3rd Quarter 2010 Commentary
The North American REIT market produced strong returns during the third quarter, with US REITs gaining more than 13% and returns from Canada even better. In the US, we seemed to have witnessed a period recently wherein "not so-bad-news" is considered good news, as a sluggish and jobless recovery continues to unfold. Although various macroeconomic data points continue to be uninspiring, investors seemed to take heart in the fact that they came in slightly better than expected. Such data appears to have lessened the odds of a double-dip recession, thus buoying equity markets in September.
Canadian REITs continue to post solid returns, outperforming their neighbors to the south on a year-to-date basis. A strong and improving economy has provided a nice backdrop for REIT earnings, plus strong access to attractively priced capital has many Canadian REITs looking for accretive acquisition opportunities. While such acquisitions are becoming harder to find, the likes of Riocan and others have all found meaningful acquisition opportunities. In fact Riocan's acquisitions should total close to $1 billion this year, with a fair amount of them in the U.S.
The Fund outperformed its MSCI US REIT Index benchmark during the quarter, almost entirely as a result of stock selection. Stock picking was most positive in the Office sector, as a large overweight position in West Coast operator Douglas Emmett as well as overweight stakes in Boston Properties and Brandywine contributed to returns. Underweight positions in Corporate Office Properties and Duke Realty, both of which significantly underperformed the benchmark, aided relative performance as well. Stock selection was also especially strong in the Lodging and Mall sectors. An overweight position in Starwood Hotels was a strong relative performer as was a large position in shopping center company Federal Realty.
Generally speaking, larger companies with higher quality portfolios, management teams and balance sheets tended to outperform during the period. The Fund was heavily weighted to such names. This is by design, as we believe that at this point of the cycle those companies possessing meaningful cost-of-capital and access-to-capital advantages versus their peers are likely to outperform.
Malls and Multifamily Housing remain significant overweight positions within the portfolio. The Mall stake is predominantly driven by attractive valuations for Simon Property and Taubman Centers. Operating fundamentals at both entities have held up well relative to their peers, a testament to the high quality of their portfolios. Multifamily has been among the best performers year-to-date as management guidance and earnings expectations have been on an upward trend. Fundamentals have improved much faster than anticipated despite the lack of any meaningful job growth—typically a precursor to rental rate improvement for the sector. Declining home ownership has been a big positive for the sector and many expect this trend to continue.
We increased the Fund's position within Industrials in moving from an underweight position at the beginning of the quarter to an overweight position by quarter-end. Following weak performance for the group, valuations look much more attractive with the Fund's largest positions residing in global players AMB and ProLogis.
The Healthcare sector continues to be the portfolio's largest underweighting. Overall, valuation for the sector is somewhat unappealing on a relative basis and companies must rely heavily on acquisitions for meaningful earnings growth. In addition, the performance of the sector tends to lag those with more leverage to an improving economy. Long lease terms make it difficult to push rates, even as fundamentals improve. The Fund's underweight position has served investors well as the sector has been one of the worst performers in 2010.
The good news is that the crisis of confidence in the U.S. has dissipated, albeit only to a small degree. Economic news can hardly be characterized as healthy of late, but incrementally better news has been met with fairly healthy positive investor sentiment. This bodes well for when the market actually receives some real positive news of note.
With much of the balance sheet repair behind them, capital markets largely open, and interest-rates likely to stay low for some time we think many REITs are well positioned at this point in the cycle. As organic growth begins to pick up in 2011 and beyond, external opportunities should present additional avenues of growth given that many possess cost-of-capital and access-to-capital advantages as well as scale efficiencies versus private and smaller public players. We have seen the cost-of-capital advantage begin to play out this year, with investors rewarding better quality companies more so than the "have-nots", resulting in outperformance by the Fund.
Still, there continues to be a fair amount of uncertainty regarding the strength, or lack thereof, of the economic recovery. While no surprise to us, it appears more certain to many that the recovery will be quite gradual and over an extended period of time. Meaningful job growth remains elusive, leading many to believe that we will continue to see the unemployment rate hover around 10% for most of 2011. Finally, there remains a fair amount of uncertainty regarding tax rates for next year and whether the mid-term elections will ultimately result in a split congress with resulting stalemates on many major policy initiatives.
Generally speaking, such a slow-growth economy is good for REITs as it would coincide with a continued low interest rate environment. In turn, this would prove positive for the REITs as they refinance debt and as they continue to look to grow externally.
Fortis Investment Management
As of September 30, 2010, Riocan comprised 0.43% of the portfolio's assets, Douglas Emmett – 4.27%, Boston Properties – 7.50%, Brandywine Realty – 1.76%, Corporate Office Properties – 0.00%, Duke Realty – 0.0%, Starwood Hotels – 0.00%, Federal Realty – 5.20%, Simon Property Group – 13.04%, Taubman Centers – 4.41%, AMB – 2.83%, and Pro Logis – 3.02%.
Note: Real estate funds are non-diversified and may be more susceptible to risk than funds that invest more broadly. Risks include declines from deteriorating economic conditions, changes in the value of the underlying property, and defaults by borrowers. Investing in foreign markets also entails the risk of social and political instability, market illiquidity, and currency volatility.
Past performance does not guarantee future results. Investment return and principal value of mutual funds will vary with market conditions, so that shares, when redeemed, may be worth more or less than their original cost.
Before investing, carefully consider the fund’s investment objectives, risks, charges and expenses. Contact 800 992-8151 for a prospectus containing this and other information. Read it carefully. Aston Funds are distributed by BNY Mellon Distributors Inc.