Investing in property: From Leeds to LA

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Jon Stewart manages the real estate investments in our Multi Asset strategies. He has been investing in the property sector for over a decade. In this short paper, he explains what matters to us when searching for property winners for our multi-asset strategies portfolios.

By some measures, real estate is the largest asset class on earth1. Almost all economic activity has some physical footprint; consequently, the sector is incredibly diverse. Today’s investible asset base extends far beyond the traditional real estate stalwarts of office and retail to encompass assets as eclectic as datacentres, self-storage and telecommunication towers.

The conventional investment view of real estate is a source of steady income with the potential for long-term growth. Many regard it as a middle-ground between equities and bonds, a dull but dependable ‘safe haven’ or ‘bond proxy’.

That, however, is not our experience of the property industry. Recent years have seen significant, enduring divergence of returns that creates opportunities for us as long-term investors.

1. https://www.savills.com/impacts/market-trends/the-total-value-of-global-real-estate.html

Framing return expectations

For Baillie Gifford’s multi-asset portfolios, we access real estate markets by investing in the shares of listed property companies and Real Estate Investment Trusts (REITs). This offers us access to a deep, broad and liquid pool of global property opportunities.

Our approach to property investment starts with the observations that the industry is:

• Opaque – There is a lot of idiosyncrasy in this asset class, and the data available to analyse is often limited in quantity and quality. Hence, ‘boots on the ground’ information is critically important but hard to obtain, while alternative perspectives can provide valuable insight;
  
  
• Slow-moving – As a capital-intensive industry, real estate responds slowly to changes in society and technology. Markets tend to underestimate both the magnitude and persistence of impact these changes can have, creating opportunities for long-term investors; and
  
  
• Management driven – There is no such thing as a passive property investment. Understanding who is managing the assets and how can be critical.

Given the breadth of investments available to us and the above considerations, we believe we can add meaningful value by investing actively. Our experience suggests that some property companies deliver materially and sustainably higher returns than the broader market. It is these companies we aim to identify and own.

How many ‘winners’ are out there?

To illustrate the opportunity, we analysed the distribution of returns for companies in the most commonly used property benchmark, the FTSE EPRA NAREIT Global Real Estate Index (FTSE E/N), to determine how many constituents generated a five-year total shareholder return in excess of 100 per cent.

While arbitrary, we felt this represented a demanding hurdle. The 15 per cent annualised return it implies would mean comfortable outperformance of both the listed property asset class as well as the broader global equity market.

Our analysis covered the 2007–2022 period, reflecting the combination of limited data availability and the nascent history of the REIT market; whereas the US REIT market emerged and reached meaningful scale in the early 1990s, many other countries only followed in the 2000s and so older data is not necessarily representative of today’s investment universe.

With these caveats, the data shows two things:

First, there are some periods where cyclical concerns dominate. As multi-asset investors, these are moments when the top-down asset allocation decision overrides bottom-up factors. This was evident around the time of the Global Financial Crisis (GFC) in 2008 when more than half the constituents of the FTSE E/N benchmark cleared our return threshold.

Second, the number of ‘winners’ was much narrower in the more ‘normalised’ market conditions from 2012 onwards at around 15–20 per cent of index constituents. However, the magnitude of outperformance was impressive with the ‘winners’ delivering more than double the cumulative benchmark return.

FTSE E/N distribution of total shareholder return by number of stocks

Source: Baillie Gifford, Bloomberg



FTSE E/N index total shareholder return over 5-year periods

Source: Baillie Gifford, Bloomberg

What does a ‘winner’ look like?
(and how do we know when we’ve found one)

In our experience, the ‘winners’ can be categorised into three broad buckets:

• Market proxies – Picking good businesses that are invested in the right market at the right time;
  
  
• Compounders – Rather than just surfing a rising tide, these companies drive long-term shareholder returns through excellent management. And because their source of excess return is repeatable, they tend to offer persistent outperformance;
  
  
• Turnarounds – Unloved and out of favour until something in the investment narrative changes, forcing investors to reappraise the shares and creating scope for valuation improvement. Often, this is triggered by a change in leadership.

In practice, the lines between these categories are blurred, with many of the best investments straddling more than one; industrial property over the last decade has been a good example. While the whole asset class benefited from ecommerce and the wave of supply chain expansion and modernisation that it triggered, some management teams have proven better than others at creating value within this market. Indeed, the best performers in the peer group produced more than double the return of the relative laggards, even though all outperformed the broader property market.

Global logistics REIT total shareholder return, December 2013 to December 2022

Source: Baillie Gifford, Bloomberg, assumes dividends are reinvested gross

Some hunting grounds are more bountiful than others

The data also reveal some factors that weigh against prospects for outperformance:

• Excess scale – Remaining small and nimble can be advantageous in property; the average market cap of stocks that hit our return hurdle is consistently below that of the index. This is easily understood for three reasons. First, it is easier for small-cap stocks to fall off the radar. Second is the diseconomies of scale: property is a local business, and small companies deeply embedded in their markets are often better at sourcing value-accretive investment opportunities than global peers. Finally, when these companies find great opportunities, the impact they have on a smaller balance sheet is more pronounced;
  
  

Market cap of average index constituent vs ‘winners’, by cohort

Source: Baillie Gifford, Bloomberg

• Over-diversification – Diversified REITs, by design, produce underlying returns that will tend towards the property market average, less fees and costs. The rare exceptions are those businesses with significant active management capabilities; and
  
  
• External management – In our experience, externally managed vehicles are typically passive asset gatherers rather than active asset managers with inherent conflicts of interest.
  
  

Rexford case study

We have owned Rexford, a California-based industrial and logistics company, in one of our multi-asset portfolios since early 2021. In our initial investment thesis, Rexford was a market proxy, offering exposure to a segment of the properly market where we saw the potential for elevated rental growth fuelled partly by ecommerce demand.

So far, this has been vindicated. However, in getting to know the business better, we can now also see its potential as a long-term compounder given the following:

• Portfolio focus in a high barrier market with limited supply – As a specialist in Southern California and Los Angeles, Rexford operates in a market that is constrained in several ways: physically, given the encircling mountains and ocean; economically, due to the higher value alternative uses for industrial land; and administratively, because of the limited land supply and ever-tightening planning constraints;
  
  
• A stable, well-aligned leadership team that is deeply embedded in its market – Founders Richard Ziman and Howard Schwimmer have both been active in Southern California real estate for decades, the former as chief executive and chair of Arden Realty until its sale in 2006, and the latter as a former executive vice president at DAUM Commercial Real Estate, a local real estate broker;
  
  
• A proprietary acquisition platform – Rexford’s strategy is to be an active consolidator of the industrial market in Southern California. Its proprietary acquisition platform aims to combine the broadest possible opportunity set with detailed asset-specific insight to identify mispriced opportunities with the scope to add significant future value; and
  
  
• Strong value-add capabilities – Rexford acquires undermanaged assets, often from private, non-specialist owners, with scope for value creation through modernisation, subdivision, refurbishment or redevelopment. A deep understanding of local occupier markets allows the company to optimise capital investments to meet local demand.
  
  

Over and above these factors, Rexford enjoys a strong balance sheet with prudent leverage levels and an emerging sustainability strategy that should allow the business and its assets to remain competitive over the long term.

In the period since we first established a position in Rexford, the stock has generated a total shareholder return of 13.6 per cent. For comparison, the MSCI Real Estate (Local Currency) benchmark generated a negative return of 1.2 per cent over the same period.

Source: Bloomberg, dividends reinvested gross, 19 March 2021 to 31 August 2023.

The principles behind our property investments

Our objective is for the property allocation within our multi-asset portfolios to represent a high conviction, ‘best ideas’ global and unconstrained portfolio. We do this by combining top-down, thematic views with bottom-up stock selection, with each holding carefully assessed to consider whether it has the potential to be a future ‘winner’.

We believe adhering to the following set of principles can give us an edge in generating attractive long-term performance:

• Return discipline – We are relentlessly focused on identifying investments with the potential to produce compelling returns in both relative and absolute terms. As active multi-asset investors, we do not need to hold low-conviction investments simply to manage risk against a benchmark. If we cannot envisage a credible pathway to meet or beat our return hurdles, we simply do not have to invest;
  
  
• Staying on the right side of history – We think deeply about where property draws its economic value from and how that might change as societal preference and technologies shift. We seek to avoid sectors prone to disruption and identify those that enjoy long-term structural tailwinds, the longevity of which are often underestimated by the market;
  
  
• Focus on winning characteristics – Our process is centred on identifying investments with the ‘winning’ features that we have identified. We seek high-quality, aligned management, enduring competitive advantages and strong balance sheet management while avoiding ‘fly-by-night’ outfits with fragile, debt-driven business models. At times this will mean giving up unsustainable short-term performance to try and protect long-term returns;
  
  
• Style agnostic – Traditional value strategies have seldom worked well in the listed real estate market. However, turnaround stories that combine value with fundamental change can result in compelling returns and we will seek to identify these;
  
  
• Sustainability is a ‘must have’ – Occupier preference is hardening in favour of modern, best-in-class, sustainable space. At the same time, governments are steadily ratcheting regulations tighter. Actively embracing sustainability is thus essential to the long-term relevance of any real estate business and a potential source of competitive advantage; and
  
  
• A rounded view on valuation – Many investors in listed real estate stocks focus on net asset value (NAV) as a valuation benchmark. Our belief is more nuanced: while NAV is a useful reference point, it can also be stale, backwards-looking and one-dimensional. We prefer to take a balanced view incorporating measures of forward-looking return to inform our view of the appropriate NAV multiple for a given business.

Current view

While this is a challenging moment for the global property market given headwinds from higher interest rates and shrinking credit availability, we are becoming more positive on the sector in recent months. There has been a substantial re-pricing of real estate assets over the last 18 months, and valuations in some areas of the listed market are beginning to look attractive on a long-term view.

Logistics and industrial property remains the mainstay of the portfolio, given our conviction behind the long-term rental growth potential in this market. We also view it as fertile territory for ‘compounders’ to add value through development and asset management; our high-conviction holdings include Rexford, Prologis, SEGRO and CTP.

Elsewhere, we have been using market turbulence to add selective exposure among the digital communications REITs and in student accommodation. American Tower and UNITE are two recent additions to the portfolio that show the characteristics we associate with long-term compounders, at valuations that now appear to offer potential for attractive returns.

UNITE Group case study

We recently added UK student accommodation pioneer UNITE to the Multi Asset Team's property portfolio, taking an initial stake in March 2023. Over the past decade, UNITE has a track record of delivering strong returns. It has moved from a post Global Financial Crisis turnaround story to the well-established compounder it is today. Given the persistence of real estate industry trends, we believe the stock can continue its outperformance. While the valuation had been prohibitive in recent years, we took advantage of market volatility to establish a position at around 1.0 times NAV for a business we believe merits a premium valuation.

UNITE is a business that we believe exhibits many of the ‘winning’ characteristics we look for:

• Exposed to an attractive and growing market – Demographics mean the UK student population should grow by around 20 per cent over the current decade. Over and above this, expansion in international student numbers is an essential component of the UK higher education funding model;
  
  
• Operational barriers to entry – UNITE does not sell beds; it sells communities, an important distinction. As the longest-established and largest provider of purpose-built student accommodation (PBSA) in the UK, it has invested heavily in its service proposition and platform in a way that associated custodial responsibilities makes it a trusted partner for universities, which positions the company well to capture incremental investment opportunities;
  
  
• Long-tenured, respected management team – Chief executive Joe Lister joined UNITE in 2002 and served as chief financial officer from 2008 until 2023. He was part of the team that masterminded the turnaround that took the company from a market cap of c.£400m in 2010/11 to $4bn today;
  
  
• Proven value-add capability – Given its DNA as a developer, UNITE has deep expertise across the entire value chain of the PBSA industry, from site origination to construction, delivery, leasing and long-term management. Development has long been a material driver of value creation for the business;
  
  
• Access to capital – While the shares today trade at a slight discount to NAV, we have observed they have averaged a 12 per cent premium over the last decade. This, in addition to access to third-party capital, has allowed the company to fund growth through the cycle; and
  
  
• Sustainability – UNITE has a strong track record of managing the environmental impact of its business and, in recent years, has committed to ambitious and comprehensive decarbonisation targets. These will see the business run well ahead of UK Minimum Energy Efficiency Standards, ensuring that it preserves its status as an accommodation partner of choice for universities.
  
  

We expect UNITE to deliver a well-balanced total return underpinned by a 4 per cent dividend yield. This assumes moderate levels of capital growth plus rental growth continuing to average at 3 per cent or higher, due to the current supply imbalance alongside higher inflation. That it does so in an industry relatively insulated from the vicissitudes of the economic cycle is also attractive from a risk point of view, adding fundamental diversification to our property portfolio without sacrificing return.

Past performance is not a guide to future results. Changes in the investment strategies, contributions or withdrawals may materially alter the performance and results of the portfolio. All investment strategies have the potential for profit and loss.

Source: MSCI. MSCI makes no express or implied warranties or representations and shall have no liability whatsoever with respect to any MSCI data contained herein. The MSCI data may not be further redistributed or used as a basis for other indexes or any securities or financial products. This report is not approved, endorsed, reviewed or produced by MSCI. None of the MSCI data is intended to constitute investment advice or a recommendation to make (or refrain from making) any kind of investment decision and may not be relied on as such.

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The views expressed should not be considered as advice or a recommendation to buy, sell or hold a particular investment. They reflect opinion and should not be taken as statements of fact nor should any reliance be placed on them when making investment decisions. This communication was produced and approved in September 2023 and has not been updated subsequently. It represents views held at the time of writing and may not reflect current thinking.

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