Annual report and outlook
Market | Portfolio update
Review, summary and outlook – with 2022 a difficult year with inflation, rising interest rates and war in Ukraine has come to an end.
Right at the beginning of 2022, fears about the impact of the Omicron wave were replaced by a new spectre called inflation. There were also concerns that international developments such as China’s zero-COVID policy or an energy crisis triggered by a military conflict between Russia and Ukraine could dampen economic growth. Then, in February, it became a certainty: the full-scale attack on Ukraine led to additional risks for the global economy, which was already suffering from rising inflation and the ongoing pandemic. Although there was a temporary recovery at the end of March as markets hoped that a diplomatic solution between Russia and Ukraine could reduce the negative impact on economic growth, overall the first quarter ended with a negative performance for all regions. Global REIT markets performed slightly better than the broader equity markets and were still able to close the first quarter in positive territory.
The second quarter of 2022 was marked by further uncertainties and conflicting expectations. A toxic combination of high inflation, massive energy and food shortages and general tendencies towards deglobalisation weighed on the global economy. Surprisingly, none of this was really priced in by financial markets, as signs of rising inflation were tempered by hopes that trade tensions between China and the US might ease. However, these hopes did not last long and equity markets ended the second quarter with losses once again. Warnings grew louder that central bank interest rate hikes could lead to an economic downturn. At the same time, the sharp rise in inflation and the environment of rising interest rates depressed the equity markets. Unlike in the first quarter, REITs were unable to escape this downward trend, and rising interest rates in particular led to underperformance relative to broader markets. Investors shifted investments from real estate stocks, which were bought as a substitute for bonds due to their regular distributions, back into the bond market.
The third quarter began with a recovery as the economic slowdown and threat of recession led to a significant decline in expectations for future interest rate hikes. This, together with the predominantly good quarterly and half-yearly reports of many companies, triggered a significant rise in share prices on the stock markets. But even these hopes were soon disappointed again because there were increasing signs that the leading central banks would maintain their restrictive stance in the fight against high inflation. Moreover, hopes of a turnaround in the war in favour of Ukraine were replaced by new fears of escalation. Equities came under selling pressure and all markets closed lower again in the third quarter. After an interim one-month outperformance in July, global REITs followed the overall markets and also ended the third quarter with a weak performance.
In the fourth quarter of 2022, the path taken continued. Rising interest rates and recession fears continued to weigh on the markets. Sentiment changed when reports emerged that several central banks, especially the FED, would consider a less restrictive pace. Supporting this: falling government bond yields and the significant fall in the price of gas. Equities rallied and this positive sentiment lasted until December. Then, however, the more robust-than-expected US labour market report led to a trend reversal, because an easing of monetary policy was now no longer anticipated.
Overall, it was the worst year for the broader stock market since the great financial crisis in 2008.
Performance REITs and Property Sectors
The negative performance in 2022 was also reflected in the global REIT markets. Overall, although performance in the fourth quarter was better than in the broader equity markets, this was not enough to achieve a comparable performance for the year as a whole. Nevertheless, REITs again demonstrated their major advantage over “normal” equities, namely their stable long-term returns. At 4.5 per cent, dividend payments were more than 200 basis points higher than dividends in the broader equity markets and significantly higher than those of bonds. A real plus for investors seeking a high regular income.
In terms of dividends, our model portfolio as well as our REIT fund performed even better, confirming our approach of a stable dividend payment over the long term: For the full year 2022, we achieved a dividend yield of +6.71 percent (gross without withholding tax), which is again 220 basis points above the yield of the Global REIT Index. Our forecast of 4.0 to 5.0 percent for the year 2022 was thus clearly exceeded.
For the full year 2022, only the special real estate sector ended up in positive territory with +12.98 percent. Not surprisingly, infrastructure such as radio towers and pipelines showed high resilience in turbulent times. Healthcare and mixed-use real estate ended up in the middle of the pack with performances of -17.9 per cent and -9.27 per cent respectively. The worst performing sectors were residential with -31.41 per cent and mixed-use industrial/office with -27.28 per cent. Residential real estate was particularly burdened by the financing problems of Chinese housing companies. In mixed-use industrial/office REITs, the unclear development of future demand for office and industrial space due to recession fears weighed on the sector.
REITs market outlook
The first six months of 2023 will be difficult for the overall markets and especially for REITs as the battle with and against inflation and rising interest rates will continue. A better second half of 2023 will require success at the macroeconomic level to trigger a market recovery. Favourites here are REITs with low leverage and those where post-pandemic property yields remain high.
Overall, only economic stabilisation can stop the downward pressure on share prices. For REITs, avoiding a recession may lead to higher interest rates, but on the other hand, it may also lead to higher rents if accompanied by GDP growth. A hard landing would trigger interest rate cuts, but a protracted recession could dampen rental growth and increase vacancy. So it’s all about incoming economic data and numbers, and how central banks will adjust the pace and extent of further rate hikes accordingly.
As there is room for large fluctuations in individual share prices, stock selection is crucial. For example, mention should be made here of fundamentally strong names vs. highly leveraged names, investing in the right sub-sector and regional allocation, and investing in companies with positive ESG attributes.
Industrial real estate could face a sharp correction in value as rising interest rates and falling demand create a double headwind. In contrast, indexed rents can lead to additional rental income.
Office purchase yields are also expected to rise in 2023. The spread of the risk premium over 10-year government bond yields has shrunk to virtually zero, increasing upward pressure and threatening valuations.
An important point to mitigate all these risks is indexation, as it will lead to higher rents over time. Rising rents are important because they support assets and cover higher debt costs, which in turn leads to greater resilience to higher interest rates.
Actual interest rate increases are likely to have only a limited impact on borrowing costs in the short term, as loans are fixed or fully hedged. An average maturity of more than five years means that there is virtually no refinancing stress for REITs in the near future.
Our monthly market reports as well as further information on DeA Real Estate and our funds can be found here.
Your contact persons
Dr. Thorsten Schilling
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