Andrew Gogerty: This is Andrew Gogerty with Morningstar and today we're taking a look at domestic real estate funds. The category has continued its strong returns from 2009 through late November. The category is up over 22% making it one of the best returning categories in all of Morningstar's universe. It is also one of the few equity categories that has seen positive inflows this year.
And to shed some light on the category and some perspective, I'm joined today by Ken Statz, Co-Manager of the JPMorgan U.S. Real Estate Fund. Ken, thanks for joining me today.
Kenneth Statz: Thank you, Andy. Glad to be here.
Gogerty: Why don't we start with what I see as a little bit of a disconnect between commentary that we're seeing not only from JPMorgan, but a lot of your colleagues and the returns this year.
Reading your quarterly commentaries and your peers, I think it's best that they're cautiously optimistic, but I don't think you would really see 22% returns and cautiously optimistic. It seems there's a little bit of disconnect.
So what's really going on in the market right now in terms of fundamentals versus may be investor demand for these securities?
Statz: Well, I think partly part of the disconnect that you might be observing right now is where these stocks have come from. Because clearly when we had the severe recession, when the credit markets shut down and interest rates soared for the kind of debt that these companies used to finance themselves, you had a 75% plunge in values. So, we're working our way back up from that pretty big trough level.
So, any one year, you look at the percentage change and you have to remember this is an area that cash flow was under attack because of the terrible economy and discount rates, the cash flow discounting mechanisms that many investors like us use to set value, when the bond markets shut down and interest rates soared that meant the discount rate went up very sharply. The combination of lower cash flow, higher discount rate meant very depressed valuation for commercial real estate. That's what these stocks are. You're buying everyday commercial real estate.
So, let's see what's happening this year. Cash flow is starting to moderate in its downturn. In fact, in many areas we're starting to see glimmers of hope. We're seeing some increases, that's good. Second, the bond markets become very, very accommodative again to REITs. The rates are low, the duration is long and the supply is plentiful.
So you have cash flow stabilizing, discount rates declining and that means values are going up. So, I think the real disconnect is people that are just looking at cash flow are missing the discount rate change, the nervousness, the uncertainty has declined dramatically and that's been the major change that has caused these stocks to rally so strongly this year.Read Full Transcript
Gogerty: How does volatility fit into that because it seems like a lot of people will equate market volatility with uncertainly and sentiments swinging from one way to the other. Even though REIT stocks are up, it's still been a pretty volatile year. There's been a lot of 5%, 6%, 7% swings in the matter of a week. What's really driving that type of sentiment in the market in your opinion?
Statz: Well, I think the uncertainty has declined, but there's still significant levels of uncertainty in really three areas. Cash flow, we mentioned that it's starting to grab a hold, occupancies have stopped declining, rents are starting to stabilize. So that level of uncertainty of just what cash flow do I have today to pay a dividend and over time grow my business, that's starting to abate, but it's still not clear how fast cash flows can return. So, that's one level of uncertainty.
The other is plain leverage in this group. Remember, you own the equity of these companies and your return comes after the debt is satisfied. So, we went into this last recession with REITs over the years creeping up on the leverage ratio. Now, the good news is they've re-equitized, they raise a lot of new equity. Levels are lower. They are not as risky as they were going into the recession, but there is a compelling question whether the market after experiencing a 75% drop in value, is still saying I'm not so sure what the right equity debt ratio is. And until the market is comfortable that the equity debt ratio will not lead to further possibility of a 75% decline.
And we believe the companies have dramatically changed their riskiness. I think the combination of cash flow uncertainty; the debt market, how much is a right level of debt, and then finally, because they are commercial real estate, not much commercial real estate is trading yet.
Gogerty: That was going to be my next question, how does transactions fit into this?
Statz: That's very important because there is a lot of investors that invest in REITs for different reasons, dividend yield. But our investor group and what we try to do in our fund is really create a very diversified commercial real estate investment and in the concept of buying and selling real estate at the right price every day.
The big overall market of commercial real estate simply isn't trading and that's not giving a lot of confidence. Did pricing go down 30%? Is it starting to come back up 10%? And so, until we get cash flow confidence, balance sheet confidence and overall transaction confidence in commercial real estate; you're going to see heightened volatility.
Gogerty: What about – you touched on some of broad sector fundamentals, maybe in some of the big ones – industrials, office and apartments. Apartments seem to be the only thing that is showing more hope than the others right now or maybe it's had a little bit more liquid transaction volume. What are some of the big drivers in some of the big sectors right now?
Statz: Well, if you take the big food groups. As you mentioned, let's start with the good news. Let's start with apartments. Apartments really are benefiting from a major fact that they were in major disequilibrium for demand going into the downturn. What? People are buying homes in unprecedented numbers, and there is a ratio called homeownership versus rental that is a long term ratio that was always 65% of American households owned homes, 35% rented.
During the big splurge towards single-family home ownership, we had one period of time that went up to 70% home ownership. That's how we entered this recession, and all the problems in single family housing meant that we are going back to more traditional 65% ownerships trends in our opinion. That builds in tremendous demand for rental.
So, on the one hand, unlike all the other property types that are very tied to the economy, job loss is bad, job gain is good. There was something special going on in apartments. And not only did the surge towards buying homes affect demand, it cut off supply because nobody was building apartments. They are building condos. They are building single-family homes.
So, here you have this group with this huge surge in demand as we kind of go back to normal and at the same time there is no supply, so we have 95%, 96% occupancy rates. Lots of new households being built always in United States and they are choosing to rent. Maybe, they can't afford a home. Maybe they don't want to buy a home. So, you have all those demand and no supply. So, we got rents going up there.
Now, every other property type is not as good as that. The good news for real estate securities is there's been very little building of any type for years, and right now nothing is going on.So long term, think of that as a great source of future rent growth, but in the meantime losing as many jobs as we have in America really has cut demand sharply across property types. And you have some pockets outside of multi-family like Midtown Manhattan office, Washington D.C. office. Those demand has been good and robust, and no supply. So, you've got a pretty good demand – supply demand balance. The rest, where is the demand coming from in this kind of weak market?
Gogerty: Especially, areas like suburban areas, I know and…
Statz: Suburban office undifferentiated. Where is the demand driver until we get a lot more jobs? So, rents – you know, the good news is rents are stabilizing, occupancy starting to creep up, but the bad news is occupancy is down a lot and rents are down a lot.
I think I saw an interesting statistic where Chicago in the area that we currently have our offices, if you look at the rents charged in community shopping centers, the type of centers people go to, to buy their groceries, go to the drug store, et cetera. Occupancies are starting to grab hold good news. Rents are back to 1998 levels. We've lost a decade of growth in rental rates. So, it's true for REITs that things are starting to stabilize, in general, but boy we've dug a pretty big hole.
So the cautious note that you've seen in many of the firms like ours that are specialists in this is its good cash flows catching hold at these levels, but the pathway of growth is still a pretty unclear until we get a robust economy.
Gogerty: With that growth being unclear, what are some of the metrics that maybe you are leaning more heavily on in your analysis now. There was obviously there was cash flow, there was net asset value, there was a bunch of metrics that real estate managers like yourself use. Which ones are you leaning toward now just given it's still kind of atypical market for commercial real estate?
Statz: And I think you're right. There is so many different metrics because there are stock, there are real estate which ones do you use. Our firms says use them all but we are tilting more towards a number one statistic, what's my cash yield today owning these properties in this company with their debt structure. And cash yield today is starting to get much more important because as the market stabilize that cash yield becomes important. It's like where are we right now, and then you can overlay your supply demand analysis to say, well how fast can this cash flow grow or will it be a pretty murky environment for a while.
So, I think we're always very cash flow sensitive in our firm that's the number one thing we track. But right now the key question our team asks of every security we buy or sell is what this cash flow yield right now, and we think that's a fact. And prior to stabilization it wasn't a fact, it was sort of a point of moment in time it's like cash yield is this but I think it's going down, but I don't know. Right know, you know what you own.
Gogerty: Got you.
Statz: And so that's the most important thing. Secondary, things that we look at would be debt yields. At security capital we look at the entire capital structure and the debt markets aren't so worried about future growth, they are just worried about getting paid back. The good news and one of the reasons the stocks really have rallied so much this year is debt rates and spreads for high quality REITs have come down to very low absolute levels, some REITs are raising 10 year money at 4% which is unheard of and the spreads are as tight as they were at the peak of the market.
So, that's giving you a sense that the debt market is very comfortable with commercial real estate as long as the leverage levels are low. So, we're watching that market. The most recent backup we've seen in REITs, if you really trace it REITs backed up when the 10-year treasury very quickly went from 2.5 to 2.9.
Statz: And so in the meantime as we're watching all the cash flow prospects, we keep a close eye on debt rates, treasuries just to get a sense. Short term, they are probably going to be pretty interest rate sensitive.
Gogerty: Thank you very much for your time today. I appreciate the insight. It was helpful. This has been Andrew Gogerty with Morningstar and Ken Statz from JPMorgan U.S. Real Estate. Thank you for joining us.