AWP Q1 Fund Update- Feb 6th, 2023

In this episode we are focusing on global infrastructure investing with a manager of the abrdn Global Premier Properties Fund - ticker AWP

Transcript

Dan: Welcome to the latest in our abrdn closed end fund podcast series, where we catch up with our portfolio managers to gain some perspective on these complex market conditions. Today, we are focusing on the global real estate market with the manager of the abrdn Global Premier Properties fund – ticker AWP - Mr. Bill Pekowitz, morning, Bill. 

Bill: Dan, how are you today? 

Dan: Good. Thank you, Bill, be good to start off with just a general overview of the global real estate market, it was a pretty volatile 2022 for broader equities and fixed income, how has real estate fared?

Bill: Yeh, let's say 2022 was marked with news flow that was difficult for all risk assets. And unfortunately, real estate really was not any different. During the year, we saw issues arise on the geopolitical front with the war in the Ukraine, we had COVID issues still impacting supply chains and manufacturing in China, you had inflation pressures exploding globally, energy prices that were quite volatile. And just, you know, central banks really took a changing policy, and we had very sharp rises in interest rates across the globe. And all of that led to just increase talk of a recession. And what this all meant for asset prices. And like I said, real estate securities were not immune to these factors. And they also suffered sharp declines last year, and actually slightly underperformed the broader equity markets. You know, we think when we look back at all this, it was the rising interest rates that drove much of this downward move in real estate prices. Buyers were forced to adjust their underwriting and their return requirements for the increase in what they saw in their cost of capital.

This led to just a dearth of transaction activity in the second half of the year, as both buyers and sellers pause to reassess what they thought their assets were worth and where valuations were. And so this makes it kind of difficult for us to fully assess the impact that we saw.

But we believe that underlying asset prices in real estate markets likely decline, probably roughly around 15%, on average last year. And we think, you know, there's probably another maybe five to 10% of declines left,  depending on the property sector and the region as we go forward. That said, a lot of this is already fully priced in and reflected in what we're seeing in listed security prices. You know, another thing that I'd like to call out is, despite the weakness we saw in the sector as a whole last year, you know, there's a very wide variance in performance between various regions and property types. So active managers, were still able to generate returns that were better than the benchmark during the year, you know.

For example, sectors that had strong underlying cash flow protections and an ability to pass through inflationary pressures contractually in the form of higher rents. So, something there like  the casino, REITs in the US, which we've talked about in the past, that sector was actually able to post positive returns last year.

And then we also saw sectors that historically are defensive, amidst economic uncertainty, things like triple net rates, grocery anchored shopping centres that cater to non discretionary spenders and healthcare REITs. They all suffered much smaller declines than what we saw in the overall market. You know, office landlords, unfortunately, they found themselves on the opposite side of that coin. You know, they, many of them dropped more than 40% last year. And, you know, we think that's a sector that is going to continue to struggle with lacklustre demand in a post COVID world, and just continuing rising capex needs to keep their existing buildings relevant in a changing world.

Dan: And Bill, you had mentioned interest rates, and there's been some Fed movement as of late as we all know, and also some misconceptions around rates or rising rates and how that affects real estate. Could you delve into that a little more for us please? 

Bill: Yeah, sure, Dan. You know, it's commonly asserted that REITs are just destined to underperform as interest rates rise. However, when we examine the historic record, we think that this is a bit of a misconception, although interest rates certainly affect real estate valuations, and therefore the performance of REITs, higher rates in themselves don't mean that you have to have poor return. So just because today, the tenure is north of three and a half percent doesn't necessarily mean that real estate has to do worse than it would have when rates were at, you know, in the 1% range that we were we go back a year ago.

You know, undoubtedly, as we witnessed last year, that shift in interest rate policy, those changes do impact the sector as people kind of price in those changes, and the impact that that will have on powering costs, and just where your cost of capital is, and how you will, what returns you're going to underwrite for real estate. But as we kind of move forward, and we get into more of a stable environment, even at higher levels, historically, REITs are able to once again, kind of start to post attractive returns, you know, and we think a lot of this just has to do with, you know, unlike bonds, where the coupon level is fixed, real estate landlords are able to grow rents over time, at a rate that is usually slightly above that of inflation. As such, cash flows, and therefore the ability to pay higher dividends, also rise in time, so you're getting growth with your income. And we think that is what allows real estate to be an attractive, even at higher interest rates. And so, you know, we think this is something that is going to be more important for investors as we look forward. 

Also, when we look back at history, despite like we talked about that initial period of underperformance when tightening cycles commence, you know, REITs, usually when we start to look out, versus broader markets, kind of 12 months after that kind of inflection and change in rate policy, REITs start to outperform relative to other asset classes. And you know, we've seen this trend in the early 2000s. We also saw it following the GFC. So, we think we're approaching kind of that 12 months after period, yet again, so we might be getting into an attractive period for listed securities.

Dan: Right. Thanks, Bill. And conversely, can we talk a little bit about this looming or pending global recession that seems to be on our doorstep? And maybe its impact? If you can prophesize a bit on real estate investing? 

Bill: Sure, yeah. This feels like this is the most widely predicted recession in the history of recessions. So, I don't really know if what that means for one coming if everyone, everyone assumes it's here, but, you know, real estate, obviously, it's not immune to the economic cycle. And a slowdown in activity does negatively impact demand for space in just about every property type, slowing the growth rates the sector has been enjoying over the last several years. That said, landlords do have contractual leases with their tenants. Thus, the kind of the earnings and the cash flows are much more predictable and stable in the real estate sector than in other elements of the economy.

So we're already seeing this very modest downward revisions to earnings estimates in 2023 and real estate, versus what we're seeing in some of the other segments of the equity market. You know, and we think that stability and predictability, could be a positive factor for the sector as we move forward.

The other big thing here, kind of looking at real estate today, versus what we've seen when we've gone into other past economic downturns, is that just the underlying fundamentals are much healthier today than they have been historically. Occupancy for pretty much all property types are near all time highs, construction activity, it really remains relatively low for most property types, meaning there's just not as much competition from that new product that's look that's going to compete against you for that fewer number of tenants versus what we've had in past cycles. And so, this takes away some of that downward pressure that normally hits market rents.

Moreover, and most importantly, balance sheets are just much healthier today than they have been in the past. You know, really, we've had, the use of variable rate debt is much lower than it was at the start of the financial crisis. So that means just that movement in rates, it's not as abrupt of an impact on earnings and cash flows as it would have been, when you have just that variable rate environment.

Also, just overall leverage is lower today, as a percent of the asset values, you know, this allows landlords to kind of weather the downturn that they might see in demand, much better than they would have in the past so you're not going to get as much force selling activity in the market, which is something that would kind of weighs on underlying asset prices.

Looking at it just now at real estate in the different sectors, we think, you know, the sectors that are kind of better, better aligned to weather any economic storm, are those with kind of strong secular demand drivers like the industrial sector, which we think kind of continues to benefit from the growth in E commerce nearshoring changes in the overall supply chain. And we're seeing occupancy levels globally that are, you know, north of 98% today, all of that we think, is even if we see the economy slow, this is a sector that we think could still put up, you know, high single digit kind of rental growth and continued growth, over the next couple of years.

Dan: And, Bill, if I could switch gears for a moment, and maybe we can talk about ESG, meaning considerations of environment, social and corporate governance. How does abrdn address ESG? Did they implement it into their philosophy? And how does that affect management of real estate portfolios? 

Bill: Yeah, so you know, the first thing we should mention is the abrdn Global Premier Properties fund, it's not a sustainable fund. And as such, it does not have a specific ESG mandate that it must adhere to, in its investment process. That said, the fund has always had elements of ESG investing integrated into the process. And we see this as a continued importance and a growing aspect of our investment process.

When we're looking at companies that we're investing in, you know, when we go through those underlying components of ESG. The one that is, for the longest time been at the forefront of our process has obviously been corporate governance, as investors in real estate companies, in addition to the individual assets that make up these portfolios, we think we are investing with a management team. And so making sure that, you know, we have the skill to assess the abilities of that management team, as well as their ability to allocate capital in a prudent manner and also to make sure that they're there rewards are aligned with ours as shareholders are very important. 

And, you know, we have seen instances in the past where misalignments have occurred, where that has been, you know, tremendous amount of value destruction, for shareholders. And so that is something because of that, that we have to always have focused on and have that thorough understanding of management, their compensation structure, and how different classes of investors are being treated, or, you know, in our process, that's something that's not really changed since we've begun to manage that fund, and remains that a core tenant of our process. For that, we're constantly out there meeting with senior management teams, and assessing them.  

Where our process has evolved, and where we're putting greater importance, has been on the environmental impact and the strategies of companies there. Not only do we believe that there are social benefits to the world that are important for the future, in having a greener portfolio. But we are seeing that being a leader in these measures, is increasingly becoming a component of the future sustainability and growth of the cash flows for these landlords. You know, an increasing number of cities and countries are instituting regulatory initiatives aimed at reducing carbon emissions, controlling your water usage, the amount of green space that you must provide, when you're built when you're constructing new projects.

An ability to navigate these requirements and adapt both existing and future buildings to these requirements, we think will be a key issue to make sure your properties don't become obsolete. And or require just significant capital outlays in the future that would become drags on returns. What's more, and probably even more important, or that tenants are increasingly placing just greater importance on the sustainability of their workplaces globally, you know, this is an important factor for, for the comfort for these tenants and for their employees. And because of that, you know, we're seeing having a building that is green certified, those buildings are seeing greater demand from tenants than buildings that do not have those same offerings. And so by doing that, you're going to get a greater demand for your property. And if you have greater demand for your property, that means you will either be able to get higher rents, or your occupancy will be higher, all of which we think creates value for us as a real estate investor over time. And so because of that, you know, we are thinking that while it's not like I said, it's not a sustainable fund, having this as part of our process in integrated into our analysis, and making sure that we are investing with those companies that we think are at the forefront of these initiatives on regional and global basis. will create value over time.

Dan: And Bill, finally, as we wind down, we talked about rising rates and REITs, we talked about the impact of a potential recession, the ESG considerations, I think is important for a lot of listeners out there. So in light of all of these scenarios, these situations that we find ourselves in, how do you position a fund like AWP in today's marketplace?

Bill: Yeah. So I think, first off, I would say that, you know, the downturn of 2022 has resulted in real estate securities trading at some of the most attractive relative valuations versus equities and bonds that we've seen in probably the last five years. That said, you know, valuation on itself is not a, is not a catalyst. And we think that rising rates and inflation into that economic uncertainty that we talked about, it does present challenges for global real estate portfolio.

Real estate remains very much a local business, with individual property type fundamentals and economic dynamics, often being the key drivers of performance. As such, while taking a slightly more defensive tilt toward our portfolio construction, currently, we remain focused on our in depth on the ground research approach to seek out the best property types and markets at any given time. In general, we feel underlying real estate fundamentals remain strong. And real estate historically, will be able to increase prices in conjunction with inflation, and due to that, we'll also see lower levels of new construction, stemming from rising input costs, which is beneficial to existing landlords. 

As such, we're focusing on sectors and companies where we see opportunity to increase rents, both in the near term and with structural tailwinds, that can support outsize growth into the future. That's things that, which we think will lead to higher dividends. So that's, that's investing in some things that are shorter, shorter duration rents, like the Self Storage sector, where there is still strong demand, and that landlords are being able to achieve nice rental growth at this point and with good occupancy levels. Additionally, we think that things that have structural changes that we're witnessing across the real estate sectors will continue. So non traditional spaces, like cell towers, digital infrastructure providers, those continue to have tailwinds that we think will exist over the coming, you know, five to 10 years that will continue to support value creation there. And then, like we've talked about earlier, the logistics and industrial properties that continue to just have long term opportunities. So that's kind of where we are focusing the portfolio today.

We continue, obviously, always, like we always talk about strong balance sheets, strong management teams, those things will also be just key drivers of the portfolio. 

 In terms of just how we're positioning globally, right now, the fund remains overweight to the Americas. We have confidence in the near term economic health, relative to the rest of the globe, we think that the Fed has acted quite aggressively and prudently in their efforts to combat inflation. And so we think that this is all supportive of fundamentals for properties in the US and Canada. 

We've also been increasing our exposure to continental Europe and UK in recent months. And you know, this was an area where we were underweight for much of last year, and we talked about concerns on the economy there, and the impacts that we're seeing. And while we think some of those risks still exist, we just think that the valuations that we're seeing right now, where there's a number of companies that we've been investing in, in, such as in the German residential sector that are trading at, we think, less than half of what the underlying real estate is worth. And so we think that over time, there's going to be value creation there, and that that value will be realised.  So we are starting to increase exposure there. And then lastly, we maintain our underweight positions in Hong Kong and China, just due to continued concerns on the geopolitical front. And also just some concerns about the ability of some of the developers there to finance their projects.

Dan: Bill, thank you very much for your insights today. Very comprehensive. And thank you, especially to our listeners for tuning in. You can find out more about the fund like factsheets, other pieces of collateral and research at www.abrdnawp.com. Do look out for future episodes.