4th Quarter 2010 Commentary
North American property capped off a very solid year with the MSCI US REIT Index posting a return of 7.4% during the fourth quarter, bringing its total return for the year to 28.5%. This compares favorably with the 15% return generated by the S&P 500 Index in 2010. The stellar performance owes largely to a number of themes that we've touched on in previous reports throughout the year, namely continued improvement in property operating fundamentals, increasingly positive economic news, the lack of meaningful new supply coming on-line, and compelling dividend yields. Looking ahead, many companies now find themselves at very comfortable payout ratios and improving earnings and cash flows. Thus, expect many to show meaningful dividend increases over the next few years while still maintaining conservative payouts.
Fund Performance Review
The Fund outperformed its MSCI US REIT benchmark for the calendar year 2010, but underperformed during the fourth quarter. During the quarter, positive sector allocation was more than offset by negative stock selection. The Fund's continued large underweight stake in the largely defensive Healthcare sector was the largest positive attributor. We have maintained a large underweight position to this sector in the portfolio for some time now, preferring to concentrate in those property sectors more highly leveraged to an improving economy. Overweight positions in the Mall and Industrials sectors also meaningfully added to performance during the period as well.
The negative stock selection effect during the period was the result of meaningful overweight positions in a few names. Douglas Emmett, an owner of predominantly office assets concentrated in the West LA submarket, trimmed its earnings guidance due to refinance charges contributed to the underperformance of its shares. Federal Realty likely suffered as investors began searching for companies with higher near-term growth prospects. We continue to think that Federal possesses the highest quality shopping center portfolio among its public peers with the highest household income and density figures among its competitors, resulting in strong and consistent internal growth over the long-term.
The Mall sector continues to be the largest sector overweight position in the Fund with valuations continuing to look attractive, especially for top-10 holdings Simon and Taubman. Operating metrics appear favorable for all of the holdings in this sector as the better quality properties, which are almost entirely in the hands of the public REITs, continue to see healthy sales supporting solid occupancy and rent trends.
The best performing sector in 2010 was Multifamily as earnings continue to exceed consensus estimates and management guidance continues on an upward track. Fundamentals have improved much faster than anticipated despite the lack of any meaningful job growth—a typical precursor to rental rate improvement for the sector. A declining home-ownership rate has been a big positive for the sector and many expect this rate to continue to decline. Other major positives include strong access to debt at low rates via the GSEs, very low levels of new supply over the next few years, favorable demographic trends, and expected job growth. We remain especially cognizant of valuations in the sector, which are pricing-in multiple years of solid earnings growth, but thus far the Fund continues to benefit from a overweight position in the sector.
The Fund's largest sector underweight continues to be in Healthcare. The performance of this sector tends to lag those with more leverage to an improving economy. Long lease terms make it difficult to push rate, even as fundamentals improve. Overall, the valuation for the sector is somewhat unappealing on a relative basis as companies must rely heavily on acquisitions for meaningful earnings growth, which even then doesn't necessarily translate into relative outperformance.
Our outlook took on a more positive tone during the fourth quarter owing to incrementally positive news on the economic front. A number of economic indicators have come in a bit better than expected, especially on the employment front. In addition, clarity on tax rates for 2011 was a huge positive, especially the decision to keep current rates in place as opposed to a tax increase. The net effect of all this was a meaningful rise in most Gross Domestic Product (GDP) forecasts for 2011. Perhaps the biggest risk to the recovery continues to be housing. After appearing to have been nearing a bottom, recent data shows that housing prices are still declining and may continue to do so in the near-term.
Given the improved economic outlook, we have a more favorable outlook on the North American listed property sector, especially in the higher growth US. Improving operating fundamentals will produce healthy internal growth and strong balance sheets. Coupled with meaningful access to capital, this allows REITs the opportunity to pursue attractive acquisitions, and maybe even selective developments/redevelopments. We think that reasonable current valuations combined with meaningful earnings and dividend growth expectations over the next several years set the stage for attractive return prospects.
Fortis Investment Management
As of December 31, 2010, Douglas Emmett comprised 3.97% of the portfolio's assets, Federal Realty – 4.81%, Simon Property Group – 12.78%, and Taubman Centers – 4.44%.
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.
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.