Michael Hedstrom, director of the Closed-End Fund Association (CEFA), spoke with Steve Burton, Co-CIO and Senior Global Portfolio Manager at CBRE Clarion Securities, to discuss his insight on the real estate market and potential opportunities for closed-end fund investors.
The following Q&A recaps the conversation that originally took place as part of CEFA’s podcast series on June 27, 2017.
MH: Some investors may be concerned about rising interest rates and the impact on real estate investments. At the same time, economic growth and inflation are often tailwinds for REITs during a period of rising interest rates. Can you share your perspective of what you are seeing in the real estate market, and also, what is your outlook going forward?
SB: Although REIT stocks can be volatile in the short term as interest rates begin to move higher, and interest rate risk becomes more prevalent, they tend to perform well in the long-term, if you look through this time-period of rising interest rates. The reason, I suppose, is the obvious one which may not be apparent to investors in the short term. That is, typically rates go up because economic conditions are improving. The Fed is looking at employment stats, is looking at statistics which reflect the economic health of the country, in the case of the U.S. and rates are increased as a result of that. The Fed, as an example, has raised policy rates twice this year with another rate rise expected during the second half.
This, ultimately, is good for demand. It's good for demand of commercial real estate. It ultimately flows through to the topline of the real estate companies. REITs, as we've studied this, looking at both longer-term rates via the 10-year and short-term rates via the fed funds rate, have performed well as we look through these time periods of rates increasing.
I would note that with a global strategy, which is what we have, we can take advantage of economic and real estate cycles that differ depending on where you are on the globe. The growth can be uneven, depending on geography and property type. As an example, the European property stocks are up strongly this year as political risk has been mitigated post-French elections. And more importantly, it becomes clear that economic growth is improving off of a low base.
A lot of investors don't know it, but real GDP growth in the Eurozone is just a touch behind that of the U.S. That applies to both 2016 and what's expected this year in 2017. European property stocks are up over 15% year-to-date. Moving to Asia, Hong Kong and Singapore, again, are responding to economic news, which is kind of less bad in property fundamentals which, in some property types, are at an inflection point. Hong Kong and Singapore stocks up over 20% year-to-date.
This rising rate phenomenon can differ depending on geography and ultimately is good for real estate demand, and that's reflected in performance as you look through that cycle.
MH: Steve, that's a good transition into my next question. For investors looking to boost their income and broaden their diversification, REITs may represent an attractive opportunity. Can you elaborate on the benefits of REITs and why investors and advisors should consider including REITs in their portfolio?
SB: REITs are the listed way to own commercial real estate. By listed, I mean they trade every day on the major stock exchanges of the globe. With that, there is liquidity. Real estate is an asset class which, historically looking back decades, has been privately owned. It's been opaque. It's been difficult for the individual investor, in particular, to invest in.
With REITs, your real estate investment trusts, or more broadly just with the property companies, this investor can access property types and geographies that otherwise couldn't be accessed.
As an example, in the U.S., the vast majority of malls, regional malls, shopping malls, are owned by the listed property companies. If you want exposure to the Class A mall business, in particular, in the U.S. you almost have to invest in the REITs. Simon Property Group, which is the largest REIT in the U.S., single handedly, owns over 20% of the Class A malls in the nation.
That's point number one. If you go outside the U.S., this access might include some of the Asian markets in particular. Or say German residential, which again, otherwise are property types that would be almost impossible to invest in for an individual.
Two, diversification. This is huge. One REIT may own 400 properties. This portfolio of REITs could easily number 60-70 companies, each of which owns many, many properties. With the REITs is immediately diversification. Diversification which really cannot be replicated in the private markets, certainly not in the classic co-mingled fund which is how real estate has been owned by institutions, if you go back decades. The diversification benefits of REITs are significant.
Third, transparency. REITs have brought a much higher level of corporate governance to the ownership of real estate. Governance including conservative leverage levels. The average debt to total enterprise value right now among REITs is in the 30% range, which is low versus private real estate and versus the history of real estate. There's a lot of transparency with respect to quarterly earnings releases and teams of analysts and portfolio managers, including us asking management hard questions and measuring whether or not they've created shareholder values apples to apples or on a per-share basis over time. A lot more transparency.
With this, discipline of capital allocation. A lot of real estate investment trusts not only have to have a very strong CEO, but they need a strong CFO. Someone who's helping to allocate that capital so that it adds value to shareholders over time. The universe of listed property companies is big, and it's expanding. Approximately three trillion U.S. in equity market cap and over 1,000 real estate companies. It represents an increasing slice of the overall global real estate high. It's an increasingly important way to own real estate, both for institutions and individuals.
Last, maybe this is second to last, if you look at the long-term performance of real estate stocks versus competing asset classes, namely equities and fixed income, it is very competitive. It's rewarded investors over time.
Last, I just would note that the defining characteristic of REITs is current income. It's the dividend yield. It's current income via the dividend. REITs, by structure, need to disperse the majority of their income to shareholders, so that generates an attractive dividend yield versus other asset classes.
MH: We have discussed the topic of active and passive management in several of the CEFA podcasts lately, and the fact that both can – and do – play important roles in building diversified portfolios. With that said, what are some advantages of investing in REITs with an experience active manager versus using passively-managed investments such as ETFs?
SB: Real estate is an industry which lends itself to active management, given the need for local information in a global portfolio, in a business which has been very local historically. It is true that passive strategies have expanded in recent years since the global financial crisis, during which time a lot of central banks globally have been actively managing monetary policy and distorted the number of factors which have contributed to investors looking at a passive strategy.
We believe, as we look past post the global financial crisis (NYSE:GFC) time-period, though, that active management will ultimately be rewarded, given our access to research in the local markets and our underwriting, which pays a lot of attention to real estate value. We don't like to buy companies that are trading at premiums to the underlying real estate value. As we underwrite these companies, fundamentally we know that that approach pays off over time.
We think we're finally, as I mentioned briefly before, entering a time-period where interest rates are being normalized. The yield curve, arguably, will shift up as we look forward. In this environment, fundamental real estate underwriting should be rewarded.
Last on this, one part of the market where active management definitely has paid off in the past and will in the future, is during any market downturn or any market turbulence. Active managers have the ability to protect on the downside much more materially than a passive strategy.
MH: That's a very good point. Let's turn specifically to closed-end funds. After the financial crisis, the REIT closed-end fund landscape consolidated dramatically. Can you highlight some of the benefits of using the CEF structure to invest in REITs, and talk briefly about the overall CEF real estate space?
SB: We look at the context here, there are over 500 funds in the closed-end fund space and only 9 investing in listed real estate companies. We're one of those nine. Most of those nine are invested in a U.S.-only strategy. I will point out that this 9 is down from 24 pre-GFC, so there was a lot of consolidation following the financial crisis.
Given its global nature, (NYSE:IGR) is one of the few funds that affords the diversification of being global and in markets which otherwise are not offered by closed-end funds. We can invest in London in the U.K. The Pacific was mentioned and markets throughout Europe, as well as the U.S., of course. With this we get lower correlation and investment characteristics that differ from a U.S.-only strategy.
I would note that with a closed-end fund structure we can do things that cannot be done with opened-end funds, including using tactical leverage to generate dividend and current yield and to enhance that yield to the underlying investor. That's an advantage that closed-end funds inherently have versus opened-end funds.
MH: As we have mentioned, the opportunity for higher and consistent income is why investors are often drawn to CEFs. You mentioned the fund that you manage, which is one of the largest global real estate closed-end funds. How do you manage the income and distribution component? Earlier you also mentioned leverage. What are your thoughts on using leverage in this environment, and where do you see opportunities?
SB: Our fund, IGR, is one of the largest funds in its space at approximately $1.2 billion, which is more than twice as big the average for the other CEF funds. As mentioned, the defining characteristic of real estate stocks is current income via the dividend.
I can tell you that, although I mentioned leverage, we do use leverage very modestly. Our leverage is a lot lower than a lot of the other funds. We're not comfortable with high levels of leverage, so we truly use it to enhance current yield via the dividend, but in a modest way. Our leverage over time has averaged 8%, which is less than half, if not less than a third, the average of leverage among competing funds.
The opportunities as we look at the world of listed property stocks is the focus on companies that pay attractive total return anchored by the dividend yield, so that we, in turn, can pay out a distribution yield, which is approximately 8% right now on the fund.
What does that opportunity mean? It means investing in the REITs of the U.K., the REITs of Western Europe, including some of the dominate retail companies and companies invested in, for example, Northern Europe, including German residential, which I mentioned. The Asia Pacific region, it's going to mean a skew to the Australian REITs. Australia is always the poster-child of an attractive combination of yield and growth. Average dividend yield in Australia is above average globally, and the real estate markets there are very strong.
Right now, we do look for special dividends. Periodically, companies sell properties or generate significant gains, which result in special dividends. We're positioning to capture some of those above average distributions. We do consider the preferred stocks in the U.S., as well. The U.S. preferred stocks of the real estate investment trust are a material part of a portfolio strategy with respect to generating income.
REITs, by definition, generate income, and within that, we actively seek to harvest the best of that while generating attractive total return.
MH: Steve, in summary, what are 2-3 key points about investing in real estate that you would like to leave us with today?
SB: Real estate is an asset class that has stability of cash flows which come from the leases. Lease terms, in duration, average 5 to 8 years, so there's a contractual nature to those cash flows. Despite interest rates nudging up recently in the U.S., the fact remains that we remain in a slow-growth world. Economic growth is positive, and it's improving and it's expanding. With this slow growth, real estate offers an attractive combination of yield via the dividend and contractual underlying growth we would argue is very attractive versus competing asset classes.
The REITs, just to reinforce, provide diversification, not only by geography, but property type. They, importantly, provide liquidity which I talked about in an asset class, which over the decades looking back, has been encumbered by illiquidity. The REITs solve that problem. It enables me as a portfolio manager, to quickly take advantage of value opportunities and to reshape the portfolio literally on a daily basis.
Lastly, I'd point out that real estate is cheap via the listed markets. The listed markets trade at nearly a 10% discount, but we think the value of real estate is the private markets. It's an attractive way to access commercial real estate in a liquid and diversified format.
I would note that if you just look at the sheer performance the REITs, and this is an industry comment, REITs have historically out-performed other asset classes within the closed-end fund universe. With total return, for example, over the past three years exceeding 8%, versus the closed-end fund average, which is less than 5% over this time period. We expect this type of absolute performance and relative performance to continue as we look forward.
Closed-end funds trade on exchanges at prices that may be more or less than their NAVs. There is no guarantee that an investor can sell shares at a price greater than or equal to the purchase price, or that a CEF’s discount will narrow or be eliminated. CEFs often use leverage, which increases a fund’s risk or volatility. The actual amount of distributions may vary with fund performance and market conditions. Past performance is no guarantee for future results.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.