3rd Quarter 2013 Commentary - ASTON/Harrison Street Real Estate Fund
3rd Quarter 2013
REITs Suffer as Stock Market Marches On
Despite sabre rattling concerning Syrian chemical weapons use, the typical summer trading doldrums, and a looming Federal government shutdown, U.S. equities in general marched upward during the third quarter of 2013, leading some of the broader equity indices to record levels. Vacillating views as to merits and timing of ‘Fed tapering’ aside, the yield on 10-year Treasury Bonds finished the period little changed from the end of June easing investor concerns of a tightening pullback. The Technology-laden NASDAQ Index delivered an impressive 11.2% gain, while the small-cap oriented Russell 2000 Index rose a stout 10.2%.
In contrast, U.S. equity REITs struggled again during the third quarter, posting a negative return as measured by the Fund’s FTSE/NAREIT All Equity REIT Index benchmark. The stark performance divergence between REITs and broader equity markets likely relates to the relationship between REITs and interest rates. REITs typically retreat early in a rising rate environment. Broadly deemed interest-rate sensitive by equity investors, higher interest rates are expected to translate to higher capitalization rates and lower net asset values for REIT portfolios. Given their capital intensive business models, rising rates are also thought to increase REITs weighted average cost of capital—as both their cost of equity and debt rise. Although this view is accurate in short-to-intermediate term, the eventual impact of rising rates on REIT valuations has typically been fairly benign, particularly when rising rates are corroborated by an improving economy (increasing employment, rising consumption, and growing demand for space).
The Fund lagged the benchmark during the quarter as positive contributions primarily from positions in large cap cellular tower owner American Tower, Chesapeake Lodging, and NYC centric office landlord SL Green were overwhelmed by performance drags from data center owner Digital Realty Trust, Sabra Health Care REIT, and a couple of apartment operators.
We think REITs are trading at an average 7% discount to net asset value, within the typical 10% discount to 10% premium range where REITs have traded nearly 90% of the time during the last 20 years. REITs in general have continued to increase their dividends, affording some protection against the impact of rising interest rates, particularly compared with fixed-income investment alternatives. Replication costs of commercial real estate continue to rise, thwarting new supply/construction particularly as rents, in many markets and property types, are not rising as fast as construction costs. New supply of commercial real estate also remains near 20-year lows as a percentage of existing inventories, a favorable construct for well-capitalized existing landlords. REITs generally write leases with inflation-linked or fixed annual bumps providing cushioning against rising interest rates and inflation. Given that, REITs have in the past typically rebounded three-to-six months after sharp pullbacks triggered by past interest rate spikes.
Unfortunately, future interest rate moves remain captive to uncertain fiscal/monetary policy and a dysfunctional Federal government. REIT share pricing may face a bumpy path in turn. We think commercial real estate fundamentals remain sound, however, and that visible contractual cash flows from real estate portfolios should drive solid per share cash flow growth and fuel rising dividend streams as REITs remain attractively valued relative to their private market counterparts.
Harrison Street Securities
As of September 30, 2013, American Tower comprised 7.86% of the portfolio's assets, Chesapeake Lodging – 2.14%, SL Green – 2.90%, Digital RealtyTrust – 2.54%, and Sabra Health Care– 0.00%.
Note: The Fund is classified as non-diversified and may be more susceptible to risk than funds that invest more broadly. In addition, REITs may decline from deteriorating economic conditions, changes in the value of the underlying property, and defaults by borrowers. Small- and mid-cap equities are considered riskier than large-cap equities due to greater potential volatility and less liquidity.
Before investing, consider the Fund’s investment objectives, risks, charges, and expenses. Contact 800 992-8151 for a prospectus or summary prospectus containing this and other information. Please, read it carefully. Aston Funds are distributed by Foreside Funds Distributors LLC.