FA Online editor Dorothy Hinchcliff recently asked Scott Crowe, senior vice president and global portfolio manager with Cohen & Steers, for his thoughts on U.S. and international real estate markets. Crowe manages three mutual funds Cohen & Steers Global Realty Shares (CSFAX), Cohen & Steers International Realty Fund (IRFAX) and Cohen & Steers Emerging Markets Real Estate Fund (APFAX).
FA: How would you describe the state of the U.S. commercial real estate market today and how does that compare to other markets around the world?
Crowe: The U.S. commercial real estate market has been characterized by a modest recovery in demand, but in the context of very limited supply. These generally favorable fundamentals, along with good liquidity and low interest rates, have underpinned a strong recovery in U.S. real estate securities. At present, I think the U.S. is well situated in comparison with commercial real estate markets in Europe and Asia. Many European economies are seeing slow growth at best, and they face ongoing financial challenges. Parts of Asia, meanwhile, are experiencing rising inflation, and governments are actively working to contain growth in the overall economy and within segments of real estate.
To be sure, the U.S. commercial real estate market has been divided, mirroring broader economic trends. Large cities with highly educated populations and better employment and income trends have benefited from good fundamentals, while smaller regions with softer demographics have lagged.
FA: How have securitization levels changed around the world over the last five years and how do they compare to the United States? In which countries has it become significantly easier to invest?
Crowe: Five years ago U.S. real estate was riding a wave of privatization that, on a net basis, drove a decline in securitization for a while. After the credit crunch brought everything to a halt, real estate IPO activity began to pick up again, including the listing of Hyatt Hotels and some securitization in U.S. non-core property types such as data centers and health care companies. Globally, over the last few years there have been a number of new listings in Asia and in emerging markets in general: China, Malaysia and Brazil are notable examples. Partly because of this it's become easier to invest there.
In Europe, securitization has been quieter, reflecting a clouded economic outlook but also the challenges the region faces in terms of raising capital. Unlike in the U.S., European companies lack the ability to issue equity capital free from restrictive pre-emptive rights. Cohen & Steers advocates more liberal policies that, among other benefits, could facilitate growth through the securitization of private real estate. We recently published a white paper on this topic.
For now, I would cite Germany as a potential bright spot. Although not much happened when the country adopted a REIT structure five years ago, there are now a decent number of deals in the pipeline. Germany could see significant public offerings in the next few years as highly leveraged companies take advantage of the REIT legislation to improve their balance sheets. It helps that the country is seeing rental growth in the office and residential markets for the first time in many years.
FA: Has the collapse in U.S. home prices as well as severe housing market troubles in places like Spain affected your investment choices?
Crowe: The decline in U.S. home prices has affected all asset classes at least indirectly, given that it sparked the recession. The single-family housing market has been hit particularly hard due to a severe glut of sellers and a limited number of buyers due to stricter mortgage requirements in the wake of the price bubble. However, our focus in the U.S. is strictly on commercial real estate, which of course turned down, but did not suffer from oversupply. That put it in better position to recover quickly. Also, with low funding costs, REITs could find ways to generate growth through acquisitions.
From a sector viewpoint, we became more cautious toward secondary retail properties, which do have a close link with the housing market, since home equity influences consumer spending. On the other hand, demand for apartments began to rise, and the improvement in rental fundamentals was a development we had anticipated.
We have had no direct exposure to Spain. As a euro country, it doesn't have independent control over its monetary policy and can't inflate its way out of its crisis. Its only recourse is to endure austerity measures, which will harm property values.
FA: You recently authored a white paper for Cohen & Steers that says emerging markets are ripe for real estate investment because their growing economies are demanding improved real estate infrastructure. However, you also noted that real estate markets in those countries are still in their infancy. Which emerging markets offer the most promise?
Crowe: Brazil is the largest emerging real estate market, and we still believe it is one of the most attractive. It has a relatively transparent economy, and it is home to well-managed retail companies positioned to benefit from the emerging consumer, a key theme of ours. We also like Poland, which has a good balance sheet, a low-cost, well-educated population and ongoing infrastructure investment. And the country's real estate stocks offer higher yields than what's available in much of Europe.
In Asia, I'd highlight Thailand and Indonesia, two smaller markets that are better positioned in terms of the region's inflation problem. Both have floating exchange rates and more-flexible economies. They are also only in the early stage of the real estate cycle, unlike China for example, and hence there is less pricing pressure and less chance that policy makers might intervene.
FA: How are you investing in emerging market countries, and do any of them have anything comparable to REITs in which to invest?
Crowe: We invest in a variety of emerging market property securities, but one of the things that encouraged us to launch an emerging markets real estate fund is the potential expansion of the REIT concept. REIT models have existed for several years in South Africa, Malaysia and Thailand, among other countries. Mexico just launched its first REIT and we participated in the IPO. China has now issued the first REIT to be denominated in its yuan currency. The Philippines appears set to open a REIT scheme and markets such as Brazil continue to explore the possibility.
The growth in emerging market real estate securities has been exceeding that of developed markets by a wide margin, and we expect this to continue with REITs playing an important role.
FA: What percentage allocation to real estate would you think advisors should consider for their clients? What percentage of that would you suggest for international real estate?
Crowe: Advisors make their recommendations based on a given client's profile. Our experience is that they tend to allocate between 3% and 10% of a portfolio to commercial real estate stocks, with around half toward international real estate within that allocation.
FA: In which countries do you see the most corporate governance risk and what are they?
Crowe: Corporate governance has improved markedly with globalizations. Today, I'd say that at least 90% of the companies in our investable universe have managements that seek to add shareholder value. The question for us is whether or not the quality of a company's governance is high enough to meet our standards. If it isn't we won't invest.
FA: How does the stability of a country's banking/financial system play into your international real estate choices? Do you stay out of any countries because of concerns about corruption in their finance markets?
Crowe: The health of a country's banking system is certainly a factor we take into consideration. The soundness of banks in Scandinavia, to cite an example, is one reason we favor that region. While corruption is not really an issue in our investable markets, we are concerned about governments' respect for open markets and property rights. China and Brazil make an interesting contrast, for example. Brazil has become more like the U.S. in its approach to free markets, whereas China is more unpredictable.
FA: Is it possible for U.S. investors to invest directly in international real estate, and if so, how?
Crowe: For most investors it would be difficult to invest directly in real estate through private markets, which is why the availability of listed real estate securities is important. However, by investing in a global REIT mutual fund, investors can own a diverse group of public companies that own, operate and develop commercial real estate properties across Asia and Europe, including companies located in rapidly growing emerging markets.
FA: What kind of returns have international real estate markets delivered over the last five years and what is the outlook for the next few years?
Crowe: International real estate stocks had only a modest gain in the last five years, although that particular period is somewhat unique. It started just before markets surged, and then ended after the downturn bottomed. Going back 10 years, however, international real estate stocks had an annualized total return of about 10% as measured by major indexes. That is in line with the group's historical returns, and we believe international real estate markets have the potential to deliver similar performance over the next few years, provided that fundamentals continue to recover.