Our title, based on a quip from Lady Windermere’s Fan by Irish playwright Oscar Wilde that concerns cynics, could equally apply real estate appraisers. Indeed, one could wonder whether investors in listed real estate, or elsewhere for that matter, do not fall into the “A man who knows the price of everything and the value of nothing” category.
- Real estate valuations may look stretched compared to other assets as well as historically
- But REITs are benefiting from demand for property and an attractive cost of capital
- In uncertain and volatile markets, REITs also profit from their haven status
- A very long-term investor should be able to ride the peaks and troughs of valuations.
The witticism from Wilde’s Lord Darlington sprang to mind in September when value stocks had their best month for some time, rising impressively at the expense of growth stocks. Their renaissance also battered parts of the listed real estate sector as it favoured cheaper, higher-dividend and value stocks. Once the surge in yields that drove the revival slowed and indeed turned, growth stocks – and the REIT market – recovered some of their lustre.
The gyrations raised fundamental questions. Do REIT valuations currently look, for want of a better expression, ‘normal’? How might investors view the asset class if volatility returned?
“The price of everything”
Global real estate was up by 22.8% (in euro terms) in the year to the end of Q3, so it might be reasonable to assume that property stocks are becoming expensive. A look at price/earnings appears to confirm that with the sector’s P/E at 23 versus 18 for global equities.
However, the listed real estate price indices have barely returned to their pre-financial crisis highs. The US index has recovered, but Asian and European indices have some way to go still. Among the sectors, only office real estate has risen to the levels seen before the 2008/09 recession. Purely on a historical basis, in other words, real estate does not appear overly expensive.
Exhibit 1a: Regional real estate returns (30-9-2004 = 100)
Exhibit 1b: Global real estate sector returns (30-9-2006 = 100)
Source: FTSE EPRA, Bloomberg, 30-9-2019. The value of your investments may fluctuate. Past performance is no guarantee for future returns.
“The value of nothing”
How to correctly value a property company is a subject for healthy debate. A look at two common metrics – discount to net asset value (NAV) and spread over bond yields – suggests that real estate is not fully priced and expensive at this stage of the cycle.
Real estate globally is at close to NAV, but in the US, companies in the industrial and net lease sectors are trading at big premiums. This may suggest the stocks are pricey. However, the current costs of capital allow them to raise equity cheaply, so that they can buy and develop property at advantageous rates. As a result, they can grow their portfolios and earnings, even into 2020, which in these markets attracts investors who are happy to pay for growth.
Comparing the dividend yields of REITs and real estate companies and bond yields, the spread is large. This reflects the sharp fall in global yields over the past 12 months, which has benefited the performance of listed real estate.
More recently, short-term interest rates have dropped as central banks cut their rates in response to tighter financial conditions. Whatever misgivings economists may have about the efficacy of such moves, low and indeed negative rates are typically supportive of property.
Exhibit 2: Spread of listed real estate over global bond yields
Source: FTSE EPRA Nareit, Bloomberg, 30-9-2019. The value of your investments may fluctuate. Past performance is no guarantee for future returns.
In the direct markets, demand for high-quality real estate in major cities has remained high, particularly for industrial, residential and CBD office property. While investment volumes have slowed, there is no sign of the sharp drop usually seen as the cycle ends. This has supported pricing and valuations in the listed sector.
Normal has never been simple
Clearly, under ‘normal’ market circumstances, real estate valuations could look stretched compared to other asset classes as well as historically. Delving deeper though, REITs are benefiting from demand for physical property and in many jurisdictions, particularly in the US, are profiting from an attractive cost of capital.
Also, in uncertain and volatile markets, REITs typically act as a haven. Indeed, with the recent rotation into value, property companies did not significantly underperform global equities. The market thus appears to have rewarded them for their relative defensiveness.
However, what is a normal property cycle after nearly 10 years of central bank experiments with monetary policy? Can we even agree on when it started and whether we are near the end or halfway through? Do we need to? Perhaps not, if you are a very long-term investor and are willing to ride the peaks and troughs of property valuations.
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Any views expressed here are those of the author as of the date of publication, are based on available information, and are subject to change without notice. Individual portfolio management teams may hold different views and may take different investment decisions for different clients.