FidelityConnects: Global real estate – Steve Buller’s outlook and opportunities

[00:04:11] Pamela Ritchie: Hello, and welcome to Fidelity Connects. I'm Pamela Ritchie. With markets now expecting a Fed cut in September many investors are wondering if they might need to adjust their portfolios. Given this possible new stance from the Fed towards lower rates, the back to office push and the AI infrastructure build-out, what role, ultimately, can real estate play in your diversified portfolio over the longer term? Do tariffs impact builder and real estate supply chain costs over the longer term? To unpack the real estate story and how the various sub-sectors might perform, as well as giving you insights on a topic that almost all Canadians like to talk about, we are very happy to be joined by portfolio manager, Steve Buller. Steve manages the Fidelity Global Real Estate Fund. Just to let you know, this discussion today is available with live French audio interpretation. Welcome, Steve. Great to see you. How are you?

[00:05:05] Steve Buller: I'm wonderful, good morning to you.

[00:05:07] Pamela Ritchie: Delighted to have a chance to speak with you here at the end of August and to sort of put things into perspective for the fall season here, ultimately. Let's ask you about the rate story because it does seem to be always linked to real estate. You're going to tell us some nuances about that but what did you think about the comments out of Jackson Hole and the shift there?

[00:05:27] Steve Buller: To some extent I think they're expected that, ultimately, here in the U.S. we are going to get rate cuts on the short end of the curve. Ironically enough, I'm more concerned what could happen on the long end of curve, the 10-year Treasury yield, or long interest rates generally speaking, as real estate is more priced off of that given it is a very capital-intensive business.

[00:05:50] Pamela Ritchie: So capital-intensive business makes you wonder about the supply chain story that we just mentioned there. Ultimately, there's a rate story there, there is also a tariff story and an inflation story that would love to dig into with you. It costs more to build things if you can't get the raw materials. Is that sort of the scope of the story there?

[00:06:11] Steve Buller: No, that's a fair assumption that we have seen hard costs, as they're known in the industry, go up tremendously given the tariff uncertainty. You also have, at least here in the U.S., the immigration uncertainty has been driving up more of the labour cost. Over the last four to six months it's estimated to replicate a commercial building, for example, in the United States has gone up at a minimum of 5%. That means you need to justify, that is, have higher rental rates to justify new construction.

[00:06:55] Pamela Ritchie: Therefore, as an investor in real estate, if rents have to go up to adjust for that, well, that was quite good, actually.

[00:07:04] Steve Buller: That is a medium and longer term positive that on the fundamental side of things does paint a pretty good picture.

[00:07:11] Pamela Ritchie: Tell us a bit more. Maybe we'll go into demographics for a second to get to that demand story. We hear a lot because of interest rates people have stayed put, is this going to, ultimately, change mortgage rates if we see cuts from the Fed in the next couple of weeks or so? Will that impact, will that unstuck the market? That gets discussed a lot at the high level. I wonder if you can bring your perspective to sort of rates going down and unleashing some animal spirits that aren't there right now in the real estate market.

[00:07:45] Steve Buller: The demand for all forms of commercial real estate have a high correlation with GDP and job growth. If these annual spirits are released, that is GDP growth goes up or the employment rate goes up, that is a very good demand side equation for all forms of commercial real estate.

[00:08:19] Pamela Ritchie: Should we think, for instance, last year when the Fed cut rates, in September it was a monster rate, or discussed that as 50 basis points, it's a different market then than it is now but should be expecting that to create the conditions for a better mortgage deal for people to then have more demand?

[00:08:39] Steve Buller: We would anticipate that but there is something I often ... besides the fundamental side of the story, besides the capital and the interest rate side of this story, to some extent what's going on in the rest of capital markets. We've often seen in the past that global REITs will trade as much as a reaction to how equities are trading, whether they're trading well or poorly and, especially, the growthier part of the equity market. For example, the NASDAQ, which is a great example of growth stocks, where we've seen when that has performed well, unfortunately, REITs oftentimes don't perform as well. I tell people, for example, last July when there was a correction in the NASDAQ what was one of the best performing sectors or asset classes? It was REITs. Earlier this year that also held true. Even more recently we've seen a little wobbling with the NASDAQ and the REITs have done well. This, once again, reinforces that diversification benefit of why you want to include a portion of any portfolio in real estate stocks or REITs as kind of a ballast to the growthier part of the equity markets.

[00:09:47] Pamela Ritchie: Which is, as you say, sort of one of the purposes of it. It's an interesting ... I don't know if it's contrarian but it just seems like we stare at interest rates to get a sense of how lots of things that are interest rate sensitive, like real estate, will perform. You're, actually, saying take a look at growth stocks, maybe, for a better cue.

[00:10:05] Steve Buller: Take a look at the growth stock. There's been an increasingly negative correlation of the performance of REITs, or global real estate, listed real estate, and the NASDAQ. I tell people let's look more in a triangle and not just looking interest rates performance of REIT type world.

[00:10:22] Pamela Ritchie: We've seen a big international discussion for equities, particularly around the world, investments through this year. It's been one of the hugest themes. Is it the same for real estate for you, particularly?

[00:10:37] Steve Buller: This Global Real Estate Fund primarily invests in the developed world. A lot of the same thematics kind of permeate throughout the world, that is, what are the fundamentals. We continuously, around the world, amount of new competitive supply fall off, one, because the cost to replicate is also reinforced throughout the world. Second, the cost to capital that is often driven by interest rates, it has kind of stabilized throughout the world so if we have some of that stabilization of interest rates and the cost of capital, that can lead to, I'd say, lower cost for interest rate. Secondly, it can also lead to more, what I call, accretive investments. Because of the REIT structure you have to distribute the majority of your cash flow out in the form of dividends. Often REITs have to access either the equity or debt markets to make acquisitions. We're starting to see, in some cases, where they're accessing both the debt in the equity markets and making accretive acquisitions, which then leads to external growth. In addition to rental rates going up, if you add external growth to it that is a double positive.

[00:11:50] Pamela Ritchie: That's fascinating with rents going up. I have to ask you about back to office. This has been rolling for some time. There does seem to be a bit more of a push right now, particularly for the fall season. Does that mean suddenly there's a demand for that type of real estate? Is that sort of happening right now?

[00:12:10] Steve Buller: Most corporations, when they sign an office lease are making long-term decisions. It really has less to do about the seasonality of it. I'd say that the return to office, it's less ... what we see in the statistics around the world has started to plateau, what I would call this new normal post-COVID period, that is, yes, most people have some form of remote work, yes, the office isn't dead, but at the same time we're still seeing some degradation of demand for office on a long-term basis, especially in North America. I tell people, even though the office market is slowly recovering in major cities here in North America, like Toronto, like New York, like San Francisco, the occupancy rate is not yet to its pre-pandemic level. Secondly, for example, office REITs in the U.S., their cash flow growth in the latest quarter was down more than 5% year-over-year. So even though leasing is occurring it is still a very tough and difficult business. That's one reason why this fund has, for an extended period of time, been underweight North American office. Now, outside of the U.S. the office lease is better. Return to office is higher. It never got as beat up in cities like Tokyo or Hong Kong or Singapore. The fund does have exposure to office in those markets.

[00:13:37] Pamela Ritchie: We sometimes read headlines, you'll put us straight, about people moving out of cities because of all the things you just mentioned and what's more available in terms of remote work, or even just to different cities, for instance. Are centres of population dispersing because they can? Do you see that in terms investment? Do you want to invest more rurally or more, maybe, I don't know, just outside of cities or different cities?

[00:14:07] Steve Buller: We saw that, obviously, during the COVID period. We've seen some return, actually, ironically enough, to major cities. One, for example, an Amazon in Seattle calls their employees back to the office. The apartment market benefits the most where we see leases on apartments start to go up in those markets. At the margin I think you're going to see the remote work is a fact of life. It's usually the second decision whether someone takes a job outside of the salary, what is your policy on remote work? I don't see you're going to see large influx or outflux anymore due to these types of reasons. I think it's kind of reached a more normal state.

[00:14:49] Pamela Ritchie: That's really interesting. As you said, plateau, it's sort of from an investment perspective that's happened already.

[00:14:54] Steve Buller: That's already happened.

[00:14:56] Pamela Ritchie: I have to ask you to go to long term rates for us just as they relate to the real estate sector, which they may not. I mean, there's a lot of discussion about the 30-year bond and the dollar because there's a lot of pressure on the Fed right now. The story of the day is the administration's high pressure on some of the Fed officials. It's more about what it means for an institution and, ultimately, what it does to sort of the investment case. Is that something that you're looking at? Is that that something you're pricing off? Is that something that we should think about when we think about real estate?

[00:15:27] Steve Buller: I do price off of, or think a lot about, long term rates. I do, though, use more the 10-year government yield just because you can compare them more around the world to 10-Year guilds, 10- year JGBs  and 10-year bunds. At the same time the 10-year is what most ... when XYZ reissues corporate debt, for example, they're primarily issuing 10- years debt so you get a factor of what their cost of debt capital is going to be off of that. On the flip side of that, absent the shorter lease duration sectors such as apartments and lodging and self-storage, most leases, even around the world, are more longer term in nature. On average, they can be 10-years so in some extent a company issuing 10-years is trying to match at the same time their asset side and the balance sheet so that they don't have a mismatch going on between assets and liabilities.

[00:16:22] Pamela Ritchie: It's really interesting. With the discussion of tariffs and inflation, which is linked to everything that we're talking about with interest rates, certainly, you've been modelling for months now the effect of tariffs and the inflation, as you say, to build a similar building and replicate is maybe 5% more than it was due to tariffs. I guess the question here is, is that something we can put in the bucket of transitory? It is a one time, there will be some adjustment around that. Do you have clarity at this point now that you have that general number?

[00:16:56] Steve Buller: I don't know if there's ever going to be clarity. I do think it's a step-up function and we do assume it's not going to go down. It's not only the hard cost but it's also the soft cost to labour that I mentioned earlier. Oftentimes you don't see huge deflation in kind of the value of a building or the replacement cost, the ability to replicate that building, what it will cost to do that. We don't anticipate it to come down.

[00:17:23] Pamela Ritchie: That's really interesting. In terms of what is interesting across the data centre build-out the discussion of AI, that seems to be firing on all pistons from different angles within the investment community. The data centres are getting built, can they be powered? There's sort of a question about the location of them. I'm curious where your investments lie now, where you're interested in now in terms of that story.

[00:17:49] Steve Buller: Now, the data centre business on a global basis, it's the one sector where we are seeing tremendous supply growth. At the same time it's meeting tremendous demand growth. The vacancy rate for existing data centres is as low as it's ever been. Now, data centre which, in its simplest form, is just a huge chilling thing of all the heat that's being generated from all the chips inside. You need tremendous access to power, increasingly to water, but also to fibre, that latency issue. Fight now with the AI demand layered on most people can run kind of their training models, if you will, anywhere in the world. We're being more specific in where we're looking at the companies and their investments where there's latency. Once you apply these AI models people will want latency. They don't want a little rolling thing on your phone or on your computer waiting for the answer for something. That's measured in milliseconds so that latency does matter. When we're looking at the data centre REITs, where they own these things, this is not in the middle of nowhere, which there is quite a bit of demand right now just because of that cheaper access, especially to green power.

[00:19:07] Pamela Ritchie: Let's pick up on that middle of nowhere because that's where there's space and sometimes power, and also sometimes cold temperatures that are useful, thinking Canada, actually. When you say middle of nowhere it's just a longer hookup to get to the sort of population centres, ultimately. Can you be more specific? Where are these places that are of interest? Are they on the cusps of cities?

[00:19:31] Steve Buller: No, I would say that we're seeing up in Norway, for example, or up in Alberta, or in the middle of the United States, the Nebraskas of the world. Those are where these large data centres are being built, where there is cheap access to power. They're great for some functions, I'm not belittling that, but oftentimes you can see, though, when that lease comes up in 10, 15 years will that hyperscaler still need that space, or that data centre space, because they've already run their training models. Will they want more that's closer to a population centre because of that latency issue? That's something we're constantly evaluating and looking at.

[00:20:17] Pamela Ritchie: So the investments may shift there because of that, or it may shift the actual location because of that.

[00:20:23] Steve Buller: Well, yes, and many of my investors are looking at me, how I allocate capital. I'm looking at, for example, the data centre space and how they're allocating capital. Many of them right now, or at least on the public side, they're not really involved on the data centres that are, and I'm exaggerating, in the middle of nowhere. They'd rather be someplace where there's latency, where there is interconnection, that is, where you can connect to another on or off-ramp internet. Those are the type of investments that we're primarily looking at and seeing in the publicly listed REIT space.

[00:21:02] Pamela Ritchie: How many of those companies or clients or companies you're interested in have a plan within it, maybe not today but longer term, for nuclear or, if not nuclear, what other types of power are they accessing? It tends to be a version of clean power, it seems like. I mean, they're not using heavy oil for them, necessarily. What other power sources?

[00:21:26] Steve Buller: There's a high desire for anything green related. Unfortunately, given the huge demand that we're seeing on a worldwide basis some of those green functions are falling a little bit to the wayside. Natural gas is one that's often the first choice to use the power. This is also going through any local jurisdiction's utility system, it's not necessarily in the data centre itself that is making that decision. It can be the tenant, be what type of power you can hook into, it could be a variety of type of things. Where we're seeing people access nuclear power, for example, that's inside the metre, is the term that they use, that's usually the hyperscale themselves that are building that in conjunction with that type of power.

[00:22:15] Pamela Ritchie: Is there any other area within there that is an interest? I mean, at one point, for instance, to own the land that the cell towers are on was sort of the big deal. We're kind of talking about a similar situation with the land the data centres are on. Is there something that stretches within the fund or of interest or within the universe of what you're doing that, actually, goes to sort of the power side of things, or not?

[00:22:40] Steve Buller: It's interesting because many of our logistic REITs that we own, they're a little bit under the radar getting involved in data centres. That is because many of their current logistic sites, or even development sites, have access to power. A typical term in real estate is HBU, higher and better use. Because of that access to power it has a higher and better use to be a data centre than a logistics facility. We're seeing some current logistics facilities be converted to data centres. Secondly, their development pipelines, they have data centres, and the value of a data centre, at least today, can be two to five times more than a typical logistics facility. That, in and of itself, is exploiting that current land value which is all about that access to power.

[00:23:33] Pamela Ritchie: That is fascinating. That is so interesting. Tell us a little bit about thoughts on the Canadian market. Broadly, we can go into the commercial side of things. At one point I remember you saying sort of central Canada in terms of multi-family, looking at REITs there. There was a lot of rent control coming in at one stage. There are better opportunities in other parts of the country. Currently, what are you looking at within Canada?

[00:23:59] Steve Buller: Currently, I'm kind of looking at two things more than anything, obviously, the apartment market. In a very simple way you can dissect it by where it's more rent regulated in the eastern part of Canada and then it's more market-based in the western part of Canada. We have exposure primarily to the western parts where it is more market-based. At the same time there's a few clouds on the horizon, though, this is quite well known, with immigration policy in Canada because majority of immigrants end up, firstly, renting an apartment. On the demand side of things there has been a slight downtick in demand just given the population, or I should say not negative population growth but less population growth going forward and what that will mean for the demand side.

[00:24:52] Pamela Ritchie: That's sort of an evolving situation, ultimately. Around the world, you mentioned this is always a global fund. There are areas of exposure through Asia, historically. Do you still have some of those exposures?

[00:25:06] Steve Buller: Definitely. I have very much like the Japanese market, and there's two sides to the Japanese market, what's called the J-REITs, or the REIT structures themselves, and secondly, the developers. Of the developers, though, 80 to 85% of their revenue comes from just leasing, so it's very similar to a J-REIT but also in the term they're involved much more in the development side of it. All of them, the developers, have a large exposure to the Tokyo office market. We're seeing now the vacancy rate has gone down almost to 4%. We're starting to see very strong rental rate increases. We have exposure, primarily, through these Japanese developers which have large exposures to the Tokyo office market to benefit that. They also, in addition, trade, or historically have traded, at quite a discount to their net asset value. This is one way to play a fundamental improvement, in our opinion, at a discount evaluation.

[00:26:09] Pamela Ritchie: It's really interesting. Would you say right now there are large areas of big bets and conviction or is it more, you just mentioned a fundamental way to get access to a very good investment, which strategy are you using more right now?

[00:26:26] Steve Buller: I'd say it's a combination of both. If I had to use these very long term little boxes to what I call my emphasis on positioning charts, and that's not to say that this is any top-down positioning, if you will, today it's much more neutral. The fund, currently, and how it is kind of chosen is from two-fold. Good fundamentals at the best price. That's more of a normal state. There's not any big thematic going through that we're trying to make large bets on any sector or country at the moment but more individual stock picking.

[00:27:04] Pamela Ritchie: Really interesting. Again, areas within some of the sub-sectors, I think in the past we've talked about assisted living. This is throughout North America. I don't know if it extends to further abroad but it was an area that you were interested in. Is that still the case? Is that still growing after COVID?

[00:27:22] Steve Buller: It's a North American phenomena and it's primarily private pay. Now, there's health care related kind of properties and, actually, REITs around the world but outside of North America, and even various sectors, it's more government pay. The government pay, there is usually not a lot of growth and there can be at risk that governments want to change the amount of reimbursement rate. Where assisted living, that is, primarily when, unfortunately, as many females at the end of the life, that's just an actuarial statement, plus 80 years old, they can no longer live, unfortunately, in their home and they'll go to an assisted living community. The amount of 80-year-olds in both the United States and Canada over the next couple of years is going to increase tremendously, where at the same time the amount supply of new beds is actually going down. We're seeing occupancy rates tick up and the ability to push higher rental rates higher. Because this is private pay you need to have the wherewithal where the average length of stay is about 22 months. Given how much we've seen over the past few decades in stock market appreciation and home price appreciation those two are the primary source of funding for this length of stay when, unfortunately, I mean, the mother or the grandmother goes into one of these facilities.

[00:28:52] Pamela Ritchie: So that's a North American specific story for you. What is a more global discussion? I mean, I know anything kind of anchored by groceries, often a very good area, is that something that's a pretty global story for you?

[00:29:09] Steve Buller: On the retail side of things the fund does have an emphasis on what I'll call non-discretionary kind of tenants, that is supermarket anchored retail centres, whereby you do get a tremendous amount of traffic driven by that weekly or bi-weekly visit to a grocery store. Neighbouring it can be a variety of nail salons, to a post office, to a FedEx store, to just general daily needs. A coffee shop, for example. We've seen around the world a lack of new competitive supply which started actually about 15, 20 years ago with the advent of e-commerce of all things. Supply of new competitive supply of retail has gone down whereby, you know what, the amount of kind of e-commerce disruption has also started to plateau around the world. We're seeing these retail tenants have the ability to pay higher rents, at the same time the landlords have increasing leverage to extract higher rents.

[00:30:16] Pamela Ritchie: That's fascinating. It's sort of a story as old as time, to an extent, the marketplace, where you need to go and it's a good bet that way. Is there any just final thought you would leave us with in terms of either your positioning or, really, the place in a portfolio where this can really help investors stay the course?

[00:30:34] Steve Buller: I can't emphasize enough, and I know I'm repeating a little bit, but the growthier part of the equity market, when it works we all love it because so much market cap around the world is now in the growthier part. When it does, for example, take a little breather, or God forbid, takes some type of correction, historically, we have seen where kind of income-oriented real assets with limited amount of high total return but it does have a relative place in a portfolio. I constantly emphasize that.

[00:31:11] Pamela Ritchie: Isn't it interesting how little, actually, we've spoken about rates,  because there are just so many other things that fold into the story and the way that you invest.

[00:31:21] Steve Buller: The actual long term correlation of the performance of global REITs to interest rates is, actually, close to zero, which surprises people. That's not to say over a shorter or medium period you can have periods of higher correlation but the statistics bear out that over a long period of time there's very little correlation. It's one of my little minor pet peeves that this is always perceived to be this interest rate-sensitive vehicle. That's more perception than reality when viewing it on a long term basis.

[00:31:49] Pamela Ritchie: Grateful for you joining us, setting us straight and, actually, really informing us about how you are driving the fund through this particular environment and every day. Every day's a good day to talk about real estate.

[00:32:00] Steve Buller: Every day is a great day to talk about real estate.

[00:32:03] Pamela Ritchie: Steve Buller, thank you for joining us on Fidelity Connects. Coming up on the show tomorrow, institutional portfolio manager, Christine Thorpe, she's going to be joining us to discuss how she is navigating the fixed income landscape plus market volatility and how resilience in the bond market is against this steady stream of mixed economic data. There are rates moving all over the place in the bond market, we will certainly put those questions to Christine tomorrow.

[00:32:30] Starting on Thursday of this week we're going to re-airing some recent Fidelity Connect shows as we head into the long weekend. On Thursday we'll replay our recent discussion with John Bradley, he's Director of Emerging Technology, and Vishal Chopra, he is equity research associate covering Canadian technology and health care. They share how advisors can navigate both opportunity and risk from AI-driven innovation to rising cybersecurity threats. We'll go into that, you'll go into that on Thursday.

[00:32:58] To wrap up the week on Friday we will re-air another pretty fascinating discussion, this time on how technological advancements and new challenges, issues, are creating the likes of the rise of artificial intelligence and deep fake technology are creating new challenges for advisors and how they can protect themselves from these cyber security issues. That's with special guest Imran Ahmad, he's partner at Norton Rose Fullbright Canada. He's also a University of Toronto professor. Do join for both of those discussions. Thanks for joining us here today. We'll see you soon. I'm Pamela Ritchie.