According to the report, total returns from REITs are expected to be in the 8-12% range this year, as dividends grow and continue to be an important component of total return. The primary driver of real estate company returns will be growth in cash flow per share.

Rising interest rates need not be feared, as listed real estate often delivers positive returns in periods of economic improvement, even if interest rates rise, according to the report. The year will also see large scale IPOs emerging out of the US.

Region by region, in Asia Pacific, Hong Kong property companies are expected to outperform over the next 12 months, growing earnings by 15-20% and producing dividend yields of 2-3%. Japan should deliver a total return of 5-10% and Singapore 10-15%.

In Europe, Western and Northern Europe are believed to represent more attractive investment opportunities compared to Southern and Eastern Europe, with a 5-10% total return expectation across Continental Europe over the next 12 months and a 5-6% dividend yield. The UK is expected to deliver a total return l of 8-12% over the next year.

North America should see total returns of 8-12% in the US and Canada. In the US, property investment is predicted to be helped by economic recovery as a result of fiscal and monetary stimulus, although the continued depressed housing market and high unemployment remain as obstacles.

While property markets are at different stages in the real estate cycle, the earnings growth trend remains positive according to the report.

Click here to download the full report (pdf)

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• Strong returns by listed property companies during the month were mainly driven by positive momentum in most global equity markets.
• The prospect of further quantitative easing in the US would be beneficial to property companies. Asset valuations would improve because the lower risk-free rate tends to cause capitalisation rates to have adownward bias.
• We continue to hold a positive bias to the North American and Asia-Pacific regions and a cautious stance towards property companies in Europe, which we expect to continue to lag despite the outperformance during the September quarter.

Market Review

Strong returns were generated by property companies during the quarter in virtually all major geographies. European property companies generated the highest total returns, up more than 18%, based in part on the positive response to bank stress tests in July followed by Basel III pronouncements in September, both of which were deemed to be less stringent than expected. Property companies have benefited from lower bond yields, which have improved the yield spread versus fixed-income alternatives as well as improving earnings prospects.

Macro-economic news continues to drive sentiment

Macro-economic news continues to confound investors who are seeking smooth, sustainable trends. Economic releases have been inconsistent as they appear to vacillate. As an example, US existing home sales plunged 27% in July from a month earlier to an 11-year low as demand was pushed forward from the anticipated expiration of the first-time home buyer’s tax credit, only to rebound 7.6% in August to a seasonally adjusted annual rate of 4.13 million sales.

While up nicely from the 3.84 million annualized rate in July, this remains 19 percent below the 5.10 million-unit pace in August 2009 (so good news at first glance turns out to be mixed).

One clear theme for the quarter, however, was the consistently benign nature of the review of European banks. European bank stress tests, released on July 23, were less stringent than expected as only seven of the 91 banks tested failed. Separately, the Basel III rules announced in September were more accommodating than expected as banks will have the better part of a decade to meet the new requirements. This measure has provided relief for European banks as well as industries deemed to be capital users, including property companies. Equities rallied globally on this news.

Language from the US Federal Reserve Bank (the Fed) in September indicating that it’s open to further quantitative easing also contributed to the rally during the quarter. Taken with economic growth in the Asia-Pacific (ex-Japan) region which remains robust, the case for a continued global economic recovery appears to remain intact.

The implications of potential quantitative easing

Probably the most important recent event during the quarter was the change in language from the Fed’s rate-setting Federal Open Market Committee. The Committee in its September statement made it clear that further quantitative easing is a possibility as it stated that it “is prepared to provide additional accommodation if needed to support the economic recovery.”

As background, quantitative easing has typically been in the form of the Fed expanding its balance sheet by purchasing Treasuries and potentially mortgage-backed securities in the market in an effort to reduce these “reference rates” for a variety of fixed income instruments.

The ultimate goal is to reduce the cost of private sector borrowing in order to spur economic growth. The impact on real estate companies is generally very positive both with respect to asset valuations as well as cash flow.

Asset valuations are improved since a lower risk-free rate tends to cause capitalisation rates to have a downward bias, which causes the value of an in-place cash flow to rise.

Cap rates decrease since investors are able to afford to pay more for a given level of earnings while maintaining the same spread to the cost of capital (which has gone down because debt costs have come down and possibly the cost of equity, too).

Cash flows tend to improve as the cost of borrowing becomes cheaper.

External growth (acquisitions/development) also tends to pencil out more easily as the overall cost of capital goes down.

Taken together or even separately, quantitative easing is clearly very beneficial to real estate companies.

While the Fed has not engaged in another round of quantitative easing, it has made it clear that it is ready and able to engage if and when needed. This would be positive for real estate stocks.

Low rates and high spreads improved real estate valuations

Talk of quantitative easing and fears of recession are likely to keep interest rates low in the near term. As stated previously, yield spreads for real estate companies versus fixed-income alternatives remain attractive. Even with the rally in real estate stocks in September, implied cap rates generally represent significant positive spreads to local bond yields.

For investors who expect a continuation of low yields and low returns, it is logical that real estate values have been going up and may continue to do so. In the US, the implied real estate yield on REITs is 6.5%, which implies a spread at the end of September of 90 basis points to the 5.6% yield on Baa corporate bonds (the longest duration corporate bond composite of 25-30 year paper). This remains above the
average spread, which according to data compiled by Green Street Advisors has averaged 80 basis points since 1994.

Green Street Advisors has also estimated that commercial property values in the US have risen by 25% in the last 12 months and almost 30% from the trough values in May 2009. Values are still more than 20% below the peak levels reached in late 2007.

Other markets have followed a similar trend. The following table shows real estate yields (i.e., cap rates) implied by current REIT pricing around the world, as well as the NAV premium or discount, which reflects our estimate of implied pricing versus prevailing private market valuations for comparable real estate portfolios. We currently estimate that global listed property stocks trade, on a market cap weighted average basis, at a 3% discount to private market real estate values.

Third quarter earnings season is upon us

Third quarter earnings reports should evidence continued improvement as we expect many of the themes seen during 2Q10 to continue to play out:

1. improving property fundamentals;
2. wide-open access to debt and equity capital at competitive costs;
3. increasing transaction volumes and;
4. firming property transaction yields.

If anything, we expect the “new news” to be that yields have room to compress further as a result of bond yields, which have headed lower over the past few months and the Fed which has made it clear that it would like to keep yields low over the foreseeable future.

Property companies will continue to be able to reduce their cost of capital via a lower cost of debt as refinancing improves the prospects for positive spread investing. We expect low yields to continue to underpin property values.

OUTLOOK

Improving fundamentals portend positive earnings growth in 2011

We believe real estate companies will be able to deliver modest growth in earnings in the current environment. We look for a global weighted average growth rate for property company earnings of 7% in 2011. In the meantime, the unusually wide spreads between real estate yields and bond yields suggest that real estate assets are still attractively valued. If yields remain low, then real estate values if anything are likely to improve.

The path forward

We continue to retain the view we had at the beginning of the year, but with a few caveats. We continue to hold a positive bias to the North American and Asia-Pacific regions and a cautious stance towards property companies in Europe, which we expect to continue to lag despite the outperformance during the quarter.

By property type, we remain overweight sectors which stand to benefit from an economic recovery, including the shorter lease length hotel and apartment sectors as well as certain office markets in the Asia Pacific region. We remain underweight property types which react more slowly to economic recovery including healthcare and most office markets in North America and Europe.

Our outlook remains predicated on the assumption of gradual but steady global economic growth.

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A mixture of structural drivers (through higher interest rates and scarcity of capital), together with more moderate economic growth and cyclical forces (through reduced rental demand) has negatively impacted the Australian property market. In addition, there has been a change in market sentiment and potentially higher risk in property investment markets.

Many funds have frozen distributions over the past two years, due to the need to reduce debt (to comply with bank loan-to-value covenants) and also pay higher interest rates upon refinancing. Liquidity is an issue with the majority of funds freezing redemptions over the past two years. Fund managers that have not suspended distributions, are only distributing free cashflow, with no income support applicable.

Large open-ended funds continue with ongoing efforts to reduce debt, mainly via asset sales, internal restructuring and revised investment strategies. Debt refinancing continues to remain more onerous and expensive for fund managers negotiating with banks.

Underlying property markets are now showing early signs of stabilising as current valuations (revalued late 2009 to June 2010) are now more realistic and the threat of fire sales recedes due the A-REIT capital raisings over the past 12-18 months. Office and industrial rents are expected to remain relatively stable over the next 12 months, until the economy and property markets demonstrate signs of a sustainable improvement.

In general, property funds with a higher gearing ratio and/or secondary grade property portfolios (with B-grade assets, substantial vacancies or off-shore exposures), have recorded a lower level of performance over the past year to June 2010, compared to funds with A-grade assets and well leased properties.

The following table provides a brief overview of the average range for key investment metrics in the direct unlisted property fund sector:

* if applicable

Lonsec considers that in this current environment, it is appropriate to focus on investing in funds with quality properties, managed by experienced personnel with a good ‘track record’, together with utilising conservative capital structures (gearing ratio). Experienced fund managers will focus on managing the property portfolio and extracting any added value from assets, by efficient strategic and operational management and refurbishment programs.

Fund managers with robust balance sheets may be in a position to take advantage of the potential lower priced quality investment grade property over the next 6-12 months, due to the current subdued Australian property investment markets. In addition, Lonsec considers that there will be opportunities for fund managers seeking to acquire existing fund management groups/companies, coupled with further industry consolidation.

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