2nd Quarter 2013
Positive momentum for U.S. equities from the first quarter of 2013 continued into late May until Federal Reserve Chairman Ben Bernanke’s monetary policy comments triggered a month long swoon. Despite the resulting dramatic, nearly 1% upward shift in the yield on the 10-year US Treasury bond that fueled the sell-off, most equities still managed to squeeze out gains for the quarter as the broad market S&P 500 Index gained 2.9%.
In contrast, U.S. equity real estate investment trusts (REITs) slipped during the quarter, with the Fund’s FTSE/NAREIT All Equity REIT Total Return Index benchmark posting a negative 2.1% total return. Prior to Chairman Bernanke’s comments on May 21, REITs had actually advanced more than 10% on a total return basis, and was just shy of a 20% total return year-to-date for 2013. Typical of previous reactions to rising interest rates, REITs retreated abruptly as the 10-year Treasury yield spiked. The benchmark declined 16% from May 21 to June 20, before recouping a portion of the downdraft during the waning days of June.
The Fund lagged its benchmark slightly during the quarter. Positive contributions from positions in large cap apartment owner AvalonBay Communities and NYC centric office landlord SL Green, among others, were overwhelmed by notable performance drags that included document storage operator Iron Mountain and data center owner Digital Realty Trust.
REITs and Rising Interest Rates
It is not unusual for REITs to retreat early in a rising rate environment. Deemed as interest-rate sensitive by broad equity investors, higher interest rates are expected to translate into higher capitalization rates and lower net asset values for real estate portfolios. Given the capital intensive nature of their 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 accurate in the 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 late second quarter pullback in REIT prices left the industry trading at an average 5% discount to net asset value by our calculation, well within the typical 10% discount to 10% premium range where REITs have traded nearly 90% of the time during the “modern REIT era” (1991 – present). We continue to see REITs increase their dividends by a substantial margin industry wide, which we think affords some measure of protection against the effect of rising interest rates.
Replication costs of commercial real estate continue to rise in thwarting new real estate supply and construction, particularly as rents are not rising as fast as construction costs. New supply of commercial real estate, except perhaps for apartments, remains near 20-year lows as a percentage of existing inventories—a favorable construct for well-capitalized existing landlords. Most REITs write their leases with inflation-linked or fixed annual bumps providing some cushion against rising interest rates and inflation. For that last reason especially, US REITs as a sector have in the past typically rebounded three to six months after sharp pullbacks triggered by interest rate spikes.
Harrison Street Securities
As of June 30, 2013, AvalonBay Communities comprised 4.91% of the portfolio's assets, SL Green – 4.75%, Iron Mountain – 2.44%, and Digital RealtyTrust – 5.39%.
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.