The past year has not been an easy one for JPMorgan Global Core Real Assets (JARA). This diversified investment trust portfolio of alternative assets is split across global real estate equity and debt, infrastructure and transportation, but continuing interest rate hikes and a strengthening pound have worked against it in 2023.
Despite reassuring longer-term returns, the second quarter saw a net asset value (NAV) decline in the portfolio of -2.7% in sterling terms (although NAV is more or less flat in local currency terms), while the discount widened to -25%, well above its 52-week average of -10%.
In fact, most elements of the portfolio – infrastructure, transportation and real estate debt – are showing positive performance even over the last quarter. But real estate and equities have proved to be a significant drag for JARA, broadly offsetting gains.
The asset allocation team, led by Philip Waller, has been busy with a number of strategic portfolio adjustments to mitigate the impact. These include incrementally trimming exposure to US real estate equities following 2021/22’s outperformance, and increasing allocation to US real estate debt to capitalise on the rising interest rate environment.
The team has also hedged the global infrastructure sleeve back to sterling, to help protect the largely non-sterling based JARA portfolio from the negative impact of a strengthening pound (up 5.6% against the dollar over the first half of 2023).
However, this update provides a timely opportunity for us to focus more closely on the US real estate allocation and the headwinds it has faced.
The problem here, predictably, has been caused by rapidly rising interest rates as the US Federal Reserve has battled to bring inflation under control. Although the real estate market was slower than equities and bonds to reprice, it has subsequently done so, in no uncertain terms.
Thus, the internal rate of return on US real estate has increased (as capital values have fallen) in the face of rising interest rates and increasing uncertainty. J.P. Morgan Asset Management data shows it is now (July 2023) at its highest level since the aftermath of the 2008 financial crisis.
There are signs of improvement. “We expect to see some further write-downs, but recent trends look more positive. If we can avoid recession, it seems we could be heading towards the end of this run of write-downs,” says JARA US real estate analyst Luigi Cerreta.
The big challenge for the whole sector is the debt markets. The rate hiking cycle means bank lending has become both expensive and hard to come by – and that has been exacerbated by the recent banking crisis.
The problem has been most acute in smaller and regional banks, which provide the vast majority of commercial real estate loans – making it all the harder for many projects to refinance.
However, says Cerreta, it’s not unremittingly gloomy: across the board, high-quality projects and top clients are much more likely to secure the debt they need.
Of course, some parts of the real estate market are doing better than others. Cerreta is bullish on the industrial sector, including warehousing, where the fundamentals are returning to more normal levels in the aftermath of the pandemic.
But he picks truck terminals, a so-called ’extended’ subsector of warehousing, as an area of particular focus for JARA.
These truck-focused developments, where loads can be reorganised and drivers can eat, shower and sleep, have boomed as e-commerce has grown and rail transport has waned. At the same time, supply is short, with almost no stock growth over the last decade or more.
As Cerreta explains: “Municipalities don’t like them because they don’t generate many jobs or much tax, and residents don’t like them because they bring truck traffic and they’re eyesores.” But the bottom line is that they are critical to an efficient logistics network.
Retail is another surprisingly positive story. Strong consumer demand – powered by years of low interest rates and a reducing household debt burden, as well as by the additional forced savings of lockdown – is continuing to support the sector.
“Demand for retail space has recovered all the ground lost early in the pandemic, and then some, supporting healthy rent growth at around 4% year on year,” Cerreta adds.
However, it’s not all so rosy. The office market - which accounts for only 4% of the portfolio, and falling – has suffered terribly since the pandemic. Signs of recovery last year proved premature, with further weak numbers at the start of 2023 as formerly thriving tech firms started reducing their workforces.
But bright spots remain even within this sector. Cerreta picks out life science laboratories as a long-term positive, driven by macro trends such as the ageing population and the fact that lab work cannot be done at home.
There’s also a strong market for top-quality new buildings, as employers attempt to entice reluctant staff back to the office with brand-new top-notch facilities.
More generally, he believes there’s room for cautious optimism on US real estate. The macroeconomic outlook is certainly brightening, with inflation now at 3%, down from its 9% peak last June, and yet little sign of significant damage to economic growth.
“Interest rates are still high and there is uncertainty around them, but it seems that the Fed is on the right flight path for a soft landing – and that should be very favourable for the sector, says Cerreta. “With a five-year perspective I’d say now could be a pretty good time to put capital into real estate markets.”
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