Marcus Erlank, Catalyst Fund Managers
At the very bottom of Maslow’s hierarchy of needs, next to breathing, food and water, lies shelter. Since the beginning of human existence, shelter has been pivotal to a surviving human race. With such great demand, it is no surprise that a lot of money has been made over the years in real estate developing, selling and operating. The importance of real estate as an investable asset class has never been more relevant than it is today.
If you asked the average person what comes to mind when one says “real estate investing”, chances are high that they will mention buying their first apartment or house. Possibly, you may get someone mentioning an office or hotel developer if they were familiar with the early 2000s show “The Apprentice” featuring Donald Trump.
Listed real estate vs direct real estate:
In 1961, the first REIT, American Realty Trust, was founded under a new bylaw passed in 1960 which allowed investors the opportunity to invest in large-scale, diversified portfolios of income-producing real estate in the same way they typically invest in other asset classes – through the purchase and sale of liquid securities. Every one of the 39 nations that currently possesses a portion of the roughly $1.7 trillion market capitalisation of REITs, which constitutes about 490 stocks, has its own distinct set of regulations concerning the eligibility criteria for a REIT. However, at the core of what distinguishes a REIT is the mandatory distribution of the majority of their earnings available for distribution, in the form of dividends.
There are numerous benefits to investing in listed real estate as opposed to direct real estate:
Listed real estate gives investors the ability to enter and exit their investments on a much shorter time frame and with less effort than direct real estate.
The frictional costs of entering and exiting a listed investment are far lower than all the costs associated with entering and exiting a direct real estate transaction.
Usually investing in direct real estate requires a large cheque to purchase one building. In listed markets, that same cheque can buy a portfolio of shares in multiple sub-sectors of real estate in multiple geographic regions, taking away a lot of asset, company, country and currency risk.
• Lack of property management requirements By buying a stock as opposed to an actual asset, there is no requirement to manage tenants, spend capital and incur other administrative costs. The costs get dealt with in the company and the stock is priced accordingly.
• Platform & economies of scale
A listed REIT can have a market capitalisation in the tens of billions of US dollars and can be a well-known entity with a strong platform. As a result, efficiencies of scale and management expertise can enhance shareholder return versus spending that same money on an individual direct asset.
• Transparency and corporate governance Being listed, management teams must adhere to the highest standards of corporate governance to ensure that shareholders are protected against potentially controversial business practices.
• Taxation benefits
Generally, as long as a REIT pays out the majority of its earnings as a dividend, it is granted a tax benefit within the corporate structure. The dividend paid to the investor will be subject to dividends tax, which is generally lower than the income tax rate that income from a direct property is subject to.
Listed real estate in a diversified portfolio
Traditionally, listed real estate bridged the gap between bonds and equities. The compulsory dividend and predictable cash flow underpinned through long-term leases provided a stable income stream for investors. The ability for experienced management teams to extract value through decreasing building vacancy, maximising income from tenants, accretive spending of capital and raising equity opportunistically would allow an element of growth in the underlying earnings and thus, hopefully, the share price. These characteristics are more equity like.
Globally, the listed real estate universe has changed significantly since inception. In the early years, retail, offices, industrial and apartments dominated the market cap of listed REITs, but in the last few decades new and economically relevant sub-sectors have started to gain institutional recognition. These sub-sectors are often extremely fast growing due to having tailwinds from current trends in global economies, for example increased data usage or work-from-home trends. This allows for an outsized portion of the investor’s total investment return to come from growth, rather than dividend income. A few examples of these sub-sectors are:
• Single family housing
Individual family homes are purchased and rented out to individuals. This is a highly fragmented market in the US and benefits from tailwinds of a large cohort of the US population being in their 30s and moving out of apartments and into houses. Work-from-home penetration has also caused demand for more space. The higher interest-rate environment also creates a bigger pool of renters versus buyers.
• Data centres
These are specialised buildings with critical internal infrastructure such as servers and fibre connections. Robust and reliable electricity supply and cooling allow for big corporations to centralise their super computers. In the information age, the evolution of the quantum and speed of computing power is exponential. Data centre landlords have an exceptional tailwind of demand that continues to grow.
• Self storage
Various sizes of individual storage units are available for rent to individuals or businesses. Generally self storage is seen as fairly recession resistant because it has certain tailwinds in every part of the cycle. An example of this would be a family downscaling in tough financial times – they may use self storage to store excess furniture and belongings.
Listed real estate in the current macro environment
The case for listed real estate, on a fundamental basis, makes sense when one considers the favourable risk-and-return characteristics. However, it is important to also consider the macro environment.
In a higher inflation environment, listed real estate can benefit due to the often inflation-linked lease escalation terms. In many cases, a higher inflation environment can correlate to higher nominal market rental growth, which will allow for positive rental reversions when leases expire. If companies can control operating costs, the positive operating leverage effect can be significant.
REITs generally use leverage to maximise return on equity when acquiring, developing and managing their portfolios. In a high interest-rate environment, debt becomes expensive causing expansion opportunities to become less accretive and servicing the existing debt can eat into distributable earnings. The silver lining is that REITs utilise approximately half the leverage of private market real estate companies and even so, REITs have leverage ratios that are lower than they were going into the Global Financial Crisis. In addition, companies have been very disciplined in their hedging strategies and have only a small relative portion unhedged or expiring in the short term. This gives companies optionality when determining how to navigate the current environment.
The upside to the current interest-rate cycle is clear, too. While global listed real estate has underperformed general equities over the past 18 months through the monetary tightening cycle, history shows that listed real estate tends to outperform when the hiking cycle ends and policy loosening commences.
Hedge strategies within listed real estate
While the benefits of hedge funds in a diversified portfolio are well documented, there are hedge strategies within listed real estate that can and should be used to maximise return while limiting portfolio risk.
a) Fixed income/real estate pair
Real estate is often viewed through a similar lens to bonds due to the income component of the total return – REITs have to pay out materially all their distributable income to get the tax benefits of having REIT status. Using a fixed income/real estate pair can be an effective method for removing country risk (when matching the bond country to the stock country). Additionally, this pair was an effective source of funding in the 2010s when coupons were low on bonds and the spread was compelling.
b) Sub-sector specific pair
Sub-sector pairs are a great way to take advantage of intra-sector mispricing, underlying demand fundamentals (gateway cities versus sunbelt markets) or macro head and tailwinds. A good example is found in the office sector. Offices are experiencing a structural headwind as work from home grips the globe. A lot of longer-term leases struck pre-Covid still need to roll off and reprice and, as a result, the full effect of lower demand for offices hasn’t been felt yet. A-grade offices are mopping up what’s left of the demand, as employees seek more amenities from their workspaces, while B-grade offices are becoming all but obsolete.
In addition, one theme this year so far has been the bifurcation of returns between companies with lower leverage vs companies with higher leverage. In a rapidly rising interest-rate environment, having higher leverage and a shorter debt maturity profile poses a real risk to company earnings. Hedge funds can look to have short exposure to these stocks and pair that with a long position in a stock in the same sub-sector (neutralising market risk) but with a better balance sheet.
There is, however, a risk to being short a company with a stretched balance sheet and poor management. These stocks often have depleted share prices and make for compelling take-out targets by better capitalised companies.
c) Sector long/short
The real estate sector can see notable variations in sector performance making sector allocation vital in any portfolio. For example, the fundamentals for the data centre sector differ largely from the self-storage space. Sectors benefiting from long-term thematic or demographic-driven supply/demand tailwinds should outperform. A hedge fund can choose to pair sectors against each other within a specific market (ie: long industrial/short malls based on the exponential growth of e-commerce vs in-store shopping through the Covid pandemic) to limit market risk but benefit from shifting consumer trends.
Chart 4 highlights the ability of a good long/short manager to outperform the broader market both in terms of annualised returns as well as volatility. It is important to note that this outperformance is net of fees (it is a common misconception that hedge funds charge unjustifiably high fees). The Catalyst Alpha Prescient QI hedge fund is a great example of how the long/short strategy can be successful in a South African context. In addition, the Catalyst hedge fund’s track record illustrates how taking a long/short approach to listed real estate can provide the kind of flexibility needed to negotiate turbulent markets, while diversifying both locally and offshore brings added risk mitigation.
In an analysis done from 1976 to 2022 by Firer and McLeod, it was determined that to maximise the risk-adjusted return or Sharpe ratio of an unconstrained portfolio, local property should comprise 11.7% of a property portfolio. This despite the average SA multi-manager holding less than 5% of SA property in their portfolio.
Similarly, in global asset allocation, a target allocation of approximately 9-12% to real estate (across direct real estate and REITs) is appropriate per a survey done by Oxford Economics, Cornell University and Hodes Weill.
Listed real estate both locally and globally has long proven itself as an effective portfolio diversifier. Its low correlation to other asset classes, income + growth total return profile and accurate forecast ability of underlying earnings are all unique characteristics. In addition, being able to get access to the fundamental attributes of physical real estate through the liquid market has cemented its place as an important asset class that should be at the forefront of multi-asset investors’ minds. Overlaying hedge strategies within listed real estate only aids in making the argument more compelling. Copyright. HedgeNews Africa – November 2023.
Marcus Erlank is a director and portfolio manager at Catalyst Fund Managers Alternative Investments, joining the team in 2017. He is a qualified chartered accountant CA (SA) and a CFA charterholder. The team has managed listed real estate portfolios for institutional and retail clients since 2001, with more than R1 billion under management in local and global hedge fund portfolios.