Property Point: A global fund mitigating global chaos

Hi I’m Laura Daquino, welcome to Property Point.

On today’s podcast, we have Andrew Parsons, founder and chief investment officer at Resolution Capital.

Andrew’s team runs seven property funds. The funds tend to be very highly rated by the ratings agencies. Resolution Capital takes a bottom-up approach rather than looking at regions first.

Resolution Capital started investing in local REITs in the mid-90s and global REITs in the mid-2000s. The team of around a dozen is split across Sydney and New York. They invest in hotels, healthcare, industrial, retail, across China, Australia, Europe, the US and the UK.

Andrew himself is very worldly, with strong views on what’s happening in global markets, particularly the current situations in Hong Kong with the riots and foreigner exodus and the situation with Brexit. He has a direct view on how this could impact global real estate.

Bond proxy stocks have been having a good year. REITs have enjoyed the upswing and bucked the negativity in the retail sector, for the most part. But global growth is clearly slowing and you’re a global real estate investment trust. Do you see this as a risk to your funds and your performance?

Well, I think we understand why people hold stock bond proxies and we have a bit of an issue with the starting point. The reality is that the market’s generally fairly rational and intelligent and it's constantly weighing up the nature of risks and returns and the reality is that, falling interest rates have pushed up most asset classes.

Some have done better than others. Now, to us this issue of bond proxy, again, it comes down to fundamentals and the reality is that, what we've been curious about is that this constant talk of bond proxies and the yield discussion, misses the fact that as I say there has been a broad range of assets that have increased in value simply because of interest rates. Now, if it was all about bond proxies and yield as some people want to believe, I find it curious that the last five to 10 years in this QE bond rally environment that we've also seen things like classic cars, artworks, wine, bitcoins, and more recently gold, rally. 

Now, what part of the bond proxy yield discussion do they fit in? The reality is that investments are constantly weighed based on their fundamentals. The reason why the REITs have done particularly well in the last five to seven years is that they've actually generated very good total returns. That's yield plus growth driven by strong underlying real estate fundamentals. 

We don't hold ourselves as a bond proxy. We think that's dangerous and misleading clients. We hold ourselves as an investment that will perform according to how the underlying cash flows perform relative to other asset classes. And what we like about the space at this point is that the real estate fundamentals, compared with history, are actually pretty good. Supply’s somewhat constrained in most markets and we've got the REITs with pretty good balance sheets, and they're the two things that to us, matter most. 

Now, I'll just go back to I'm not suggesting that REITs will not fall if interest rates rise. All I'm saying is that REITs are like any investment; they're going to be influenced by interest rates but it comes down to the underlying fundamentals to determine just how they do relative to other asset classes. So I know that's a long winded answer but I think it's important at the outset to lay the ground rules. If bonds were going to rally, so people looking for bond proxies and you've got real estate facing a flood of construction activity and rents falling, well I can tell you right now you don't want to own REITs, despite falling interest rates.

So, again, we have to look at the fundamentals of each investment to understand how it does relative. And the reason why REITs have done so well is because they're actually in pretty good shape.

Can you talk us through your different funds?

Yes, so we have several funds but ultimately we have two strategies. We have a domestic orientated strategy, which is focused on AREITs. Now we're actually looking at launching something hopefully in the next two or three months, that will be what's called a Real Asset strategy. Which will include, not only AREITs but also Australian Listed Infrastructure, hence a Real Asset strategy. So we're quite excited about that imminent launch. But most of our focus and energy in the last five to 10 years, has been on our global strategy. Now our global strategy, global funds, we offer two basic opportunities there. One's a hedged strategy, currency hedged, and the other one is a currency unhedged.

Basically, the strategies are identical, excluding the currency hedging. So at the moment we're basically offering a domestic, AREIT strategy, soon to be real assets and then we also offer a Global Real Estate Investment Security strategy, that offers both a hedged and an unhedged version.

And I know that regions aren't the focus for you per se, as you make investments based on sector analysis first and foremost. But a few years back I noticed that you made a point about reducing your UK exposure, and I know that you've got exposure to the US, the UK, China, Australia, and Europe. I'm wondering on that, I can't help but notice, you've got a portion of your investments in Hong Kong and China. Are you looking to mitigate risk in any regions like that?

Look, you're raised the point at the outset, that we're very much focused on sectors first and foremost, that's not to say we don't look at regions, but our first port of call is bottom-up sector focus. So we're looking for the best platforms in retail, office, industrial, lodging, self storage, apartments/residential. And once we've identified what we consider to be outstanding platforms within each of those segments, that's when we will put some local overlay, if you will, to then judge where we think the best risk-adjusted total returns are.

It's fair to say that, at the moment it's clear that Hong Kong is going through challenges, and whilst we like a couple of vehicles there, I think it's obvious that there is going to be some significant short-term at least, challenges. We've got to try and look through those short-term challenges to understand what the fundamental challenges are for Hong Kong going forward.

So, we're mindful of regional factors but at the end of the day the underlying real estate fundamentals is what's critical. Frankly if, for example, Hong Kong office is doing poorly, more often than not that just means office generally is doing poorly because all of the office markets are driven by, to some degree, tech companies like Google and WeWork, which is a co-working company. These organisations are now very prevalent in many of the major office markets. So if we don't like Hong Kong, it's because frankly what we're seeing there is perhaps a little too much supply. Obviously, we will then look at geopolitical issues. Now, it's fair to say that we, fortunately, when we started to see some unrest in that market, about six to eight weeks ago, we did actually start to reduce our exposure.

So today, we've got about 4 per cent of the portfolio in Hong Kong. The great thing there is that the vehicles that we maintain investments in, have incredibly robust balance sheets. So that's, again, part of the bottom-up. We look at financial risk, leverage, debt, and most of the Hong Kong companies, Hong Kong REITs, Hong Kong properties, securities, are underpinned by extremely robust balance sheets.

In fact, one of the vehicles we’ve got exposure in has basically no debt. The other two that we have loan-to-value ratios of less than 20 per cent. Now if we look around the world, the average around the world is 25-30 per cent. So the Hong Kong, what we're not worried about is these companies getting into financial difficulty, in terms of meeting their debt obligations. But obviously what the concern in Hong Kong will be, will be the tenant demand and that's a hard one to understand just how significant this unrest is.

Now, we've got to try and apportion some judgement there. Obviously, China will be very displeased with the unrest, and if we look at how they've responded in the past in certain regions of China, to this sort of social unrest, obviously, unfortunately the worst case, Tiananmen Square, but also in other regions of China. The concern would be that they react similarly in Hong Kong, and that's obviously a very real possibility.

There's other views that suggest that Hong Kong is still the two systems, and they will be somewhat more respectful. They will also be mindful that Hong Kong is a very, very important channel for capital, into and out of China. So it is a difficult situation for us to be too dogmatic about. What we can say is that the prices of the REITs now, we think, reflect a pretty dire situation and so we are maintaining that 4 per cent, down from I think it was about 7 per cent prior to the unrest.

Where we go to from here, obviously we'll continue to monitor and hope that the situation eases, and then we will buy back in. We might give away 5, 10 per cent off the bottom but when we get comfortable that the underlying fundamentals remain robust or are robust, that gives us confidence with a five to 10 year view. So we monitor these situations. The UK is obviously another region or area which is challenging at the moment.

Things are always evolving, obviously, and you reduced your exposure in the UK a few years back but I was wondering if that has since increased. Just to maybe highlight these things are forever changing, to our investors.

Yeah, look, we haven't increased our exposure. I mean the history there was that we had, upwards of 12 per cent exposure to the UK REIT market, back in 2015. We were concerned about the economy broadly. We were starting to see a bit of construction activity take place in the UK and we actually started to wind our exposure back because the market was becoming quite hot. Now, we were also aware there was a thing called the Brexit vote. Now, I can absolutely, clearly tell you with hindsight, we're not trying to rewrite history. We did not predict Brexit, but we certainly did not discount it. Whereas a lot of people obviously did, we were thoughtful that maybe it could happen.

The reality is with the time, we couldn't see the upside if the vote was rejected, if Brexit was rejected. But we certainly were concerned that if, surprise, surprise, it was accepted there would be significant downside. So on an upside downside scenario, we thought this is the sort of time when you should be taking some money off the table and reassessing. So we reduced our exposure very, very significantly to keep ownership, only a couple of names there that we have great confidence in, regardless of the outcome. We've basically maintained those positions. 

What were they?

We've now got about, only 5 per cent exposure, 4-5 per cent exposure in the UK, as I say, down from 12. And it's in two positions, one is a company called SEGRO, which owns logistics facilities in the UK and on the continent. It's about 35-40 per cent of its real estate platform is on the continent, and about 55-65 per cent in the UK. Now, obviously with e-commerce there are long-term drivers taking place of demand for more efficient logistics facilities. So that is a long-term growth driver that is taking place foremost, and I don't say absolutely, but almost regardless of Brexit.

Logistics companies, and retailers, and e-tailers are desperately trying to improve efficiency and speed of delivery. And someone like SEGRO is in a very, very strong position to be able to meet those changing tenant needs. So that stock has performed extremely well, despite all the uncertainties with Brexit.

The other stock that we're maintaining there is a stock called Assura. Assura owns, for want of a better term, doctors’ surgeries, or medical clinics in the UK, in fact over 550. The great thing about that is those leases to those doctor surgeries are backed by the National Health System, the NHS of the UK. So it's effectively a government backed lease. That rent is further supported by 12-year remaining lease terms.

So we've got a pretty good quality cash flow there. Again, regardless of the political situation in the UK. So those two names, again highlighting our bottom-up approach and long-term investment. Now the UK, we're not going to try and second guess how Brexit pans out. I don't think... you know, frankly we’ve asked I don't know how many countless people who would have a better idea than us, and frankly, we're not getting a particularly clear answer from anybody, there is just that much uncertainty.

So we think it's a bit naive to go into the UK at this point, and I would also add that, the opportunities there, we have some fundamental long-term issues with some of the names. Particularly the UK retail, shopping centre names. The UK shopping industry is really experiencing, almost the perfect storm of horrible conditions for real estate ownership.

You have basically, poor balance sheets. That's first and foremost. A couple of the vehicles there, have too much debt and they are under significant financial strain. Now that couldn't come at a worse time because retail is having to reposition itself, in terms of its tenant mix to meet, again, the changing consumer spending patterns and because they've got such weak balance sheets, they're not able to do that. 

So that's a horrible situation, compounded by the fact that you've got, the thing in the UK called CVAs or Corporate Voluntary Arrangements. Whereby a tenant can go to the landlord and demonstrate that they are in some financial difficulties, and therefore effectively break the leases. Even though they're paying all their other creditors, employees, etc., they can go to the landlords and break the leases under these CVAs. Cut the rents, or close stores.

So you've got as I say…

It’s really a perfect storm.

…an extraordinary situation in the UK, where these are not investible at this point in time. So our view of the UK is you should be looking to buy, in this sort of opportunity but we don't know what the opportunity is. I mean this is a reset of a system, and let's not forget if Brexit were to occur, well then the next thing and people are obviously aware of it, will be Scotland will come back and ask for devolution again.

Their vote wasn't that clear cut when they held it, I think it was back in 2012-2013, thereabouts and their preference is to stay in the EU. So the ongoing issues for the UK are very significant and we really are trying to find those opportunities that can get through this uncertainty, whilst maintaining the quality of the cash flow.

So at this point, we're still somewhat cautious about the UK but again, whether or not this Brexit issue in fact is... the government frustrates it and it doesn't occur, well fantastic. But those issues associated with retail are not going away.

Now, there's lots of instability everywhere, as you pointed out. But I would like to point out something that I think is reasonably stable, which is the income stream through your funds. I just wanted you to touch on, quickly, what level of income you are actually paying out across your funds at the moment, just for our listeners and potential investors.

We, as I said at the outset, we're not particularly focused on income. We're a total return from real estate firm. We've seen over the years, too many people fixated on yield, and there’s that great saying that more money's been lost chasing yields than at the end of a gun. So, we would say that the current dividend yield on our global strategies is around about 3 per cent.

Now what I think is important to recognise there is that 3 per cent, we believe is sustainable, because it's based on a dividend payout ratio of around about 80 per cent. So in other words, unlike say for example dividends in 2006, here in Australia in particular, the dividends then were not covered by earnings. In fact, the REITs in Australia in 2006 were paying out more than they were earning, and that was part of the problem that compounded their challenges in the financial crisis.

So today, the payout ratios globally are around about 75-80 per cent. So that 3 per cent dividend yield is more reliable. I can't give an absolute ironclad guarantee that, obviously if we face some sort of economic depression again that that isn't going to be some sort of pressure. But based on the current expectations, and compared with history it's certainly to us, a more robust number. And again, most of that is supported by underlying contractual leases, where the tenants are required to pay a fixed or set amount of rent.

Typically, the average remaining leases is around about four to five years. So we've got reasonably good visibility on cash flows from our REITs. The other great thing is that the REITs’ balance sheets are in very good shape. And again, that's the sort of thing that does threaten dividends, is when obviously you’ve got too much debt and you end up having to cut dividends in order to satisfy your banks and your lenders. Well today, the REITs’ balance sheets are in very, very good shape. Overall, leverage globally is in the 25-30 per cent range. And again, if we look back to the financial crisis, it was more like in the 35-45 per cent range. So, by and large we think that dividend yield of around about 3 per cent from the funds is pretty good. This is the global strategy I should say. On the domestic side, it's probably now around about 4-4.5 per cent.

Yes, thank you so much for that Andrew, and really thank you for discussing your global view and the house position with us. We'll definitely be keeping a close eye on those situations offshore.

Yeah look thanks, and best wishes for the uncertain times.

That was Andrew Parsons, the founder and chief investment officer at Resolution Capital.