GLOBAL MARKET REVIEW
The first quarter of 2022 was marked by uncertainty as geopolitical-factor risk spiked along with inflation. The good news is that in terms of relative performance, REITs performed well against other asset alternatives like stocks and bonds in a very sharply rising interest rate environment. REITs of course were not insulated from the events that were transpiring—whether it was the invasion of Ukraine by Russia or the spike in inflation—and as a result, they traded slightly down for the quarter.
Looking across the regions, Asia Pacific REITs were down about 1%, and our performance was flat relative to the Asia benchmark. North America was down about 4%. And Europe—as expected because it has the most geopolitical risk based on events in Russia and Ukraine—was down about 7%. So, when we thought about the portfolio in the quarter, we really had to keep in mind those factor risks. What were not necessarily going to drive performance for the quarter were fundamentals. Even though real estate fundamentals typically drive REIT performance, in certain periods REIT performance separates from that and trades more on geopolitical risk.
With regard to regional positioning during the quarter, we were underweight Europe, and that worked to our advantage. We created positive alpha as a result of being underweight Europe, and we were overweight North America and neutral Asia. Within Europe, the really big and important shift for us was an underweight in Germany. We had that on for much of the second half of last year, but we increased our conviction around it.
When you think about Germany in the context of the countries we invest in, Germany is experiencing the most-direct impact from the most exposure to the Russian invasion of Ukraine in that Germany is very dependent on oil it receives from Russia. We have no direct exposure to Russia because we do not invest in Russian securities. We also do not invest in any of the Baltic republics directly. Our Russia–Ukraine exposure in the portfolio lies in second-derivative dependences in areas like Germany—which we were underweight—and that resulted in our outperformance.
Interest rates spiked significantly in the quarter, and we are very mindful of how that affects real estate prices. Headlines have said mortgage rates are going up significantly, and the main area we have identified at this point—an area that is feeling an impact—would be M&A activity. As debt costs go up, highly levered buyers will have a harder time financing transactions, and so we’ve seen a bit of a stall in some of the M&A activity that had been a theme. The good news is that as rates have gone up, we find ourselves in a period in which a lot of landlords have pricing power. In this inflationary environment, reflation has been historically very good for real estate and REITs. We are seeing a lot of companies continue to deliver strong top-line revenue growth because occupancies are tight and supply is still not keeping up with demand.
In areas like self-storage, which have monthly rents, significant price increases are going on to the tune of double digits, which is quite small on a nominal dollar basis, but on a percentage basis, they are large increases. Self-storage companies have pricing power and very low risk to inflationary pressure on their cost structures—particularly on wage inflation because there are usually not many employees, if any, at the properties. Therefore, self-storage companies are not really vulnerable to things like wage inflation.
In the backdrop of all this, we are still in the midst of reopening after the COVID-19 pandemic, and reopenings are in various stages across the world. During the first quarter, Asia started to benefit. Some of the reopening themes around hotel companies and some retail companies, both of which sectors we were overweight, really started to perform well in the first quarter. And because Asia was one of the last markets to fully embrace the reopening, numbers began coming through that showed a little bit more than green shoots, and there was a favorable outcome in the revenue streams of those reopening companies.
There is still some reopening upside left on the table in the United States. Areas like hotels, which really benefited from leisure or pleasure travel in the summer of 2021 but ran into a bit of a stall because of concern about the pace of corporate travel coming back, are starting again to benefit, as we are seeing the same surge in corporate travel that we saw in leisure travel. In addition, leisure travel is holding up strong.
With that said, there are some concerns—particularly around inflation and high oil prices and whether those will cause a slowdown or a recession. The spike in office-driven or corporate traveler demand seems to be sustainable and has some legs. And in spite of whether we do get a slowdown, we would expect strong continued growth in that area as the pent-up demand for office travel gets exhausted. In the United States, there is certainly still upside with some of those themes—and in in Europe as well, where we see continued benefits for some of the hotel and retail names we have been overweight as part of the reopening.
When it comes to the backdrop in general, reflation/inflation is a good environment for real estate. That means that a look at real estate shows longer-term leases in general and that many of them have inflationary bumps built into them. Therefore, there is a built-in protection right in the lease. This is unlike a bond, which has a fixed payment and no opportunity to adjust to inflation. If rates go up and if inflation goes up, there will be a negative impact on a bond, but real estate can adjust contractually, or it can adjust based on market conditions. An example is self-storage with 30-day leases. When self-storage companies have pricing power, like now, they are getting above inflationary top-line growth, and their cost structures are not too vulnerable to inflation. That is a favorable environment, and then when you think about the cost of building during an inflationary environment, you know construction costs go up a lot. The result is a muted supply effect and demand that generates pricing power that can be in line with or can exceed inflation. It’s a powerful place to be in a reflationary environment.
We have not seen the impact of interest rates on pricing in commercial real estate but will continue to monitor the situation. M&A activity should temper a bit, but in terms of what we’ve seen in cap rates for higher-quality assets, we really haven’t seen pressure there at all. Where we have seen maybe longer lease durations with increases or rent bumps that are below inflation has been in B locations or for B products, which have maybe seen a few bump-ups in cap rates.
With regard to attribution for the quarter, we were in line with the benchmark on the Global Core Real Estate Strategy, and we outperformed the benchmark in the Select Real Estate Strategy during a challenging environment that was driven by macroevents. In terms of the top contributors, the underweight position to Germany was a large contributor. Stock selection in U.S. healthcare and being overweight the sector were beneficial because of some of the reopening opportunities like assisted living. Stock selection in U.S. triple net and stock selection in Japan and Singapore were contributors.
Detracting from performance was negative stock selection in Australia. Australia had some reopening names that benefited from reversion but that we were underweight. We were overweight self-storage and manufactured housing in Australia—both of them areas with great fundamentals. Plus, stock selection in Canada was unfavorable, driven by an industrial name that has great pricing power and limited supply but that got caught up in the sell-off at the beginning of the year.
We are looking for companies that are taking advantage of the inflationary environment—companies that can grow their top lines in order to achieve at or above inflationary revenue growth with cost structures that do not rely as much on wage labor and whose bottom lines in this environment continue to grow. That would include areas like self-storage. It would also include assisted living—certainly from a top-line perspective—and apartment rental, multifamily rental and single-family rental. Part of what is going on in the housing market in general will cause more individuals and families to move into the renter market, which will benefit single-family rental and apartments.