TOL - 29th May, 2023
Why the outlook for (some) commercial real estate may be better than first thought
Despite multiple debt defaults in recent times, David Kruth of Dexus argues that not all commercial real estate will struggle.
Real estate is an obsession both here in Australia and around the world. But while residential house prices are a constant topic of debate, commercial real estate rarely gets as much airtime. That is, until now.
Rising interest rates have wreaked havoc on long-term debt and the wider cost of borrowing. Recently, Brookfield reportedly defaulted on a US$161 million mortgage pertaining to 12 Washington DC area offices. The default is already the second for the asset manager this year.
Office landlords and REIT stocks heavily exposed to that space have felt much more of an impact in this part of the cycle due to the transition to hybrid work and corporate decisions to freeze hiring and/or commence layoffs.
It's this kind of default that David Kruth of Dexus is specifically trying to avoid for clients. While he does not doubt the impact rising interest rates are having on real estate and REIT stocks, he cautions investors to remember that now is the time for individual, bottom-up selection in the more resilient sectors of the space.
In this edition of Expert Insights, Kruth sits down with me to discuss how he and his team are actively managing the biggest headwinds facing the commercial real estate space and its related stocks.
EDITED TRANSCRIPT
LW: How does Dexus Global REIT Fund manage major market headwinds?
Kruth: Since we launched the fund three years ago, we've been in a very volatile period just generally around the world given the changes in the economy, from COVID to kind of coming out of COVID and the inflationary times and now the higher interest rates.
So, the amount of volatility that we've seen is really continuing this year because we're seeing most of the central banks around the world continuing to push on interest rates to bring down inflation. What we tend to do is focus more on lowly-levered companies with very strong indices or industries that allow these companies to kind of push through.
We're not paying attention to the companies that are in more stressed industries, such as commodity offices. We're focusing the business on very strong real estate sectors and strong balance sheets.
LW: Are you concerned about the values of commercial real estate given recession risk?
Kruth: You have to really peel back the onion. So, the issues that we're seeing in the credit markets in the United States and the mortgage side of the market is really more focused on certain commodity office markets that have had loans were written several years ago in a different timeframe. And as we have hit more of a choppy market, clearly office use trends have changed dramatically since COVID and will likely stay less robust.
There's going to be some issues, and we've seen this. I've been around for quite a while. We've seen four or five different cycles before, where certain assets hit kind of an air pocket and some of those assets are going to have to be worked out. So, whether the banks work with owners such as a Brookfield in that case, or in some cases, they have to take the asset back and it's going to be written down and it's going to have to be resold to the open market.
So, we look at this and say it's more specific to certain asset classes and certain types of owners who have too much leverage, but unfortunately that does is that kind of paints a broader brush.
Even the global real estate companies that we invest in, which don't largely have any real issues like that, they're impacted too. So, that gives us an opportunity to find good value in great businesses and great real estate for the next couple of years. So, in a way, it's both painful but it's also an opportunity.
LW: How has Dexus Global REIT Fund performed against its peers?
Kruth: On our three-year track record, we're running about 8.65% annualised over three years, which considering the choppiness of the overall global economy, I think if you were to go to sleep before COVID and wake up now and say "That's not a bad return." It's been pretty choppy in-between. If you look at our risk metrics, we're running well below the index in terms of our risk metrics.
So, our risk-adjusted returns are very, very strong. We're running about 170 basis points annualised ahead of the index. That's a very nice outperformance. So, if we're 8.65%, the index is far lower, and based on our numbers, if you look at our performance against the largest peer set in Australia, we're doing quite well against those peers. We're very happy on a relative basis and an absolute basis of how we're doing in a challenging market, and challenging in terms of volatility, and think about what's happened in the last couple of years, and we're very happy to have performed well, all things considering.
LW: What is your outlook for stocks in the fund?
Kruth: In our portfolio, which is about 72% in North America where I spend most of my time, the average debt ratio, so debt to asset ratio across the portfolio was around 30%. So, I would say that you can consider that a very low debt ratio. Interest cover, so the interest coverage ratio of the earnings of the company is very, very high.
The debt is locked in, mostly fixed for a number of years. So, if you think about the capital structure of the real estate companies and hence the real estate that they own, it's extremely conservative and much more conservative even if you go back to the Global Financial Crisis when the REITs were running at 50% and they've learned the hard way that you don't want to be levered, it gives them more opportunity.
So, I think from a safety perspective and the dividend safety, it's very important to understand that the companies that we have in our portfolio are lowly-levered.
More importantly than that perhaps, is because it's global real estate, we get access to a number of real estate sectors that you don't really see here in Australia. I'll name a few. Data centres, mobile towers, for rent in residential, multi-family, single-family housing, large amounts of industrial space.
These are all very strong, and self-storage. These are all very strong sectors that are getting higher and higher rents, strong margins and strong growth and dividend growth. In fact, we've been looking at, I think, more than 50% of our companies in the portfolio have already increased their dividends by an average of 6% going into 2023, which continues to show the strength of the underlying markets in which they operate.
So, while you hear about the broad market in commercial real estate having issues, there's good opportunities in many strong sectors, which is where we've positioned the portfolio for the last couple of years. And I think that's why our performance across the board has been so strong.
Broaden your income horizons
With demand for industrial properties strong and vacancies at record lows, the outlook for rents and valuations remains attractive, a view reflected in our positioning within the Dexus Global REIT Fund. Inside the world of industrial REITs, things are better than their share prices imply. And therein lies the opportunity. Click here to learn more about our offerings.
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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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