7 December 2015
By Chris Bedingfield, Quay Global Investors
Like most asset classes, real estate offers investors a total return, comprising income and capital gain. Over time, the capital gain of a property asset reflects the growth in underlying rental income.
In a low interest rate environment, however, such as that which has prevailed for most of the 2000s, it’s only natural that the rental income aspect, and the resultant distribution yield, becomes of greater interest to many investors. Real estate has come to constitute a ‘yield play’ for many investors. In the short term, there’s good evidence that listed real estate has some correlation to the movement in long-term interest rates.
The reality is that over the long term, real estate returns are far more complex than this. Changes in long run replacement cost, capital replenishment, alternate use, and marginal return on capital are far more important. Also, in the listed environment, active stewardship of investor capital can further enhance or detract from returns.
Many institutional owners of real estate focus on total after-inflation (real) returns. As active managers, they can seek to capture capital growth through a range of measures. They can provide ongoing capital to maintain the competitive position of the real estate, which may include tenant incentives, commissions and assistance with tenants’ required capital spending.
In addition, growth can be augmented by redevelopment or repositioning to higher and better use. Outperforming inflation growth can also be achieved by buying assets well below adjusted replacement cost, buying assets where the demand from the underlying tenant is expected to outperform the economy, or where natural or planning barriers restrict property supply. Rising inflation can also add to growth, sometimes offset by the rising nominal interest rate. The ability (or willingness) for real estate owners to re-invest in additional assets or improve existing assets can be a critical contributor to total return on a property securities portfolio.
A real estate fund manager can also take portfolio positions in niche sectors it believes have higher growth prospects than the rest of the market. From a global perspective, this may include the storage, healthcare and student accommodation sectors (which are not widely available in the Australian REIT market).
In the listed real estate environment, the most important metrics to a total return investor will be the operational capital expenditure requirements, expected long-term real rental growth, free cash flow generated, the payout ratio as a proportion of free cash flow and the marginal return on capital. These allow the investor to reckon a fair cap rate based purely on the prospects of each investment.
The main competing approach to this philosophy is the net asset value (NAV) approach. This is often favoured by investors focusing on relative returns. NAV investing focuses on assessed asset values of the portfolio, which are mainly calculated from periodic valuations and perceived market conditions. With this approach, a real estate investment trust (REIT) can occasionally be bought on the market at a discount to the portfolio’s NAV.
However, there are several key drawbacks to the NAV investing case. Firstly, it implicitly relies on the assumptions and return objectives of third party investors or assessors. Secondly, changes to NAV may reflect changes in but does not influence cash flow (which is one of the major determinants of value to a total return investor.) Thirdly, NAV investing potentially encourages pro-cyclical investment decisions, because the REIT analysts tend to work backwards from the near-term financial forecasts (their own and those of their peers.) The analysts’ assessed NAV applies a cap rate to the forecasts; this applied cap rate determines the value, but it usually tends to reflect the most recent direct/indirect sales evidence. This approach can result in a highly pro-cyclical approach to value, because lower cap rates (i.e. higher prices) feed back into analyst models and expectations of higher NAVs. The result is higher cyclical highs and lower lows as the cycle unwinds. Investing in listed real estate on the basis of NAV can miss crucial elements of total return, for example, the ability to generate high levels of free cash, and spend that on the portfolio. Lastly, a REIT’s price may be in line with (or below) NAV for good reasons: the REIT may have a poor payout ratio, a stressed balance sheet or a limited investment opportunity set. This may make it attractive on a NAV investing basis, but an unacceptable candidate on a total return basis.
The total return approach to real estate investment values the free (or after-maintenance capex) cash flow and disregards historic valuation norms (i.e. cap rates) when identifying investment opportunities. It also takes into account payout ratios and the ability (or willingness) for businesses to re-invest in additional assets or improve existing assets. At its heart, it focuses on the intrinsic worth of individual assets and ignores relative valuations. The investor’s primary motivations are to generate acceptable total returns over the asset holding period while minimising the risk of permanent capital loss.
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