverage in the global listed real estate sector, it would be highly surprising to expect the same level of distress in event of another financial crisis. As with all risk assets, share prices would undoubtedly be impacted, but not nearly to the extent they were from 2007 to 2009.
2. Development risk
The magnitude of development exposure (or risk) listed real estate companies’ balance sheets today is the second factor suggesting greater resilience of global listed real estate in the event of a slowdown.
Development exposure is less today compared to prior to the financial crisis. It is important to note the nature of this exposure is also different, with a large reduction in speculative development as a component of overall exposure. This applies to global listed real estate companies and their private real estate counterparts.
Limited development activity since the crisis, due to constraints on the availability of development finance (particularly for speculative development), has meant global real estate supply has been held in check in subsequent years. While overall supply is expected to pick up over the medium term, it is from a low base and still considerably below the long-term average.
3. Payout ratios
The third factor underscoring the defensive positioning of global listed real estate today is payout ratios. In the lead up to the financial crisis payout ratios were well in excess of 80%, rising to 85%, whereas today the ratio sits at around 72%2.
This is important for two reasons. A lower payout ratio underscores the greater focus applied by the sector on financial discipline in terms of the focus on strengthening balance sheets and reducing the heavy reliance on debt to finance acquisitions and capital expenditure. The headroom in the payout ratio also suggests current dividend yields are sustainable, emphasising listed real estate is in a healthier position than in the past.
4. Sovereign Wealth funds
Lastly, sovereign wealth funds have played an increasingly important role in global real estate markets over the past ten years. Sovereign wealth fund representation in commercial real estate transactions has grown from less than 1% in 2011 to a record high of 6% in 20153.
This trend that can be expected to continue, given sovereign wealth funds still remain meaningfully under invested relative to strategic targets.
Looking forward, looking back
Within the context of a lower growth environment, global listed real estate is well positioned to continue attracting demand as a stable income-producing investment and a potential refuge as global bond yields fall and in many cases, turn negative.
Certainly, global listed real estate companies will not be completely immune if a global economic slowdown was to occur – however, the sector as a whole has taken important steps to insulate itself to a far higher degree compared to the years preceding the financial crisis. This is evidenced by a number of factors centred on financial discipline as well as the emergence and nature of relatively new market participants in global real estate as an asset class.
It would be disingenuous to suggest every company or country has learnt from the unforgiving lessons delivered during the financial crisis to the same degree. It is this lack of universality that creates meaningful opportunities for active management. Managers focused on building a genuine global portfolio of best ideas, with a mandate to pick those companies and countries that offer the highest growth for the least financial risk, are well placed to generate attractive relative returns for investors.
1. Green Street Advisors LLC
2. Citi Research & Company Reports, August 2016
3. RCA, Grosvenor Research, 2016