International securities have not kept up with domestic REITs, a risk we previously laid out. The diversification into global markets only increased exposure to geopolitical risks, which have decidedly increased in the past two years. As such, we have maintained an overweight status to the US for most of the past 24 months. Long term, we still believe the international markets will prove additive to REIT investors, but we believe the best way to play them currently is through an ETF where no country is more than 22.1% of the security, and therefore only 12.5% of the overall strategy as of September 30, 2021, based on the 56.8% allocation to the international ETF. We provide below a refresher on the Chilton Global Real Estate Strategy, and some of the changes that have occurred since we wrote about it two years ago.
From September 30, 2019 to September 28, 2021, the MSCI US REIT Index (Bloomberg: RMZ) produced a cumulative total return +13.9%, which compares to the FTSE EPRA/NAREIT Global Ex-US Index Net (Bloomberg: TRNHEU) total return of +1.2%. We could never have predicted a global pandemic – and each country’s corresponding response to the pandemic – would be yet another risk factor that could reduce the benefits of international exposure, but we do believe that our confidence in the US is somewhat based on the (relative) stability of the government, wealth of the economy, and willingness of international investors to use US Dollars.
Interestingly, the US Treasury yield is only about 20 basis points (or bps) lower as of September 30, 2021 than it was two years earlier, and most interest rates around the world are similarly low. With further stimulus expected and the pandemic essentially resetting the real estate cycle around the world, the global outlook for real estate should be universally strong. However, that is not the case as some countries are still reeling from COVID and are far behind the US for vaccinations, while others (such as China) are dealing with overleveraged real estate owners. As a result, the RMZ is approximately 1.6% above its pre-COVID high as of September 28, 2021, while countries such as China, Germany, and the United Kingdom are well below their pre-COVID highs. In spite of the outperformance by the US, we believe it still offers a superior risk-adjusted return profile relative to most international markets.
The first prong in the three-pronged alpha approach is the active management of the US portfolio. From January 31, 2019 to September 28, 2021, the actively managed US portfolio has produced a total return of +40.9% gross of fees, which compares to the RMZ total return of +29.3%. Our knowledge of the property types, geographic markets, and individual companies gives us a competitive advantage over the passive ETFs, which we believe is repeatable going forward. As of September 30, the US portfolio has an active share of 59%, which means it is 59% different than the benchmark, thereby increasing the chance for differentiated returns from the index. We are confident that the deviations will be positive for our clients and are thus comfortable taking this ‘benchmark risk’. For example, we hold only 27 securities in the US portfolio, which compares to 136 in the MSCI US REIT Index as of September 30, 2021.
The second prong of alpha production in the Chilton Global Real Estate Strategy is the choice of the passive ETF. The decision to use the Vanguard Global Real Estate Ex-US ETF (Bloomberg: VNQI) was not by accident. We evaluated nine other non-US ETFs, using criteria such as fees, country exposure, security exposure, and liquidity before deciding on VNQI. From the Global Real Estate Strategy’s inception on January 31, 2019 through September 28, 2021, the VNQI has produced a total return of +8.2%, which compares to the TRNHEU total return of +4.1%. The outperformance can be attributed to the exposure to emerging markets and the increased security diversification. We believe it is just too difficult to predict geopolitical events in specific countries that could affect revenue, capitalization rates, currency movements, and regulations.
The final prong of alpha production is the monthly review of the allocation between the active US strategy and the international ETF. Our proprietary analysis has generated alpha from the decision to overweight or underweight the active US strategy since its inception in 2019. As a reminder, the strategy analyzes the difference between the two year expected returns each month for the US versus international markets, and shifts the portfolio if the formula calls for a change in allocation greater than 500 bps. We have set a maximum allocation of 70% and a minimum of 30% to either one.
Notably, the model called for a maximum overweight to the US in 2020, resulting in a 70% allocation to the US in March 2020 at the bottom of the market. After the swift recovery in the US markets following the stimulus announcements, the strategy called for a more balanced approach, eventually reaching a near 50/50 weighting (similar to the benchmark), before shifting to a slight overweight to the international ETF in April 2021. In our minds, the near-zero interest rate policies and corresponding 10 yr government bond yields, plus the potential for future growth from delayed COVID recoveries presented a more attractive opportunity than the US market where prices were at all-time highs and vaccine distribution had allowed most countries to open up fully.
The COVID resurgence in summer 2021 was certainly a risk we had planned for, but we did not anticipate that it would have such an outsized effect on the international markets versus the US. After moving to a slight international overweight on April 1, the VNQI produced a total return of +1.7% through September 28, 2021, which compared to the MSCI US REIT Index total return of +11.8%. The Delta variant has caused many international markets to shut back down due to the lack of vaccine distribution, as shown in Figure 1. We still believe that these markets will recover at some point, but a recent pullback in the US prices due to a rise in the 10 yr Treasury yield makes it seem incrementally attractive. Therefore, we are hereby increasing the US allocation upon the monthly review on October 1. Especially on a risk-adjusted basis, the US now is at least as attractive as international, if not more.
One of the risks that we did not foresee was the potential for bank contagion in China due to overleveraged real estate. While the US and much of the rest of the world learned their lessons in 2008-2009 during the global financial crisis (or GFC), China did not force banks to recapitalize. Instead, they grew their way out of the GFC via massive infrastructure projects, well beyond what was needed to satisfy demand. For example, experts estimate that over 90 million condominiums and apartments are completely vacant. These ‘ghost cities’ fueled economic growth via jobs and bank loans, while the ‘demand’ was filled by investors hoping that these would hold value.
Even worse, the developers funded these projects with high risk loans from overleveraged bank balance sheets. The largest failure thus far has been Evergrande (Bloomberg: 3333 HK), a Chinese property developer with over $300 billion in total liabilities, which has already missed an interest payment. The most likely scenario is that the government will bail out Evergrande, which will help the banks and potentially some of the investors that have seen their equity investment decline by 84.3% from January 19, 2021 to September 28, 2021. There are other similar companies that will have issues, and are already seeing their share prices decline significantly. As a result, the performance of the FTSE EPRA NAREIT Emerging China Index (Bloomberg: ENEICNA) was -22.1% over the same period. The combination of China’s issues and the resurgence of COVID internationally this summer has driven a total return of -6.3% from VNQI’s recent high on June 10, 2021 through September 28, 2021. Notably, China comprised only 8.6% of the VNQI as of August 31, 2021, and Evergrande was a whopping 0.09% of the VNQI.
While a bailout will be a nice short term fix, we are worried that the long term issues surrounding a potential hard landing for China after this debt-fueled growth comes to an end. We are currently evaluating alternative ETFs with less exposure to China. Importantly, we believe the problems in China are unique to the country, and we do not expect a ‘contagion’ event with global implications.
Future of International REITs
Long term, we are confident that the REIT structure will continue to grow internationally. As shown in Figure 2, there are 40 countries with REIT legislation, many of which have their own associations that lobby for the structure in the government. With the US comprising over 50%, it still has the majority of real estate companies, but that will likely shift over the next 10 years.
As REITs have had a significant head start in the US (the REIT structure was initially created in 1960), other countries will have to go through the same maturation process to figure out the optimal leverage, development, and dividend payout ratios to become durable investments that are attractive to institutions. We are confident that they will get to that point eventually, and the Chilton Global Real Estate Strategy will benefit from the increase in valuation multiples as they begin to check the boxes.
Diversify with the Chilton Global Real Estate Strategy
The Chilton Global Real Estate Strategy is an appropriate solution for investors seeking to diversify and gain exposure to international markets, creating lower volatility. The different starting and stopping points of economic and real estate cycles by country should smooth returns diversify risks over the long term. We believe our three-pronged approach to alpha production will take advantage of differences in valuation without adding significant country-specific or company-specific risk.
Matthew R. Werner, CFA
Bruce G. Garrison, CFA
Thomas P. Murphy, CFA
RMS: 2731 (9.30.2021) vs 2220 (12.31.2020) vs 346 (3.6.2009) and 1330 (2.7.2007)
Previous editions of the Chilton Capital REIT Outlook are available at www.chiltoncapital.com/category/library/reit-outlook/.
An investment cannot be made directly in an index. The funds consist of securities which vary significantly from those in the benchmark indexes listed above and performance calculation methods may not be entirely comparable. Accordingly, comparing results shown to those of such indexes may be of limited use.
The information contained herein should be considered to be current only as of the date indicated, and we do not undertake any obligation to update the information contained herein in light of later circumstances or events. This publication may contain forward looking statements and projections that are based on the current beliefs and assumptions of Chilton Capital Management and on information currently available that we believe to be reasonable, however, such statements necessarily involve risks, uncertainties and assumptions, and prospective investors may not put undue reliance on any of these statements. This communication is provided for informational purposes only and does not constitute an offer or a solicitation to buy, hold, or sell an interest in any Chilton investment or any other security.
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