Global Real Estate Securities Commentary 3Q 2021GlobalRealEstateSecuritiesCommentary3Q2021

Global Market Review

Global REITs took a bit of a pause in the third quarter of 2021 as returns were essentially flat following strong gains in the first half of the year. We believe REITs continue to benefit from the 3 R’s: reopening, reflation and recalibration. And we expect these tailwinds to persist for the next few years.

US REITs were up slightly during the quarter and outperformed Europe’s and Asia’s listed real estate, which were down approximately 2% and 3%, respectively. Investors turned cautious on concerns over the COVID-19 Delta variant’s impact on global economic growth as well as concerns over the solvency and contagion of Evergrande, a large Chinese real estate developer with approximately $300 billion in debt. We have not had exposure to Chinese developers in any of our strategies. Toward the end of the quarter, signs that the COVID-19 Delta variant was peaking and decelerating in certain parts of the world renewed some investor optimism about growth prospects; however, some events that had been scheduled to be held in person in September and October got canceled or switched to virtual formats. Postquarter, Merck announced successful clinical trial results for a pill that significantly reduces symptoms and that can be taken within five days after incurrence of a COVID-19 infection. Merck’s is one of many pills in clinical trials that could hit the market by the end of the year and be game changers for COVID-19 treatment and could serve as forceful tailwinds for the reopening of property types like hotels and assisted-living facilities.

The 10-year Treasury yield in the United States dipped below 1.20% during the quarter but settled in a range of 1.25% to 1.50%, closing the quarter toward the high end of the range. Notably, in spite of the interest rate increase introduced at the beginning of the year, REITs in the United States were up significantly and outperformed the broad market because the combination of reopening opportunities in the space and property types with secular growth appealed to investors.

Active management continues to be an important component of the investor toolbox as opportunities shift from earnings streams that benefited from or were resilient to the pandemic to those that were only temporarily affected, but wherein long-term demand trends are intact. In 2021, REIT investors will have to effectively balance reflation opportunities (shorter-lease-duration companies) with earnings and reopening opportunities if they are to maximize alpha generation. We expect continued M&A activity as improved fundamentals and increasing valuations narrow the bid–ask of buyers and sellers and as $350 billion of capital targeting commercial real estate sits on the sidelines. During the quarter, two of our large overweight positions were acquired. MGM Growth Properties, a big landlord of casinos, particularly in Las Vegas, was acquired by its competitor VICI Properties for an approximately 17.5% premium to its prior day’s traded value. Columbia Property Trust, an owner of urban, gateway-city office buildings, was acquired by PIMCO at an approximately 15.5% premium to its prior day’s traded value.
The best performers during the quarter were apartments and specialty housing. The global shortage of midlevel and affordable housing is leading to pricing power for landlords. We remain overweight apartments and specialty housing and expect that trend to continue resulting in strong revenue gains.

The best performers during the quarter were apartments and specialty housing. The global shortage of midlevel and affordable housing is leading to pricing power for landlords. We remain overweight apartments and specialty housing and expect that trend to continue resulting in strong revenue gains.

The worst-performing sectors during the quarter were lodging and gaming. Lodging and gaming underperformed because of concerns over the pace of the corporate travel recovery based on the Delta variant and because of concerns over employee wage inflation. Geographically, the worst-performing region was Hong Kong as concerns over the common prosperity bill weighed on housing developers, as did concerns over Evergrande contagion, although the Hong Kong developers are pretty well insulated from any direct contagion effects. We are beginning to see a shift in earnings growth leaders in 2021 from companies that were least affected by the pandemic to those most affected.

Real estate trends that were in place prior to the COVID-19 pandemic are accelerating. Penetration by general e-commerce and grocery e-commerce, at the expense of brick-and-mortar real estate, is accelerating as new adapters are becoming forced to use e-commerce; and many of them will remain long-term participants. Mandated working from home in most parts of the developed world will lead to less demand for office real estate globally as firms realize portions of their business can work remotely without a loss in productivity. We have seen announcements from governments, like in Japan, which provided incentives for employers to have their employees work from home, and in Germany, where new legislation stipulates a legal right for some workers to work from home. Although such trends may be negatives for retail and office space, they are positives for last-mile industrial, cold storage, and data centers.
Because of very limited real estate supply additions and rapidly accelerating global economic growth, we expect a stock picker’s market, with some very attractive investment opportunities deriving from a disciplined, long-term, real-estate-fundamentals-based approach.

We are balancing our opportunities between companies whose fundamentals will benefit or be less affected in the current environment and value opportunities in property types that have been most negatively affected by the current environment. As a result, based on fundamentals and valuation, we are overweight global logistics and global affordable and midlevel-priced housing. We are overweight hotel companies globally, but particularly in Japan. We are also overweight multifamily and older-adult-housing companies. Geographically, we are overweight the United States based on a balanced opportunity set of secular growth names and reopening beneficiaries that have sold off recently. We are overweight Japan based on valuation and economic recovery prospects, though we continue to monitor new policy initiatives as a result of the election. We remain underweight retail and office globally as technology secularly disrupts those business models, but we have found some tactical opportunities in both office and retail because investors may be overly discounting working from home and retail tenant bankruptcies. In addition, we are underweight German residential based on concerns over rent regulation.