International Real Estate Investment Commentary
Cohen & Steers
December 23, 2011
International Real Estate
We would like to share with you our review and outlook for the international real estate securities market as of November 30, 2011. For the month, the FTSE EPRA/NAREIT Developed ex-U.S. Real Estate Index had a total return of –7.0% (net of dividend withholding taxes) in U.S. dollars. By comparison, U.S. REITs returned –3.8%, as measured by the FTSE NAREIT Equity REIT Index. Year to date, the indexes returned –13.8% and +3.5%, respectively.
International real estate securities had a negative return for the month after an exceptionally strong October. Worries about fiscal contagion in Europe weighed on equities broadly, while slowing growth in China added to concerns about the global economy. A sharp rally in the last few days offset some of the decline, as major central banks announced a coordinated effort to lower currency swap rates, providing much-needed liquidity to European banks. Global markets also responded positively to encouraging U.S. economic data and news that China cut its reserve requirement ratio for the first time in three years.
Fears of fiscal contagion to core countries pulled Europe lower
Despite a surprise rate cut by the European Central Bank, optimism in Europe faded amid signs of rising financial stress in Italy. Investors feared that a default by Italy would overwhelm even the largest of the proposed rescue plans, potentially leading to a costly breakup of the euro. The installation of new fiscal-minded governments in Italy and Greece provided little hope, as rapid economic deceleration across the continent put additional strain on government budgets.
The U.K. (–2.2% total return - see note below) declined as fiscal and economic outlooks deteriorated, although companies focused on London’s prime office and retail markets were generally resilient. These properties continued to attract investment capital seeking a relative haven from global uncertainty, while growing demand and scant new supply kept fundamentals stable. Belgium (–0.4%) also outperformed, as rival political parties finally settled on budget and agreed to re-establish a new government.
In France (–5.5%), returns reflected greater vulnerability to deteriorating capital markets, as yields on French sovereign debt rose. Also, sentiment for the French residential market declined when the government announced new austerity measures eliminating certain housing incentives. Germany (–4.5%) declined as the debt crisis began to take an increasing toll on its economy, while companies based in the Netherlands (–10.2%) suffered from their pan-European exposure.
Asia Pacific underperformed as growth outlook deteriorated
Hong Kong (–12.5%) had steep losses amid fears of recession and high inflation, although macroeconomic trends suggested inflation pressures were likely to ease. REITs did generally better than developers, with retail landlords showing relative strength due to solid growth in nondiscretionary spending. Offices saw a deceleration in rent growth, with the Central district even seeing declines.
In Japan (–6.9%), efforts to revive the economy were hindered by slowing exports to Europe and China, sluggish domestic growth and a strong currency. Landlords saw vacancies rise in Tokyo, while the Bank of Japan reduced their daily volume of asset purchases, offering J-REITs less price support. On a more encouraging note, bank lending to real estate companies remained strong, as landlords with high-quality assets and strong credit tenants provide attractive risk-adjusted returns for banks.
Australia (+2.6%) led all developed property markets, benefiting from the first rate cut by the Reserve Bank of Australia after a long period of stable monetary policy. With further easing expected, investors were optimistic that falling inflation and lower interest rates would provide a boost to both consumer confidence and property values, particularly retail and residential.
Singapore (–6.6%) declined amid expectations for slower growth in 2012, as its economy relies heavily on exports and is therefore particularly sensitive to the global economy. Weak demand hurt residential developers, as well as office landlords. Industrial REITs did relatively well, benefiting from longer lease terms and generally stable cash flows.
Our macro outlook has turned more positive given the recent shift toward monetary easing in Asia Pacific and emerging markets, as well as U.S. economic data confirming slow but positive growth. However, Europe is likely to remain an overhang, as the region appears to be heading into recession, making a resolution to its debt crisis considerably more difficult.
International real estate securities are generally trading at attractive levels relative to net asset values (NAV) and our dividend discount models. We also expect the lack of new supply to counter slow demand, providing some support to occupancies and rents. In this slow-growth environment for most developed markets (Canada, Europe and Japan), we favor landlords with high-quality properties, steady growth and strong balance sheets. We believe these companies are more likely to see sustained demand and are well positioned to benefit from historically low interest rates. We also conservatively underwrite any risk in development exposure.
We remain meaningfully underweight Europe and Japan, and overweight Asia Pacific (ex-Japan). We also have selective allocations to emerging markets in strong, well-governed companies in Brazil and the Philippines (mostly retail landlords and developers of mass-market housing), which stand to benefit from consumer spending growth.
Staying underweight Europe
While we are very cautious toward Europe, there remain pockets of opportunity, including London’s prime office and retail markets, as well as Scandinavia and Germany, which should benefit from their relatively healthy economies. We have a positive view of the French retail market and prime offices in Paris, but see relatively high financial risk in the country given the growing pressure on its credit rating. We have limited or no exposure to secondary office and retail landlords, as well as peripheral countries such as Italy and Spain.
Asia Pacific should benefit from easing trend
We see China’s move to lower its reserve requirement ratio as a key inflection point in the region, as policymakers in many countries turn their attention from fighting inflation to supporting growth in the face of global uncertainty.
Australia appears increasingly attractive in our view, as lower overnight lending costs and falling inflation should lead to lower cap rates and higher property values. However, we are cognizant of Australia’s exposure to deceleration in China and the impact it may have on export growth. We particularly favor the prime office and retail markets. Within our Hong Kong allocation, we are overweight developers, which were trading at excessively low valuations and are likely to benefit from reduced inflation concerns. We are underweight Japan, where we expect economic conditions to remain challenging. We are also cautious toward Singapore’s historically cyclical office and hotel operators due to the effect of slowing exports on the country’s economy, as well as increasing construction of new office space.
Country returns are in local currencies as measured by the FTSE EPRA/NAREIT Developed ex-U.S. Real Estate Index.
(c) Cohen & Steers