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Erika van der Merwe (EM): This certainly is a critical time for investors to get their asset allocation right and perhaps even to look more closely at alternative assets. Financial market volatility has been strikingly high as markets have been knocked about by crises and worries about stagflation and tightening monetary policy. Listed real estate is one alternative asset class that seems to be attracting investors’ attention, having outperformed general equity over the past year, and with institutional investors reporting their desire to put even more capital to work into the sector. Well, we've lined up the perfect guests to cover this topic. Frank Onstwedder and Folmer Pietersma are portfolio managers of the Robeco Sustainable Property Equities Strategy. Welcome, gentlemen. Good to have you here with us.
It's striking, this point I made, that listed property assets having outperformed general equity over quite a sustained period, in spite of the fact that interest rates are rising and in spite of expectations that they would continue to rise. How do you assess that?
Folmer Pietersma (FP): Yeah, very good point. And thanks, Erika, for having us here. First remark I would say is that real estate can definitely perform in an environment with rising interest rates, be it short term, be it long term. So that's the first point I want to make. And particularly this period, the last couple of months, we've seen also inflation picking up, which is really helpful for real estate. Real estate also relative to other sectors, offers more safety and stability. So that also attracts investors. So these points, I would say explain, I think, why real estate has performed so well over the last couple of months.
EM: So that's on the positive side. And perhaps we can go a little deeper in some of those factors you've highlighted. But staying with the fact that interest rates are higher, surely this would weigh on performance in the future. It means higher refinancing costs, Frank?
Frank Onstwedder (FO): Yeah, it does. And we definitely understand that a lot of people are looking at interest rates while thinking about real estate. Obviously, a lot of homeowners or people wanting to buy a home are looking at mortgage rates, which are going up and which of course, is a driver for prices, as well, of real estate. So definitely like Folmer is saying, real estate and interest rates – of course, interest rates are an important driver for real estate, but it's only one of the drivers.
EM: One of which is fears about inflation and the fact that everyone knows and believes that property is an inflation hedge. Does history prove that? And how confident are you that this asset class, despite the broader environment, despite what might be happening to economic growth, will perform.
FP: I think we can spend another podcast on inflation, but the general sort of conclusion is if there's a decent, good inflation, then real estate absolutely performs well. If it's hyperinflation or deflation, that's not a very good environment for real estate. At least that's what research has shown.
FO: And of course, this depends on individual factors like demand-supply for different assets. So of course, inflation has to be translated into pricing power for the real estate company as well. But at current…
EM: …as in being able to push through higher leases?
FO: To push through higher leases. Yes, absolutely. And at this point in time, we definitely see that that's happening. So, in let's say, from early August last year, despite the fact that interest rates, indeed, like you said, have gone up by about 1.5%, we do see very strong earnings reports coming out of real estate companies, which definitely point towards this pricing power for the landlords. And also what has been interesting is in the last couple of weeks, when you see other companies in other sectors report, sometimes guidance is not being upped for coming year, but for real estate companies, it's strong earnings and actually improving guidance even for the full year. So they're very confident that they're going to be able to pass on inflation even more in the rest of the year.
EM: And that implies that their tenants are able to afford that. And yet there are concerns about some sectors struggling and suffering. So again, this must be a mixed story.
FP: Definitely. Yeah. So there are definitely sectors that benefit more, like for example, the residential sector. If you can choose to buy a home or you rent an apartment, then renting an apartment in the US, for example, is much more attractive now. So that means also there's rental tension. There's also positive rental tension, for example, in the logistics space, there's a lot of demand for good modern logistics facility, to cater to all the e-commerce demand. So also there and we've witnessed that with companies we talk to, there's so much demand. So basically the landlord or the developers are in charge and they can, it's a little bit overdone, but basically they can charge whatever they want, which is not 100% true, but there's really rental potential to go up. And it's very strong. On the other side, and you pointed out correctly, there are sectors that are more challenging, like, for example, the retail sector, where retailers face issues related to e-commerce. There is pressure on wages also for the retailer and input costs. So their earnings model is under pressure because also of wages. There, of course, tenants are less willing to pay higher rents, even if there's maybe short-term potential for the landlord because the contracts are CPI-related or linked. But then after a while there's so much pressure that the tenant has to ask for lower rent or has to leave basically the mall or the shopping center.
FO: And I think what is interesting in real estate as a sector is that I think we can all see where the rent tension probably is going to be. So we all order more on e-commerce. We are using the internet more and more, the streaming services. So data streams, data centers are probably going to be positioned well going forward as well. But of course if we walk into the city center, the high street, retail high street, you see a lot of vacancies. So obviously there will not be that same rental tension there. And we do see issues for companies owning these real estate in these high street or shopping malls.
FP: And also what we hear a lot these days is that the future supply is also sort of under pressure because of higher inflation. So there's of course, constriction inflation. Land values are rising rapidly. That means that it's not that easy to build new buildings in general and that is, of course, good for supply-demand fundamentals. So that's also a positive, I think, longer term on the back of these higher inflation numbers.
EM: Tell us a bit more about that, about the pressure, the cost pressure on the supply side, on the construction side, because I would imagine materials prices are going up and they're scarce. And then you've got a very tight labor market, certainly in the US, and I understand a huge portion of your portfolio is US focused.
FP: Yeah, so about 60% indeed is North America, US. So several drivers, I would say: steel prices go up and down also, depending a little bit on what's happening in China. But the global supply disruption, the supply chain disruption, the manufacturing supply issues, it all leads to postponement of developments, makes them costly. You see costs rising everywhere. Is it the car industry, semiconductors, but also for real estate. So components of certain, for example, within the data-center market – components you have to use to build these facilities, there's time lags, etc. And then on top of that, construction materials, but also, as I said, land prices rising. And then indeed that's I think a major issue globally – wage growth – because there's a lack of people to do these constructions and that probably will remain for a while.
EM: Let’s look at valuations in the sector. So all of this feeds through to what the property companies are having to pay and the appetite for paying that. So just looking at a recent report by the CBRE, a property consultant, survey of global institutional real estate investors, and they find that valuations are a concern for US respondents. For instance, 78% are cited high valuations and intense competition as their greatest challenges to achieving their current investment strategies. So talking to the point of scarcity of stock, but also the intense demand and I would imagine, as you said, some of the logistics properties, some of the data center properties being scarce.
FP: Yes, scarce for a good reason, I think. Because there's also a lot of underlying rental growth and that drives up prices. So that's, I think, a first point. Also remember that the listed space in general holds the best assets. Often if you look per sector and you look at the top 10%, 20% of the market, it’s often in the hands of, or at least in joint ventures, with listed real estate companies. So indeed, to invest in the best assets, it's not easy. And prices, of course, have risen accordingly. We would say in general, valuations in terms of multiples, for example, earnings multiples, are high, but still, from a historical perspective, not really high and also not in context if you compare to equities. The sector still trades at a small discount to its net asset value. Moreover, we see a 3% plus dividend yield for the whole sector, with earnings growth of high single digits. So yes, the valuations have risen, but there's still, I think, upside.
EM: There's so much there that I want to elaborate on, but I think Frank wants to add something.
FO: Well, in a way, I think it's good news that the respondents to that survey are saying, you know, that valuation is a bit of an issue when they're looking for new real estate to buy, because that means that they are definitely looking for new real estate to buy. And despite the fact that they might find it a little bit expensive, they still expect to gain, to benefit from that stable income stream that that real estate delivers. And that's why we're not so worried about, you know, current levels of valuations, because you do see that despite the worries there are about valuation, that that wall of money is still definitely moving into the sector. And as an example, you know, within the listed real estate sector, only this month, we've seen a very active investor, Blackstone, who's basically the largest real estate investor globally right now. And they've bought two US listed companies, one in the space of student accommodation, American Campus, and the other one more in the industrials side, PSB. So this shows that, you know, sure, there is a valuation point where maybe the sector might not be attractive anymore, but we are clearly not there yet.
EM: Folmer, you mentioned the 3% dividend yield from the sector. Could you put that into perspective? How does this compare with other asset classes or even similar asset classes?
FP: I would say higher than general equities. And then again in combination with the very high single-digit growth we see. Also, and I think that that's maybe a little bit underappreciated: the dividend yield itself. If you look at payout ratios in the US, they are historically low. So we are in a point in time where the payout ratios of very strong earnings is relatively low versus history and you still have a high 3% dividend yield and it's growing with earnings, and earnings are expected to grow single digits. So there's sort of a buffer also from that payout perspective. So that, I think, compares very, very favorable with general equities.
EM: You made the point, Frank, I think it was you, talking about this wall of money being ready to go into the sector. You referred to Blackstone, which I understand is a private equity buyer. So they would be investing directly as opposed to through listed vehicles, in property. Correct me if I'm wrong. So I think, having read one of your reports, you refer to a record amount of money, of so-called dry powder, USD 256 billion, standing by, looking for this asset. So this is huge. And if I understood correctly, this is an historical high.
FO: Yes, it is. And currently being deployed in some of the acquisitions we just talked about.
EM: And does this make you nervous? It's very clear you're super positive. This must be playing a role at the back of your mind. You had better find that property quickly, find the right stock to buy because there's a lot of competition here.
FP: We sometimes joke that we don't hope that everything is being bought out of the listed market, because then we won't have anything to invest in. But as Frank pointed out, American Campus and PS Business Park taken out, that means two names are not there anymore to invest in so we of course hope that we get enough and there remain enough listed companies to invest in. I think, again, it highlights the fact that people are very, very interested in the real estate asset category for different reasons. Safety, inflation protection, demand for real assets in general is growing. It's not only real estate, it's also infrastructure, etc. So it's a reflection of a strong underlying demand. And that should support also the listed sector. So we're not getting nervous for the time being.
EM: So what is the theory say, the investment theory, where should listed real estate fall into a large institutional portfolio or a so-called strategic portfolio?
FO: It would be in sort of like any asset allocation for a strategic investor. What we've seen and what you now see, for example, with the large pension funds or the large sovereign wealth funds, is that about a 5 to 15% allocation to real estate seems about sort of where most of these parties are.
EM: And there you're talking listed and direct?
FO: Listed and direct. Yeah.
FP: And you also see that big pension fund, the big institutional investors, they have these kind of allocations and it's even sometimes higher. Some dedicated long-only money has an even a higher attributions to real estate.
FO: And I think you made a good point, Erika, also on, you know, where does all that money go and are you becoming nervous of that wall of money? Because, of course, a lot of that money used to be invested in sectors which were the dominant sectors in real estate, the retail sector and in the office sector. And, of course, all these pension funds and sovereign wealth funds are also looking at, you know, where are the future growth opportunities. So you do see a move in their asset allocation, a rotation into the newer growing subsegments. So of course, you're right, there is a lot of money looking for the same type of assets, driving up those prices. And that creates some sort of like a valuation issue for some of the assets. So far, the growth trends have been so strong that they've definitely supported the valuation. I think we've heard the argument of high valuations already now for a few years. But at the same time, when you look at, for example, e-commerce and logistic warehouses, we've also seen rents more than double in the past few years. And a lot of the companies, the real estate companies, they have new tenants lined up for those kinds of property assets, which also means that some of the retail assets that we've seen, which are vacant right now, actually are in the process of being converted maybe to logistics, last-mile logistics.
EM: So there is a repurposing.
FO: There is a repurposing. And that in the end will balance the supply-demand, of course, as well, between the subsegments.
EM: Are you seeing that with office space as well?
FP: Yeah. Not massively, and it has happened also in the past for other reasons. But there's always a difference in terms of quality of the stock. ‘The’ office sector doesn't exist. We've got brand-new offices and we have got a lot of old stock. So this is a bifurcated market in a way, definitely for office and retail, but maybe also for other sectors. So this bifurcation is really important, I think to highlight. There is a quality difference. Similar if you would compare it with the car industry, there's a different market now you've got the electric, the EVs and the ICE cars. That's a completely different market. Same, I think will be true for the real estate in the future. And then offices, brand-new offices with low energy intensity with a lot of open air space, amenities, etc., that's where the demand is. And there you can you see the rental tensions, but the older stock with little windows and from an architectural perspective less interesting kind of asset, there's hardly any demand for that and sometimes indeed, and we have seen that, and some of the companies we invest, they do that, they buy these assets and reconvert it maybe to brand-new office or maybe residential. So reconversion of assets in general I think is that will definitely happen.
EM: Great time now for us to have a bit of a break, a change of tempo because clearly you’re warmed up by now so we’re bringing in a bit of a quiz here.
FO: Good. Looking forward to that.
EM: So I'm going to start with some terminology because in preparation for this podcast, of course, I read your reports and a few other things. And every now and then I had to stop and google some terms, because who knows what these things mean. So I'm going to ask you, not too many, just to see. But of course, time is of the essence. So let me know really quickly. Folmer, what is a cap rate?
FP: A cap rate, capitalization rate. So basically…
EM: Don’t look at me as though I should know that! [laughing]
FP: It should be on Google. Basically, it’s the yield you get on an asset, so you can somewhere compare it with what's the yield on a bond.
EM: And how is it calculated, Frank?
FO: By dividing the rental income by the value of the asset.
EM: Okay. What on earth, Folmer, is a comp? And we don't mean complimentary tickets to something.
FP: Comps in general are comparables, I would say.
EM: So this is just a concept. So you would what, compare yields or rental prices?
FO: Yeah. Often it's used as, you know, the comps are becoming more difficult, which means that last year was a very strong year. So it's very difficult to make this year even stronger than last year. So the comparable year or the comparable quarter was already very strong. So the comp is getting more difficult or it's actually getting easier after Covid.
FP: And why do we look at that? Because you want to see is there still acceleration in underlying trends or is it a deceleration? Which often means that maybe value or prices will level off. So that's why we look at it.
EM: Last term: FFO
FP: What do you think?
EM: I don't know. It sounds rude.
FP: It literally means ‘funds from operations’ and basically it's earnings plus depreciation. It's a way to explain what the cash flow is out of a company.
EM: Okay, thanks Folmer. Frank, what are the top three things that you look for in a property stock? And I don't mean ‘location, location, location’.
FO: Okay. Well, that would definitely be in the top three. So let's go to the top five, then, maybe. Now, we definitely, of course, look at the valuation that you pay for the location that you're buying. And then I think the sustainability of the property, of the real estate, is becoming more important as well. So that that will be, let's say, location, valuation and sustainability.
EM: And we're going to talk about sustainability in a few minutes. In passing earlier, you also mentioned infrastructure. So how big are you there? I see it is in the index; I saw ‘towers’, so presumably that's infrastructure.
FO: So infrastructure is a little bit different from real estate. But there is definitely overlap between the two and what we call infrastructure investments in our strategy are mostly digital infrastructure. So it could be data centers and then the towers; the towers are telecom towers. So that's actually the towers where all the mobile antennas are on. And they're also being considered as real estate because of course, they're real and they're an estate.
FP: But we don't invest, for example, in toll roads or the energy grid. So that's really infra infra.
EM: Yes, a good distinction. I'm going to come back to the sustainability topic. You touched on that and also when you said that there's a clear bifurcation in certain segments of the property market because some are super efficient, advanced new buildings, incorporate all the new technology and the old stock certainly doesn't. How important is sustainability for a property investor?
FP: I think crucial and we've written many pieces on that and we will soon publish another report. But the first thing is to remember that almost 40% of greenhouse gas relates to the real estate sector. That's huge. We can talk about the car industry again or whatever, but the real estate sector is so big in terms of greenhouse gases. So it is and will be more and more important for the real estate sector. So from a regulatory perspective, it will get a lot of attention in the future, we think. And there are already regulations, especially in terms of future regulation, that prohibit even to rent out properties if your energy intensity is too high. So that means, basically, either you pay a fine or you invest heavily in these assets to reduce the energy intensity. So we also see companies that provide basically their own solar energy to also make the buildings in the end more green.
EM: So let's draw it all together. What would be your final message? Yes, both of you seem very positive on the sector, but perhaps in your final parting remarks, if you could say what would be the risks to this outlook?
FP: Higher interest rates will always be, I think, on investors’ mind when they look at real estate, but we hope to have shown in this podcast and explained that real estate is much, much more than just looking at interest rate movements. Real estate is always a sort of local, or sometimes global, but a local demand-supply story. And we have, I think, explained that there's a lot of structural growth there for a new kind of real estate assets. And the companies that can deliver that kind of product, they can definitely grow their earnings. And you really should focus on the companies that deliver a product that in the end the tenants need. And that's, I think, crucial. And then on top of that, of course, companies that are well positioned in terms of the decarbonization process.
EM: Frank, do you have anything to add there?
FO: Well, maybe a small addition will be, you know, so definitely the outlook for the sector we both find is positive. But obviously, as we've discussed, there are differences between segments and between tenants. Not everybody is doing well. So it means that we really have to focus on where we do see those growth opportunities. And those growth opportunities: also on looking for the companies that can best capitalize on those growth opportunities, which are the companies which have the strongest balance sheets. And in particular in this interest rate environment where interest rates are rising, you don't want to be invested in companies where there's too much money flowing into interest rate-financing costs. So we'd like to have a company that has a lot of free cash flow and can invest in all these growth trends that we are looking for. And then, overall, with a positive sector outlook, I think you’ll have a well-balanced portfolio if you invest in those kind of companies.
EM: Frank, Folmer, thank you so much for your time and for the insights. And to listeners, thanks for being part of this conversation. We'd love to hear from you, so please send us your comments, feedback and suggestions to email@example.com and you'll find all of our podcasts on your favorite podcast platform as well as at Robeco.com.
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