3rd Quarter 2011
REITs Outpace Broader Financials
The third quarter of 2011 was a tough one for U.S. Equity markets, with the broad market S&P 500 Index down nearly 14%. Worse still was the performance of the Financials sector within the S&P 500, which dropped almost 23%. Fortunately, real estate securities held up better than the broader Financials sector, with REIT indices declining roughly 15%.
The good news for Real Estate Investment Trusts (REITs) space during the third quarter was that it was able to outperform both small-cap and financial stocks, two segments with which REITs are often linked in the minds of equity investors and the popular media. For the first two months of the quarter REITs proved to be relatively defensive. As the flight from risk assets approached a frenzied level late in September, however, REITs suffered disproportionately. This came partly because REITs were the “last man standing” so to speak and partly because their lesser liquidity came home to roost as equity selling accelerated.
Tale of Two Periods
The Fund’s performance during the third quarter was a tale of two periods. During July and August, the portfolio outperformed as REITs in general proved a relative safe haven. Then, during the period of accelerated risk aversion in September, the portfolio underperformed as many of the smaller-sized, less-liquid positions in the portfolio suffered along with small-caps in general. For the quarter as a whole, the Fund underperformed its FTSE/NAREIT U.S. REIT Index benchmark.
Among the major detractors from relative performance during the quarter were stakes in regional retail REITs and hotels. Large active weightings in class B regional mall companies, including CBL Properties and Penn REIT detracted significantly from returns once the market sell-off got underway in August. Hotels severely underperformed in September as the market seemed to eschew the sector as the most economically sensitive property type. Poor security selection within the Hotel space exacerbated the problem with an out-of-index holding in casino and resort operator Wynn Resorts declining 25% during September alone.
The Multifamily sector proved to be a mixed bag during the quarter, with holdings in the space outperforming in July and August before succumbing to the sell-off in September. All four active positions generated positive results initially, with United Dominion Realty the most additive to relative performance. The catalyst in the multifamily names seemed to be a convergence in operational metrics among the lower-multiple REITs owned in the portfolio with the operating metrics among many of the higher-multiple names not owned in the portfolio. Unfortunately, the group gave back much of that outperformance in September.
Performance in the Office and Industrial sector was generally positive, as seven of the 11 positions in the portfolio outperformed. Among notable individual contributors were large active positions in Health Care Properties and out-of-index holding Crown Castle. Health Care Properties was one of the best performing REITs during August and held on through the rest of the quarter to aid returns. Crown is the largest independent operator of wireless tower communication sites in the U.S. and continues to benefit from the country’s growth in wireless communications.
Although the recent market correction has been pronounced, it has not approached the absolute levels seen during the depth of the financial crisis. Nor does it appear likely that it will for four key reasons. First, public real estate companies today carry markedly lower leverage than was the case during 2008 and 2009. Second, REITs are not facing a liquidity squeeze. There is ample debt capital available today at very low rates. Unsecured lines of credit are being made available with rates below 2% in many cases and medium-term debt (5-7 years) can be had below 5% in many cases. Third, REITs are not likely to issue highly dilutive equity to repair strained balance sheets as many did during 2009. Fourth, public real estate companies today are not overextended on development projects which burdened balance sheets during the financial downturn.
We think the correction has left public real estate companies trading at substantial discounts to net asset value (NAV). By the end of September, we calculated the unweighted average discount in North America at 20%. Historically such large discounts to NAV have not been persistent. Although the gap could be closed by falling private real estate values due to higher capitalization-rates, this does not seem the likely outcome. Given the low interest rate environment underscored by Federal Reserve policy statements and the already large risk premium implied by the spread between cap-rates and US Treasury yields (or BBB-rated Corporates), a meaningful increase in cap-rates does not seem to be the near-term mechanism for closing the gap between public and private real estate valuations in the U.S.
Harrison Street Securities
As of September 30, 2011, CBL & Associates Properties comprised 3.19% of the portfolio's assets, Penn REIT – 1.28%, Wynn Resorts – 3.76%, United Dominion Realty – 0.00 %, Health Care Properties – 0.00%, and Crown Castle – 2.47%.
Note: Small- and mid-cap stocks are considered riskier than large-cap stocks due to greater potential volatility and less liquidity.
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.