How global property can protect your portfolio
Property is not just an Australian obsession nor is it just a story about investing in places where people live. The return-to-office is a global narrative still playing out. Many people are slowly returning to air, land, and sea travel after two years docked at home. And after two years of waiting for your goods to arrive, foot traffic in shopping centres is slowly returning to life.
For Stephen Hayes and the Global Property Securities (GPS) team at First Sentier Investors, investing with a global mandate presents a near-limitless universe of ideas. This may sound good but the current environment also presents important considerations as well as opportunities.
Does an office in Manhattan, New York present a better opportunity than a mall in Knightsbridge, London? Which commercial location will fare best in a post-pandemic world - Kowloon, Hong Kong, or Raffles Quay, Singapore?
Luckily, Stephen's team has a decade-plus track record in sorting through the rubble. The team specialises in their field - each tasked with an intimate knowledge of their regions and the investable ideas in the space. In this edition of Fund Manager Q&A, Stephen and I will discuss the team's approach to global asset investing. In particular, we'll take a look at:
- Asset diversity: how the team decides what properties make the grade
- Why global is better than local
- Why real estate is the best way to invest where ESG is concerned
- Post-pandemic opportunities
What is your general assessment of the state of global commercial and industrial property?
From an operational standpoint, the majority of fundamentals in most cities are very healthy. This is typically categorised by high occupancy rates, good market rental, and cash flow growth.
The stand-out property types are logistics, self-storage, convenience retail, and life science assets. Whilst seniors' housing, student accommodation, and hotels are emerging strongly from the pandemic-related lockdowns.
In contrast, operating fundamentals have deteriorated in CBD-based office assets and shopping malls over the past few years. Both of these asset types are disrupted and are being impacted by rapid societal change. From our perspective, these disrupted assets are a small component and not material.
Operating fundamentals in Australia are a little different. Fundamentals in the logistics market are very strong and tenant demand remains way above historic levels. Market vacancy rates are also at historically low levels.
The biggest concern for Australian REITs is the large exposure to CBD office buildings and shopping malls - totalling over 30% of the sector.
In the largest CBD office markets (Sydney and Melbourne), vacancy levels are at double digits. With little pricing power, effectively zero net tenant demand, and excess supply coming online, these assets are expected to experience deteriorating real cash flows for many years to come.
The GPS funds have been around for a number of years, with the exception of the hedged/unhedged versions that have launched more recently. How has the sector evolved over the last 10-15 years?
A material change in the last 10-15 years has been an expansion of the investment universe as REITs continue to offer more specialised models. These include alternative property types and expansion across geographies. The asset class has also seen large inflows of capital.
Total FUM has moved from US$8.7 billion in 1990 to US$1.6 trillion in 2022.
As the asset class has developed over time, we have seen a shift in the types of assets that we own. From a portfolio that was skewed to more old-world traditional asset types (e.g. office and retail) to becoming more heavily skewed towards new world assets (e.g. logistical warehouses, data centres, self-storage facilities, land lease communities, and student accommodation).
But the most notable change of all that we have witnessed has been the uptake in ESG across listed real estate companies.
Although more needs to be done across the sector, it is important to recognise the substantial headway some companies have made in their ESG efforts. We have noticed significant improvements in decarbonisation efforts, and gender diversity at both board and management levels has also seen substantial improvements in disclosures to investors.
We believe that ESG alignment will continue to generate long-term value for our shareholders and have been pleased with the developments made to date in the investment universe.
Can you take us through your evaluation process for potential investments?
The first stage of our evaluation process is a defined initial screen, which filters down our investment universe based on five criteria.
We then undertake fundamental research, financial forecasts, and valuation analysis. This analysis includes assessments of management, asset quality, financial position, strategic direction, regulatory environment, and overall competitive landscape. Bottom-up research is very important to the investment process given the focus on active stock selection.
We spend the majority of our time undertaking company visits and asset tours, stock forecasting, and valuation analysis. As a part of stock fundamental analysis and due diligence, we undertake ESG analysis across a range of environmental, social, and governance factors.
Environmental: We analyse and score on environmental factors including carbon, water, and waste reduction programmes
Social: We analyse corporate social responsibility programmes including considerations of modern slavery and minorities down supply chains with the procurement of all goods and services. (e.g. investing in employee health and wellbeing, staff diversity and the gender pay gap through charity and foundation donations)
Corporate Governance: Board independence, expertise, and diversity.
Remuneration: Policies include exceeding market benchmarks inclusive of remuneration levels, alignment of interests with shareholders, employee engagement, and social and environmental targets.
Alignment of Interests: Clear demonstrated agenda to make substantive improvements across the majority environmental, social, board, and remuneration policies.
Once fundamental research has been carried out, we assess relative return to determine an investment's eligibility into the portfolio which influences weighting and portfolio construction.
Given there is no universal ESG standard as of yet – does that make this process more difficult?
The market is quickly moving towards the Taskforce on Climate Related Financial Disclosures (TCFD). Overall, we consider this to be a positive development. Social disclosures have been improving whilst corporate governance evaluations have been a mainstay for investors already now for many years.
However, environmental disclosures need to materially improve - particularly around carbon disclosures. The World Business Council Green House Gas Emission Protocols don’t fit very well when it comes to property. As a result, we have developed our in-house methodologies that cover “controlled” and “non-controlled” operational carbon and embodied carbon. For our sector, this entails the development, redevelopment, and maintenance of CAPEX programmes.
Given the lack of standardised benchmarks, we have had to develop this in-house through our research. The analysis is detailed and complex. To address this we had Ernst and Young independently assess our methodologies and assure our operational carbon disclosures.
Why is real estate the best investment opportunity for those with an ESG-centric mindset?
We have had ESG considerations embedded in the investment process for a decade now and it’s clear there is a high correlation between these considerations and shareholder returns.
There are no losers, broader society and the environment benefit, corporate culture strengthens as so do employee and executive and shareholder outcomes.
However, the investment opportunity for real estate is particularly distinctive with regard to environmental considerations. The modernisation programmes are leading to major improvements in the portfolio's energy and carbon efficiencies. In simple terms, this means lower ongoing tenant costs of occupation. These savings are typically shared between the landlord and the tenant. These improvements in energy efficiency also increase the “rentability” of the buildings leading to more secure cash flows.
Another area of materiality is carbon offset programmes. Those landlords with established high-quality offset programmes are at less risk of increasing financial liabilities associated with the rising cost of carbon credits as carbon regulation gets rolled out over the coming years.
Late last year, you mentioned that one of the themes to watch in 2022 was logistics - how do you see this playing out?
We believe that supply chain bottlenecks will likely subside as the globe normalises post the covid era. It is important to note that the supply chains already exist, ports, rail, roads and logistics facilities have not disappeared.
The biggest disruption to supply chains outside of European geopolitical risks is labour productivity. The former is new and the latter has persisted for longer than original expectations.
Although most of the world has now reopened, China is an exception with their zero-COVID policy.
The impact of supply bottlenecks has in the main subsided and in many instances, the reverse has occurred. Many businesses have over-catered for their forward orders which have led to a strong rise in inventories and a marked rise in warehouse utilization rates. The risk of economic slowdown does loom which could lead to a fall in aggregate demand, which could lead to a slowdown in tenant demand. However, it should be noted that any slowdown in tenant demand would be from very high elevated levels.
Tell us about one of your most significant holdings/assets in the portfolio – and how they reflect the standards you wish to have for all your investments.
The Unite Group (UTG) is the largest provider of private purpose-built student accommodation in the UK. It owns and manages a large platform of 74,000 beds across 172 assets in the top 25 UK university cities (London, Liverpool, and Birmingham to name a few).
UTG is a leader in sustainability with a well-regarded development capability. As a market leader, they have high operating margins. The company has also developed a cloud-based technology platform - leading to management efficiencies and a more seamless customer experience.
The UK tertiary education system is well regarded which attracts large numbers of foreign students and contributes approximately £50 billion to the British economy every year.
UTG’s portfolio is highly occupied (+95%) with a split of 70/30 of UK versus foreign students.
As activity post-Covid normalizes and international travel returns, Unite is expecting strong EPS growth (+10% FY22 and +23% FY23). They are also increasing their dividend payout to 80%. UTG are currently in the process of delivering a record development pipeline of 6,000 beds, at a cost of nearly £1 billion. Having said this, the pipeline will add an additional 10% to EPS over the next five years. They are also well placed in a rising interest rate environment with a strong balance sheet.
How have offices and hotels done in the pandemic recovery era and how compelling are valuations today?
We have introduced some hotel and leisure assets into the portfolio as economies have reopened post the pandemic.
We have witnessed a strong recovery in domestic tourism as social distancing restrictions have eased. Corporate travel is also recovering as business returns to normal. Hotel and resort occupancies have spiked and room rates are increasing driving revenue.
Valuations remain attractive at below replace values which are also constraining supply. We are expecting hotel and resort fundamentals to continue to improve with the only caveat being a more pronounced economic slowdown which may delay the recovery of corporate travel.
We have very little CBD office exposure - mainly investing in the five main wards of Tokyo. Valuations are very attractive at a 50% discount on net asset values.
Our retail exposure is mainly through convenience-based shopping centres which as performing very well with high occupancy and rent collections. The assets are service-based offerings with less threat of online cannibalisation. Valuations are appealing and are expected to provide defensive cash flow exposure in the event of an economic slowdown.
Where do you see the biggest opportunities/growth moving forward?
We expect that current macroeconomic conditions, comprising higher energy costs, the start of the monetary tightening cycle and the potential for a slowing of economic growth will favour landlords that are able to maintain pricing power.
More specifically, those assets that are supported by long-term structural themes, that are demonstrating resilient tenant demand. Strong balance sheets are also imperative.
The US, whilst it won’t be immune from macro headwinds, has shown to be comparatively resilient to other major economies given their higher labour mobility and tight labour markets.
We believe the biggest opportunity lies in the detached housing for rent sector in the US. Fundamentals are currently very strong with occupancies +97% and double-digit rental growth. Housing affordability issues have increased in the US due to elevated housing prices and the primary method of housing finance in the US 30-year fixed mortgage rate has increased to 5.7%. This means a greater propensity to rent and the average age of the renting cohort will continue to rise.
Cash flows from detached housing are expected to continue to grow and likely prove resilient in the event of a pronounced economic slowdown. Valuations are also attractive trading at a 20% discount to net asset value with the recent market pullback.
Seizing the opportunity
The First Sentier Global Property Securities Fund offers a unique opportunity for investors, who can benefit from the underlying defensive characteristics of real estate while gaining exposure to growth industries. You can learn more at the First Sentier website here.
Managed Fund
First Sentier Wholesale Global Property Securities
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Hans leads the team's coverage of the global economy and fixed income. He is the creator and moderator of Signal or Noise, Livewire's multimedia series dedicated to top-down investing.
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Hans leads the team's coverage of the global economy and fixed income. He is the creator and moderator of Signal or Noise, Livewire's multimedia series dedicated to top-down investing.
Expertise
Hans leads the team's coverage of the global economy and fixed income. He is the creator and moderator of Signal or Noise, Livewire's multimedia series dedicated to top-down investing.
Expertise
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