A confluence of high savings rates, businesses reopening and low housing stock are driving healthy real estate cash flows. But an uneven recovery may demand an active, diversified and international approach to best capture the opportunities ahead.
“Consumers are generally healthy and have more money in their wallets and there is pent-up demand to spend. That dynamic has led to a strong rebound across many real estate sectors,” says Ji Zhang, portfolio manager at New York-based Cohen & Steers Capital Management, the sub-advisor of the $453.9 million 3-star silver-rated Renaissance Global Real Estate Class F.
Like many other asset classes real estate securities endured a brutal bear market in 2020 and the Real Estate Equity category returned -6.8%. “It was certainly a challenging year for global Real Estate Investment Trusts [REITs], says Zhang, “Many businesses were impacted by the shutdown and people were not going to their offices or malls or restaurants. Needless to say this had a very negative impact on real estate.”
Fortunately, 2021 is reversing the trend and the category is up 21.85% year-to-date (Sept. 8). Going forward, portfolio managers like Zhang admit that the pace of returns may slow but the asset class still looks promising.
“Since the positive vaccine announcements late last year, there’s been a light at the end of the tunnel. Things started to re-open and there has been a gradual return to normalcy. We have seen and continue to expect to see a strong rebound in real estate fundamentals, relative to the broader market. We will continue to see that recovery over the next 12 to 24 months.”
Year-to-date (Sept. 8), Renaissance Global Real Estate Class F has returned 18%. In contrast, last year the fund returned -5.15%.
Zhang believes the recovery of real estate securities was quicker than the decline, mainly because the market tends to be forward-looking. “When we got the vaccine announcement late last year, it took a while for the vaccine rates to increase and the case counts to come down,” says Zhang, a 14-year industry veteran who earned a Bachelor of Science from the Massachusetts Institute of Technology and joined Cohen & Steers in 2018, after previously working for Neuberger Berman and Bank of America Merrill Lynch. “But the stock market reacted much quicker because it was able to look through the choppiness in the first and second quarter to what a more ‘normal’ environment would look like. We got the first leg up in October and November,” says Zhang, adding that central bank monetary measures have also been a contributing factor.
Zhang admits that the Delta variant is a risk that needs to be monitored. “It could impact consumer and corporate behaviour, more so in certain regions than in others. Companies are pushing back their re-opening dates. That will delay the recovery of the office sector. But the Delta variant has been more negative for Asia and parts of Europe, which are more dependent on border re-openings than the U.S.,” says Zhang, adding that the recovery could be pushed out by one or two quarters. “We are seeing a de-synchronized recovery across the world. But the overall trajectory is continued recovery.”
The Renaissance fund is modelled after the US$2 billion Cohen & Steers Global Realty Shares Fund and employs the same strategy. Zhang works closely with Jon Cheigh, the firm’s chief investment officer and head of global real estate.
From a sector viewpoint, specialized REITs comprise the portfolio’s largest sector at 13.8%, followed by 11.7% retail, 11.5% healthcare and 11.4% industrial REITs. From a geographic standpoint, about 56% of the fund is invested in the U.S. and 44% in international markets. The fund has a running yield of 2.7%, before fees.
The U.S. weighting has been pared back slightly as the managers have taken profits. “There is a desynchronized recovery and a lot of other countries are catching up, either with vaccines and re-openings. Given that the U.S. has performed very well we believe the valuations across pockets of Europe and Asia are more attractive today. So we have re-allocated some capital from the U.S. and into international markets.”
In selecting stocks, Zhang and the management team blend top-down and bottom-up approaches. “But we do consider whether the property type and the market are favourable,” explains Zhang. “We look at whether the sector has favourable supply and demand dynamics. At the company level, we take into consideration whether the firm owns the right asset and the right location to capture growing demand. We like companies that have a competitive moat, whether it’s having exposure to markets where it’s difficult to build or having irreplaceable assets such as data centers with thousands of businesses connected to each other. Those kinds of assets are very difficult to replicate. As a result, they have much higher pricing power.”
Management teams are critical in the stock selection process because their skills in allocating capital are vital in creating shareholder value. “But ultimately it comes down to valuation. We are strong believers that when a good company gets too expensive, we should be selling. And when a lower-quality company gets too cheap, we should be buying.” Over three- and five-year periods, the fund had an annualized return of 10.13% and 7.18% respectively. In contrast, the Real Estate Equity Fund category had an annualized return of 9.67% and 7.58%.
While compliance rules prevent Zhang from discussing specific holdings, she notes that the team has focused on themes such as residential housing which has benefitted from strong demand. “Many global markets have a housing shortage. That should lead to relatively favourable demand over the coming years, and it should sustain high occupancies and promote development opportunities,” says Zhang.
Promising markets include Germany, Austria and Spain, where housing stock has not caught up with immigration and population growth. “Our exposure to residential is through developers. They tend to have lower multiples than REITs, but higher growth. They have sustained relatively high margins because of that dynamic.”
Another theme is the recovery in consumer spending. “Because of the shutdown in many countries consumers are sitting on historically high savings rates and pent-up demand,” says Zhang. “In many places, the consumer has been the first to recover. So we have exposure through retail, in the highest quality portfolios. We also like gaming which has a higher exposure to the leisure segment than your typical hotel companies.”
Looking ahead, Zhang concedes that the investment returns could slow. “But when we look beyond the recovery trade we still see healthy returns for real estate. When you look at the outlook for global economic growth over the next few years, it could continue to accelerate,” says Zhang. “That should translate into higher demand for real estate. While we are likely to see some monetary tightening, rates are at historically low levels. That’s a pretty favourable environment for real estate.” Moreover, some sectors, such as retail, healthcare and lodging, are still 10-15% below pre-pandemic levels. "They should start to experience healthy cash flow growth.”
To boot, areas such as industrial and cell phone towers will continue to benefit from secular tailwinds. “These are sectors that should sustain high single-digit to low double-digit cash flow growth for the next three to five years. When you combine all of that, it should lead to very good cash flow growth for the sector over the next 12 to 24 months.”