THE EVOLUTION OF GLOBAL REITS SINCE THE END OF THE GLOBAL FINANCIAL CRISIS

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1 THE EVOLUTION OF GLOBAL REITS SINCE THE END OF THE GLOBAL FINANCIAL CRISIS For Financial Advisers Only JUNE 2015 Presima Inc 1

2 Executive Summary The Global Financial Crisis (GFC) of 2008 changed many investors perceptions of G-REITs. With the majority of G-REITs owning stable income producing properties, the leverage driven volatility of their share price during the GFC appeared like a sharp contrast. More than six years later, some concerns are still fresh in the minds of many in the G-REITs investment community. This paper aims to discuss these issues and shows how G-REITs have evolved in recent years, both in terms of their general characteristics and by tapping into new investment themes that have emerged since the GFC. Driven by strong access to capital in both the equity and debt space, the G-REITs market has more than doubled since 2010, offering more exposure and diversification opportunities. This increase also provides more liquidity, with an average of $8.8bn USD worth of REITs shares trading every day. This expansion has not compromised G-REITs ability to grow their dividends per share, which have come back strongly since the end of the GFC. Looking at debt, G-REITs now show less leverage and lower costs of funding. They also have lower correlation to equities and fair valuation levels. With increased return dispersion amongst G-REITS, companies exposed to emerging trends such as low home ownership in the US, office densification, e-commerce and Chinese tourism, often come out as winners. The size of the G-REIT market In the current investment environment, it appears that many institutional real estate investors are looking to deploy sizeable amounts of capital. For some, this raises questions around what G-REITs can offer in terms of size, depth and exposure. The market capitalization of G-REITs reached $1.54 trillion USD, as at 31 March This is a simple measurement of the market cap. of the 317 companies in the FTSE EPRA/NAREIT Developed Index, a recognized global listed real estate benchmark. Today s market cap is more than double what it was 5 years ago and 3.4 times more than 10 years ago 1. From a regional perspective, North America and the Eurozone have shown the largest increases. Researching balance sheets and accounting for leverage, there are approximately $2.3 trillion USD of real estate assets held by REITs in the FTSE EPRA/NAREIT Developed Index. This demonstrates strong progress 2. This increase was driven by asset value appreciation but also by strong external growth. Since the end of the GFC, many G-REITs have performed large numbers of acquisitions and development or re-development projects with their much improved access and cost of capital. The market has indeed been receptive both on the debt and equity side, with more than $88bn USD worth of secondary offerings and $49bn worth of IPOs in the G-REIT space between 2012 and Source: Bloomberg, LLC. 2 Source: Company reports 3 Source: Company reports, Bloomberg, LLC. Presima Inc 2

3 With this evolution over the past few years, G-REITs are now more diverse from a regional and sector standpoint. What s more, the growth in the depth of assets listed in public markets means greater exposure and diversification opportunities to real estate investors. The liquidity argument With the growth in publically available assets, G-REIT investors continue to remain widely interested in liquidity. While creating volatility in some markets, liquidity is at the center of what listed real estate should provide. Measuring average daily trading volumes of G-REITs over the last 3 months (as at 1 June 2015), approximately $8.8bn USD worth of shares have changed hands every day 4. This daily amount is equivalent to the value of all the assets held by listed companies in Downtown New York or the whole city of Montreal, Canada. This means G-REITs trading currently amounts to around $2,218bn USD per year. Compare this with direct real estate market sales that saw a very strong 2014, with $710bn USD worth of transactions 5. In line with the growth in the market, this amount has also increased significantly since the end of the GFC. Interestingly, a growing number of pension funds in Canada and the United States are taking advantage of this liquidity to build significant direct stakes in public real estate companies. For example, according to Bloomberg, Ontario Teachers Pension Plan from Canada built a 14.7% stake in American shopping mall owner Macerich during the last 9 months. In the 4 th quarter of 2014, another large Canadian pension plan, the CPP Investment Board, took a 15% stake in Citycon, a Finnish shopping mall owner that operates mostly in Scandinavia. It appears that public markets are being used as a means to gain immediate access to well-managed, high quality assets otherwise not available in private markets. Earnings and dividends: long-term growth trajectory Investors often view the long term, steady growth profile of earnings and dividends as a key feature of investing in G-REITs. While G-REITs have historically delivered strong dividend per share growth, 2009 and 2010 felt the impact of the GFC. Many companies either issued shares or lowered dividends because of weaker income. This raised many questions about the predictable and sustainable nature of these dividends. The graph below (figure 1) shows G-REITs earnings have since turned and the dividend per share growth profile has resumed its upward trajectory. Over the longer term, it appears the volatility in share price contrasts with the reliable nature of distributions paid to investors. Average dividends per share have grown by 92.3% since 2001, a compounded annual growth of close to 4.8% 6. This is despite difficult real estate markets in 2009 and 2010 and the capital appreciation that G-REITs have enjoyed. Looking ahead, positive earnings and lower than average payout ratios in some markets should support to this trend. 4 Source: Bloomberg, LLC. 5 Source: Jones Lang Lasalle, Global Market Perspective, First quarter Source: Companies reports, Bloomberg, LLC. Presima Inc 3

4 Figure 1: Yearly dividend growth delivered by G-REITs and the growth of $100 invested in dividends only Source: Company estimates, Bloomberg, LLC. Correlations of G-REITs and global equities Figure 2 shows the correlation between G-REITs and global equities spiked in 2008 with all public market assets classes correcting severely. Given the V-shaped recovery that G-REITs enjoyed, along with broader equities, the high correlation lingered around until This seemed to have affected the mindset of many real estate investors towards the listed vehicle. Since 2013, four years into the post-gfc recovery, a decoupling was observed, taking correlations back to historical norms and back to levels that have traditionally provided diversification benefits to investors. Presima Inc 4

5 Figure 2: 12 month rolling correlations between the G-REIT and global equity indices Source: Bloomberg, LLC. Interest rates normalization It s safe to assume that the recovery in global markets post-gfc was partly driven by the central banks actions which dramatically improved the availability and cost of debt financing. G-REITs directly benefited from this easing and in many countries, were able to recapitalize and solidify their balance sheets. With the prevailing easy lending conditions, G-REIT investors often question the impact of rising interest rates and a reversion back to levels more in line with historical averages. There are two dimensions to this question. On the fundamental side, looking at G-REITs balance sheets and despite their record low average cost of debt of 3.6%, companies have not increased their leverage levels. Figure 3 shows leverage levels at historical lows, hovering around 30%. In other words, G-REIT managers do not seem over-aggressive in their expansion plans using excessive gearing. Firms have also generally expanded their average debt maturities with, terms of 5 to 10 years widely available in many markets globally, some even seeing maturities as long as 30 years. Presima Inc 5

6 Figure 3: G-REITs leverage and cost of debt 55% 50% 45% 40% 35% 30% 25% Debt to EV average (LHS) Average cost of debt (RHS) 6% 5% 4% 3% 2% 1% 0% Source: Presima estimates, Bloomberg, LLC. Another aspect of interest rates normalization is the sensitivity of G-REITs share prices to bond rates. As shown in figure 4, using US REITs as an example, REITs are sensitive to bond yields in the short run, i.e. for periods of one to three years. Correlations diminish quickly beyond 3 years and vanish beyond 5 years. What is typically observed is that rates rise in an improving economy and real estate environment. The gains made by REITs on earnings over-compensate for the increased costs that they eventually have to bear on their debt. Presima Inc 6

7 Figure 4: Correlation of US REITs to US 10 year treasury bonds Number of years Source: Bloomberg, LLC. G-REITs valuation G-REITs share prices have rallied significantly since the end of the GFC which leaves many investors questioning the prospects for further upside, despite the positive growth in real estate fundamentals. Comparing current levels to longer-term averages, G-REITs now appear fairly valued, both relative to private real estate and to bonds. Looking at the Price to Net Asset Value (NAV) ratio, G-REITs now trade at 102% of the value of the underlying real estate they own. This 2% premium is just above the 5 year historical average of 1%. This is demonstrated in figure 5. Presima Inc 7

8 Figure 5: P/NAV ratio of G-REITs stdv Average -1 stdv Average P/NAV Source: Presima estimates Comparing dividend yields of G-REITs to 10 years bond yields, the average spread currently stands at 1.8%, which is close to long-term historical averages 7. Looking at the largest market, the United States, the current spread stands at 1.7% while the historical average stands at 1.5%. From that standpoint, it appears that real estate investors are still well rewarded. Increasing return dispersion Looking back at the severe correction that characterized the vast majority of the G-REITs space in 2008, many investors wondered if companies holding superior and better managed assets got unjustifiably punished. Over the last few years, questions have often arisen on the divergence between companies earnings and, in turn, between the performances of their share price. In other words, investors wonder if public real estate companies can distinguish themselves beyond the external factors that affect a specific sector, city or country as a whole. Figure 6 clearly shows that some REITs emerged as winners in the present cycle. It shows the performance of the top and bottom REIT in different clusters of companies operating in similar geographies or sectors. The divergence has been significant over the past 3 years, highlighting the impact that business strategies and the actual underlying assets can have on long-term returns for G-REIT investors. 7 Source: Bloomberg Presima Inc 8

9 Figure 6: Stock performance dispersion over 3 years (local currencies) 900% 800% 700% 600% 500% 400% 300% 200% 100% 0% -100% -200% Source: Bloomberg, LLC. Emerging investment themes benefiting selected REITs In line with the obvious dispersion in returns, G-REIT investors often raise questions about real estate trends. The main trends discussed here have either emerged or continue to evolve following the GFC and have also driven the strong performance of specific sectors, or clusters of companies, over others. The next section highlights a few of these themes and how selected G-REITs have benefited. 1. Home ownership in the United States The end of 2007 saw the peak of the home ownership ratio in the United States. During and after the GFC, a large number of home owners lost their homes to the banks and never came back to the market, often down-sizing their living space. Also, it appears that the younger generation of potential buyers is not fully embracing the concept of owning a home which somewhat compromises their mobility. Figure 7 shows the median rent level of residential units in the US has grown quite steadily, mostly on the increased demand for units. Presima Inc 9

10 Figure 7: US home ownership ratio and the residential rent level index rent level index 70% 69% 68% 67% 66% 65% 64% % Residential Rent Index (LHS) Home Ownership Ratio (RHS) Source: US Census Bureau US REITs which own rental apartments have benefited from this trend, outperforming the overall market. In comparison, self-storage REITs have also shown strong outperformance over the last 5 years. These companies were able to drive up their occupancy and rent levels as many previous home owners downsized while wanting to hold on to their goods. 2. Office density Having met with a large number of G-REITs in recent years who own office assets, it is reasonable to think that the amount of space needed by tenants is shrinking. Among other things, this trend is driven by the evolution of technology and an increasing use of work concepts such as hot desking and activitybased office layouts. As an example, Royal Bank of Canada (RBC) is developing a new open air asset, RBC Waterpark Place in downtown Toronto, where space per employee will be about 120 square feet vs. around 160 square feet in older buildings. This is a 25% reduction. With such evidence of cost conscious tenants optimizing and downsizing their workspace since the end of the GFC, many have taken the opportunity to upgrade from a location standpoint. Centers of cities like San Francisco, New York, London, Seattle and even Tokyo have been on an uptrend in recent years. Figure 8 looks at the United States as an example. This trend clearly impacted the earnings and performance of office REITs. Presima Inc 10

11 Figure 8: Growth of $100 in US office REITs % US REITs owning centrally located offices US REITs owning suburban offices 2015 Source: Bloomberg, LLC. For landlords exposed to centrally located office assets, business is thriving with high occupancy levels and high single digits earnings growth. On the other hand, those owning lesser quality buildings mostly in suburban locations never fully recovered from the GFC and are seeing, at best, low single digit earnings growth. As shown in figure 8, the performance of US REITs owning office assets since 2010 has clearly followed the same trend. 3. E-Commerce and the transformation of shopping malls Since the early 2000s, the rise of e-commerce has been significant in a large number of markets globally. It s estimated that the annualized growth of online sales since 2003 has surpassed 100% in China, 20% in Japan, France and Australia and 12% in the United States, the United Kingdom and Canada 8. Despite such a rapid pace of growth, online sales remain proportionally small when considering overall retail sales. The United Kingdom appears to lead globally with more than 12% of its sales being made online. The same proportion reaches close to 6% in the United States and Australia but still only about 2% in China. In such an environment, listed real estate companies owning retail space certainly need to proactively adapt to technology but not necessarily to revolutionize their operations dramatically. To keep growing foot traffic and compete with e-commerce, a number of successful malls around the world have become lifestyle destinations, in addition to being shopping centers. Typically, these successful malls push initiatives such as more diversified and better quality food and beverage offering or large scale entertainment events organized by the landlords. This generally gives potential customers another reason to visit the retail space, in addition to shopping. Sawgrass Mills in Florida or Harbour City in Hong Kong 8 Source: Datastream Presima Inc 11

12 are good examples of malls which have made efforts to become lifestyle destinations and have shown clear outperformance in terms of foot traffic and sales. The outperformance also appears in the REITs share prices. Looking at the United States as an example, in recent years, post the GFC, owners of grade A malls typically labeled as lifestyle destinations have reached much higher sales productivity and earnings growth performance vs. their counterparts owing B and C class malls, which seem to struggle to attract retailers and compete. This is demonstrated in figure 9. Figure 9: Growth of $100 invested in US shopping mall REITs % US REITs owning grade A malls US REITs owning grade B-C malls Source: Bloomberg, LLC. 4. The rise of the Chinese tourist It s estimated that close to 31 million Chinese citizens travelled abroad for tourism in 2014, 24% more than in 2013 and multiples of the level reached at the end of the GFC 9. While 12.5 million of these tourists visited Hong Kong in 2014, their destination preferences are broadening and, from a marginal growth standpoint, Hong Kong is being left out at the expense of Japan. 621,000 Chinese tourists visited Japan in 2014, more than 94% more than in This gradual shift is having a profound impact on the operational performance of certain clusters of the Asian REITs space. On one side, the marginal deceleration of visitors to Hong Kong has had a significant effect on retail sales growth and, in turn, on the relative performance of REITs owning shopping malls in the country. The situation is very different for Japanese REITs owning hotels or resorts which benefit directly from the current tourism boom. This is shown in figure 10, below. 9 Source : China Outbound Tourism Research Institute 10 Source : Bloomberg, LLC. Presima Inc 12

13 Figure 10: Monthly tourist arrivals v. Hospitality JREIT share price performance Thousands 1,600 1,400 1,200 1, Number of foreign visitor arrivals (LHS) Hospitality JREITs share price index (RHS) Source: Japan Ministry of Land and Infrastructure, Bloomberg, LLC. These Japanese REITs have seen a strong acceleration both in their occupancy and room rate levels, especially over the past two years. Their earnings growth generated internally has been much above the average of their counterparts, so has their share price performance. Conclusion This paper addresses issues raised by G-REIT investors, particularly with the volatility that characterized the asset class during the GFC. With the renewed strength in their access to capital, G-REITs have, as a whole, become much larger and more liquid in recent years. On an earnings and dividend per share basis, they have nonetheless been very steadily growing their distribution to shareholders. Despite record low cost of debt, G-REITs have, for now, resisted the temptation to re-lever to the levels recorded before Also, their correlation to global equities is now back to historical averages, with the post-gfc high correlation period appearing like an anomaly. Current and historical correlations seem consistent with the real estate nature of the vehicle offering diversification benefits to investors. Looking at valuations, G-REITs look fairly valued relative to private real estate and bonds. Multiples are in line with historical averages. Since the end of the GFC and with the overall market becoming more diverse, G-REITs performances have diverged from one another. Generally speaking, selected REITs now have exposure to positive investment dynamics that shape demand for certain assets or locations. Investors appear to benefit from being selective in their approach towards the asset class. Presima Inc 13

14 Legal Disclaimer The author declines any responsibility with respect to direct or indirect damages or consequences of the inaccuracy of the information reproduced in this document, or for any actions taken in reliance thereon. Past performance is not indicative of future performance. No information or data contained herein may be reproduced by any process whatsoever without prior written consent. Certain statements made in this document may be forward-looking statements. These forward-looking statements are based upon current assumptions and beliefs in light of the information currently available, but involve known and unknown risks and uncertainties. The author s actual actions or results may differ materially from those discussed in the forward-looking statements, and the author undertakes no obligation to publicly update any forward-looking statement. Presima Inc 14