Real estate a buffer for inflation
As winner of Asia Asset Management’s Best of the Best 2022 performance award for Global REITs, Cohen & Steers seeks to maintain global strategies that are regionally diverse, invested across North America, Europe and Asia, including select emerging markets worldwide as opportunities arise. The company is focused on investing in a range of property types globally, from traditional areas such as offices and shopping centres, to “next generation” sectors that have evolved more recently, such as data centres and cell tower REITs.
“We target companies that derive most or all of their revenues from rental income, as well as companies that also have property development operations. Through it all, we take an active approach, seeking companies with solid earnings and dividend growth potential trading at attractive valuations,” notes Hong Kong-based William Leung, head of Asia Pacific real estate and portfolio manager.
When examining valuations, Cohen & Steers employ a relative-value investment process to identify securities that it believes are mispriced relative to a company’s real estate assets and/or its discounted projected dividend stream. Analysts incorporate both quantitative and qualitative factors in their estimates, including management, strategy, asset quality, financial strength and corporate structure. Evaluations also take into account the varying business models of real estate companies, as well as differences in country risk and monetary policies.
“We rank the investment universe using a proprietary valuation model. Judgments with respect to risk management, diversification, liquidity and other factors overlay the model’s output and assist the portfolio managers’ investment decisions,” adds Leung.
Macro challenges
For the one-year period through February, Cohen & Steers’ real estate portfolios generally performed well compared with the relevant FTSE EPRA Nareit indexes the company benchmarks them against. Notably, its global real estate strategy outpaced the global index, net of fees. Meanwhile, its international real estate strategy, which does not invest in the US, had a similar degree of outperformance, but with a much more modest absolute return.
Asked about the challenges faced in the past year Leung concedes that these have been largely related to macro factors, as real estate fundamentals have remained healthy in most markets and property types, aided by a generally steady demand and limited new supply, especially given the rise in construction costs. On the macro front, inflation escalated from still-low levels in early 2021 to near 40-year highs late in the year, as stimulus-driven demand met with supply-chain constraints, with supply trends then exacerbated by Russia’s invasion of Ukraine in early 2022. The rapid rise in prices increased the likelihood that the world’s central banks would need to raise interest rates to control inflation.
“Even if other central banks follow the lead of the US Fed and Bank of England to raise interest rates, we believe inflation is likely to remain higher than over the last economic cycle. However, an environment of higher inflation can provide a potentially sturdy backdrop for REIT investors. Real estate has distinct characteristics that can help provide a buffer to inflation. Sectors with shorter lease durations such as self storage, for example, have the ability to reset rents promptly as conditions change,” he adds.
Asia markets
REITs have typically enjoyed operating margins around 60%, reducing the impact of rising costs. Real estate companies also tend to have low commodity and labour price sensitivity; their biggest costs are often property taxes, which tend to rise slowly. And importantly, the asset class offers inflation-linked leases, with many commercial leases, particularly in Europe, explicitly linking rent increases to a published inflation rate. When inflation is extremely high, these lease contracts can help landlords negotiate better and new lease agreements with existing tenants, which can have a positive effect on investment values.
According to Leung, Asia markets, like their global peers, are also exposed to similar macro factors such as higher interest rates. Having said that, he thinks the major Asia economies, such as China and Japan, face less pressure in raising rates relative to their global counterparts. Meanwhile, some Asia markets, like China and Hong Kong, are also adopting different Covid strategies compared to other regions like the US and Europe.
“As a result, we could see delayed border reopenings with the rest of the world, which would hinder the recovery of tourism-related sectors. Still, we believe Asia’s REIT markets can continue to grow, supported by new listings in different countries, including in non-traditional sectors,” he adds.