The global real estate sector has been on a roller coaster ride since the COVID-19 pandemic, enduring losses in 2020 and then gains in 2021-2022, followed by more losses. Yet long-time real estate investor Steve Buller argues that the worst is almost over, and prospects look better down the road.
“Whenever I answer, I say there are three legs in a stool: the fundamentals, the capital side of the business, or the cost of capital, and valuations,” says Buller, portfolio manager at Boston-based Fidelity Management & Research and lead manager of the 4-star silver rated Fidelity Global Real Estate Series F, which has $130.7 million in assets. “Interestingly enough, there are many headlines out there. But they are mixing up commercial real estate when they just mean office. And, the fundamentals, absent office in North America, and so-called commodity office space, are actually okay. Demand and rental increases are occurring, and occupancy rates are relatively stable. So, the fundamental picture is good.”
How High Rates Hit Real Estate Stocks
On the capital side of the industry, however, there has been a significant disruption that began with the rising cost of capital about 18 months ago. “What matters more for real estate is long-term interest rates. We had a massive shift upwards in the yield curve around the world and that caused an adjustment in the cost of capital, and the financing of buildings and on the valuation aspect,” says Buller, a 31-year industry veteran who joined Fidelity in 1992, after earning an MSc from the University of Wisconsin. “That’s the primary cause for the blah or even negative returns. We don’t need a reduction of interest rates, but more of a ‘normalization.’ We do live in a macro world and need [a scenario] where long-term rates are not going up anymore. Or, put another way, ‘are we at the peak of short-term interest rate hikes?’ This would generally be a good thing for listed property.”
Year-to-date (Oct. 12) Fidelity Global Real Estate Series F has returned -2.33%, versus -4.52% for the Real Estate Equity category. Buller, who has managed the portfolio since May 2006, has generated category-beating returns over the long term. Over the past 10 and 15 years, the fund returned an annualized 6.01% and 7.24%, respectively. In contrast, the category returned an annualized 4.83% and 6.22%.
Negative Headlines Make for Discounts
Apart from improving fundamentals, Buller argues that valuations are good and real estate investment trusts (REITs) and equities are trading at about a 20-25% discount to net asset value (NAV). “Of the two legs of the stool, fundamentals are pretty good, although recognizing that North American office component. And valuations are attractive,” observes Buller, who oversees about US$6.3 billion in assets that follow U.S. and global real estate strategies. “But it’s the capital side of the business, which is the biggest uncertainty. That’s where you need a pause or normalization.”
In the U.S. 10-year government bonds are now yielding 4.78%. This means, given that the cost of financing is about 150 basis points above the bond yield, borrowing costs around 6.3%. “Real estate is a long-term asset class. And financing is all about long-term debt. I’m not dismissing the impact of short-term rates and in today’s world it would help if major central banks were on hold, or no longer raising short-term rates,” says Buller, adding that in the last ten years or so the cost of financing was closer to 4%.
Earlier this year, with the collapse of two U.S. banks and Credit Suisse, there were concerns about the credit side of things, Buller notes. “But the credit side has calmed down. So, generally speaking, spreads for listed real estate companies are pretty good. It’s the cost of the interest-rate capital that is more important.”
Rates Overshadow Strong Fundamentals
Historically, Buller observes, there has always been a tug-of-war between the fundamentals and the capital side. “I could argue that about half the returns from listed property come from the fundamentals, and the other half from the capital. Given that the capital side has seen a violent adjustment in long-term interest rates, it has become more of a negative driver in the last 18 months. So, if the markets concentrate on the fundamentals side, then that would be a good thing.”
No question, however, the fallout of the pandemic has seen the emergence of so-called losers and winners. “The bigger losers are North American office REITs for a variety of reasons. And the obvious one is the impact of work-from-home [phenomenon]. As long as there is white-collar job growth that means there is still demand for offices. But there is a slow-moving adjustment taking place,” says Buller. “Office leases in North America are typically 10 years in length, so it’s not as if all these leases are coming due in one year. That means 10% do come due every year. Absent employee growth, we’re seeing the average tenant leasing 85,000 square feet, instead of 100,000 square feet—with the same number of employees. There’s been a general reduction [in demand] without employment growth, which means a 10-20% reduction in office demand. But, fortunately, it plays out over time.” The office segment accounts for about 10% of the global benchmark, the FTSE EPRA/NAREIT Developed Index.
Still, Buller admits he does worry that on the capital side a lender falls victim to an event, or, worse, the global economy slows down significantly, and capital becomes scarce. “Earlier this year, we had the collapse of Credit Suisse and Silicon Valley Bank, although we still had a pretty good economic backdrop. But what if the economy slows? That could cause more credit issues.”
Largely a bottom-up investor, Buller focuses on strong industry players at attractive valuations. As a result, the fund’s sector weights are a by-product of the stock-picking process. At the end of August, residential REITs accounted for 26% of the portfolio, followed by 16% industrial, 14% retail, 10% offices and 2.5% in hotels. There is also 29% diversified which is an agglomeration of sub-sectors such as data centres and self-storage. On a geographic basis, the U.S. is the largest country weight at 60%, followed by Japan at 9%, the U.K. at 7%, Canada at 4.3% and 1% Hong Kong. “Generally speaking, we don’t make huge country bets. But the exception is Hong Kong, which is driven by geo-political risk, and property fundamentals that are some of the worst in the world.”
The Trifecta for Success in Real Estate Stocks
In analyzing REITs or stocks, Buller looks for good fundamentals, access to capital and the ability to exploit that capital. “When a company has an advantageous cost of capital, it can acquire stuff that is accretive, and develop new projects that are accretive. So, there is actually external growth,” says Buller. “In a perfect world, you would get that ‘trifecta’ in any individual stock pick. But that is very difficult to do. So, you are often looking for two of the three or even one of the three.”
Running a portfolio with 63 names, Buller highlights Equinix Inc. (EQIX), a dominant U.S. data centre with a market capitalization of US$70.7 billion. “It is a beneficiary of the digitalization of everything, both personal and professional. Because of the increased digitalization—which was accelerated during the pandemic—we are seeing increased demand,” observes Buller. “Plus, we are seeing increasing demand from artificial intelligence, or AI, because AI happens in a data centre, or close to it.” Meanwhile, he notes that the supply of data centres is being restricted because of the high demand for electricity, and water for cooling purposes. “You have this supply and demand imbalance. Hence, we own EQIX.”
A long-term holding, EQIX is trading at US$756.20. As the U.S. REIT market uses a metric known as funds from operations (FFO), consensus estimates for EQIX in 2024, according to Bloomberg, are 31.5 times FFO. Because of compliance rules, Buller is prevented from offering estimates of the stock’s discount to intrinsic value or expectations for the stock in the next 12-18 months.
Another favourite is Ventas Inc. (VTR), a REIT which owns and operates healthcare assets such as hospitals, laboratories, and nursing homes. “The primary driver to the stock is its 40% exposure to assisted living centres. Post-pandemic, we have had a recovery in this area in the U.S. and Canada. Occupancies are going up. Their ability to push rates is going up. With the pandemic ending, we have seen quite a bit of occupancy gains.”
One of the top two listed companies in this specialized area, VTR has a market cap of US$17.7 billion. Its shares are trading at US$44. Consensus estimates, according to Bloomberg, peg VTR at 13.7 times FFO in 2024.
Looking ahead, Buller reiterates that a lot depends on the cost of capital. “When that [leg of the stool] sees a normalization, or a pause, and the long-term cost of capital is not going up anymore or even going down, then historically that’s been a very good time for the performance of real estate securities,” says Buller. “If central banks pause, or even look through events because they worried about a recession---that arguably could be good. I would emphasize arguably.”
