The most attractive opportunities today are in the public rather than private markets, writes Isaiah Usher
In the coming months, as the long and arduous efforts to control the spread of COVID-19 bear fruit and the roll out of vaccine distribution worldwide hits its stride, investors will transition from putting out fires within their real estate portfolios to identifying attractive opportunities to achieve their investment objectives. As we survey the real estate investment landscape, the most attractive real estate opportunities we see today are in the public rather than the private markets.
Listed real estate and real estate investment trusts (REITs) repriced sharply in response to the pandemic and valuations remain attractive relative to equities, bonds and private real estate. Global REITs ended 2020 at an earnings-multiple discount to the broader equity markets that was approximately 10x, a level not seen since the global financial crisis. Furthermore, as interest rates have remained at record-low levels, REITs are priced attractively relative to sovereign bonds and trade at wide spreads across most major markets. As a result, REITs offer attractive income returns in today’s low-rate environment that are significantly higher than equity dividend and sovereign bond yields.
One of the most important factors for real estate investors to consider, however, is that REITs currently trade at an attractive discount of 10% to 20% relative to the value of their underlying property portfolios in the private market.
This short-term divergence between public and private markets has been a common occurrence in past recessions as REITs, which are liquid, transparent and able to price in new information in real time, react quickly to investors’ changing views of future prospects and cash flows. Private market values, on the other hand, take significantly longer to price-in new information as transaction volumes can dry up during downturns and values are marked-to-market infrequently through the slow-moving appraisal process.
Ultimately, returns for both private and listed real estate are connected to the performance of the underlying assets themselves, which are affected by the same fundamental drivers. As a result, the performance of private and listed real estate tends to converge over time and short-term divergences in pricing can present attractive arbitrage opportunities for investors that understand this relationship. Historically, when REITs have traded at a discount of between 10% and 20% to their private market values, they have outperformed private real estate by more than 700bps over the subsequent 12 months.
In addition to the attractive discounts to private market values that persist in the listed real estate market, REITs have historically delivered their strongest absolute and relative returns following recessions. In the early phase of economic recoveries since 1990, REITs have outperformed both the broader equity markets and private real estate by over 600bps and 1500bps, respectively.
Furthermore, considering that the current economic downturn was caused by a pandemic that severely restricted face-to-face interaction, real estate appears particularly well positioned to benefit in a vaccine-driven recovery as cities, offices and stores reopen for business.
An allocation to listed real estate can complement investors’ existing private real estate investment programmes through enhanced liquidity, opening up a broader opportunity set, particularly in alternative sectors, and through enhanced diversification.
Listed real estate offers a high level of liquidity compared to private real estate where transaction timeframes for properties are typically months (and sometimes even years) and where investments in real estate funds have long lock-up periods. In addition to the time necessary to acquire or dispose of private real estate, transaction costs can be high, especially for direct acquisitions. On the other hand, Investors are typically able to deploy large amounts of capital in listed real estate markets in days without affecting pricing and can liquidate investments at will. As a result, investing in listed real estate allows institutions to take advantage of market opportunities and deploy capital rapidly and cost efficiently in a way that is difficult through private markets.
Listed real estate also offers a broad and attractive opportunity set in alternative sectors including digital infrastructure such as cell towers and data centres, cold-storage logistics, life sciences, and healthcare that can be challenging to access in private markets. Many of these property sectors have seen the best performance through the COVID pandemic and are supported by secular growth trends that support strong fundamentals going forward. Furthermore, these sectors are often operationally intensive, require specialised expertise, or have individual investments that are small lot sizes (or all three) making it challenging for investors to gain exposure efficiently through private markets.
Investing in a portfolio of listed real estate securities can provide enhanced diversification benefits by providing access to hundreds of market, thousands of properties, and dozens of best-in-class management teams. Listed REITs can also be an efficient way to access international markets and build a global real estate portfolio with strong asset diversification, which would require a significantly larger amount of capital and long periods of time to replicate in the private market through acquiring individual properties.
The diversity of REIT sectors and geographies often results in a wide range of returns in any given year. For example, somewhat unsurprisingly, data-centre REITs outperformed mall REITs by a wide margin in 2020, as the former benefitted from a surge in internet traffic and the latter were forced to close for much of the year. What might have been harder to forecast would have been REITs focused on Finland outperforming those based in the Netherlands by over 60 percentage points during the year.
Distinct economic factors and underlying market supply and demand affect the performance of each property type and must be rigorously assessed and evaluated to determine the risk-and-reward potential of REITs that operate in these markets.
The total market capitalisation of global real estate securities is approximately $2trn and, while this is a meaningful opportunity set, it is less than the market capitalisation of just Apple and Amazon combined. For ‘generalist’ equity market investors, carrying out the detailed research and analysis and conducting the thousands of property tours needed to understand hundreds of real estate markets around the world is just not a valuable use of their time.
This creates an opportunity for specialists with the resources and expertise required to understand the market and position portfolios appropriately, including CenterSquare Investment Management, who we are working with to develop a bespoke Shariah Compliant (in line with Islamic Finance principles) global REIT strategy for Asian institutional clients, to add value and enhance potential risk-adjusted returns through active management.
Historical data suggest that REITs have been particularly well suited to active management as 76% of REIT managers outperformed their benchmarks over the past 10 years compared with 44% of large-cap equity managers and 68% of fixed-income managers, according to eVestment Alliance.