As Winston Churchill once said, “never waste a good crisis”. The listed real estate market most certainly entered a period of crisis in 2007-2008, but many hard lessons were learnt, and the asset class is in a far stronger position as a consequence of the global financial crisis.
There are four key factors that support our belief that global listed real estate will act more like a defensive investment the next time meaningful dislocation in the economy occurs.
1. Financial leverage is better disciplined
Financial leverage was clearly a significant factor in the relative underperformance of listed real estate during 2007-2008. In many cases, real estate companies were over-levered, and short of tenor in their debt books. They were essentially over levered at the wrong point in the cycle and fully exposed to any fall in asset values.
For context, at the start of 2008, US real estate investment trusts (REITs) had very high leverage (debt to assets) and debt to earnings before interest, tax, depreciation and amortisation (EBITDA) multiples around 7.5 times, rising to eight times in late 2008 to 2009.
When debt markets effectively closed in 2008, many listed real estate companies were close to breaching debt covenants and faced difficulty refinancing near-term debt. They were forced to either raise equity at deep discounts or offload assets many at fire sale prices.
But the average leverage ratio of US REITs today is around 31 per cent – roughly half what it was at the peak of the global financial crisis. The debt to EBITDA multiple has also been cut by 30 per cent, falling from around eight times during the global financial crisis to 5.6 times today.
Leverage adds financial risk into the return profile of real estate. At times it enhances returns and other times it detracts. Over the cycle, the higher the leverage the riskier the return profile becomes.
Very few people can call real estate cycles, and as the cycle nears its latter phase, you want to have close to no leverage; in 2008, at exactly the wrong time, this was where leverage was at its highest. We are rewarding management teams today with a more conservative approach to leverage as the business cycle gets longer dated.
2. Operational leverage (or risk) is also better disciplined
Operational risk, such as speculative development, can enhance returns in certain segments of the cycle, but not all, and through the cycle the risk/reward is questionable for a large number of landlords, unless you have a niche in this space, a long runway and clarity on how to diversify that risk away.
Analysis has proven that over the longer term, higher speculative development activity detracts value from real estate and adds in additional risk.
Since 2008 banks and other creditors have been less willing to lend for speculative development, unless the returns were exceptionally compelling and hence the risk sufficiently rewarded. This reduction in development appetite has held the supply of global real estate in check. Whilst supply is expected to pick up momentum over the medium term especially in certain real estate sectors, it is from a relatively low base and still at, or below, the long-term average.
3. Sustainable dividends
The third factor underscoring the defensive proposition of global listed real estate is a more sustainable approach to dividend payments, which longer term should provide a more defensive income stream to investors. In the run up to 2007-2008 dividends were overstated in Australian REITS (AREITs) and, in some areas, reliant on financial engineering, a practice that has been dramatically cleaned up as the crisis ended and ultimately reset to pay dividends out of free cash flow. Turning to the largest market, the US, prior to the crisis payout ratios were around 85 per cent. The payout ratios in the US are now at near-historic lows of around 72 per cent.
This is important for three reasons. Firstly, a lower payout ratio means companies have a greater focus on financial discipline including strengthened balance sheets and cutting the heavy reliance on debt to finance acquisitions and capital expenditures.
Secondly, headroom in the payout ratio suggests that current dividend yields are growing and sustainable, putting listed real estate in a very healthy capital position.
And finally, as they now have increased capacity, if there were ever a pull back in earnings for a short period of time, there is plenty of buffer for dividends to be held at current levels.
4. Wall of capital
Care must be taken using the wall of capital argument to point towards continued capital demand for real estate, as we know from history that this demand can turn quickly.
However, globally, real estate allocations from a variety of sources have continued to go higher. Some of the world’s largest private equity funds have raised enormous quantities of capital to put to work and acquire assets. Blackstone has raised over US$17 billion for its latest global opportunistic real estate fund, as has Brookfield, raising US$15 billion for its strategic partners fund, surpassing its initial US$10 billion target. These are merely two examples, albeit two of the largest, of capital that needs to find a home.
Sovereign wealth funds and pension funds have also continued to seek increased real estate allocations, such as the Japanese Government Pension Investment Fund (GPIF), the biggest pension fund in the world who are embracing an allocation to real estate for the very first time. Given the diversification benefits and strong risk adjusted returns with an income bias, we anticipate these allocations to be maintained, if not continue to grow larger (a larger percentage of balanced portfolios) than the five to 10 per cent weightings they typically have today.
In the event of any future crisis, listed real estate like any risk asset will not be completely immune. However, we believe that the sector has taken important steps to improve and ensure it can once again play a diversification and defensive role in balanced portfolios as it historically did (prior to the risk-taking period in the run up to the global financial crisis). This result can be seen in its cyclically low beta and lower correlation to equities. It’s back to playing the role in portfolios it was always supposed to, as a defensive asset class.
The result is an asset class that is positioned to deliver what is expected of it: real estate-like returns over the long term, with the benefit of both liquidity and diversification, a far cry from what investors are seeing today in the over-extended residential market.
While every care has been taken in the preparation of this article, AMP Capital Investors Limited (ABN 59 001 777 591, AFSL 232497) and AMP Capital Funds Management Limited (ABN 15 159 557 721, AFSL 426455) (AMP Capital) makes no representations or warranties as to the accuracy or completeness of any statement in it including, without limitation, any forecasts. Past performance is not a reliable indicator of future performance. This article has been prepared for the purpose of providing general information, without taking account of any particular investor’s objectives, financial situation or needs. An investor should, before making any investment decisions, consider the appropriateness of the information in this article, and seek professional advice, having regard to the investor’s objectives, financial situation and needs. This article is solely for the use of the party to whom it is provided and must not be provided to any other person or entity without the express written consent of AMP Capital.
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