Market Sector Update
- A stronger economy generated momentum in commercial real estate, with improved occupancy rates and growth in rent revenue. Industrial, retail and central business district office properties benefitted from increased growth. However, rising interest rates derailed the strong, multi-year outperformance of REITs versus the broader equity market.
- Hotels, apartments and self-storage had the strongest fundamental growth. Their shorter-term leases synch with overall economic growth. Apartments are growing revenues but at a slowing rate. The pace of multifamily construction is starting to hurt the ability to hike rents. Slowing fundamentals in the apartment, self-storage and healthcare facility sectors meant lesser investment returns.
- Rising interest rates are creating headwinds and companies are seeking to increase investment returns to offset higher borrowing costs. However, there is plenty of capital seeking investment opportunities, keeping returns stable for high-quality properties.
- Refinancing continued to increase across real estate portfolios. We think commercial real estate’s fundamentals can offset rising rates.
- The Fund had solid performance relative to the benchmark in the quarter, led by stock picking. It benefited from holdings in shopping center and cell tower companies, and from being underweight in the underperforming healthcare facility sector. It also benefited from holdings in non-benchmark homebuilders and commercial mortgage REITs. Stock selection in the apartment and timber REIT sectors negatively affected performance.
- We reduced exposure to interestsensitive REITs by lowering holdings of net lease and commercial mortgage REITs, which tend to be negatively affected by rising rates. We increased the exposure to sectors with accelerating earnings growth, such as hotels, office and industrial warehouse properties.
- Many stocks in the REIT sector have been punished by the overhang of rising interest rates. We have selectively added names that we believe are trading at substantial discounts to underlying asset values.
- In general, we favor companies that have been able to make creative acquisitions or that have development pipelines able to capture economic growth.
- We think 2014 will be a battle between improving underlying fundamentals and rising interest rates. Job growth is the main driver of fundamental demand for commercial real estate and we expect it to support improving fundamentals.
- We think interest rates will rise, but not as much as in 2013. We are limiting our interest rate exposure while positioning for what we think are better growth opportunities. We believe rising rates will lead to an increase in capitalization rates for commercial real estate, suppressing valuations. However, we think strengthening economic conditions that lead to rental revenue increases will offset some contraction in REITs earnings multiples.
- The high quality of REIT balance sheets helps lower their cost of capital, an advantage when acquiring properties. Lenders are seeing REITs as lower risk borrowers; we think higher interest rates will affect REITs less than private real estate.
- Markets such as apartments and assisted living are seeing significant new construction, but rent growth in other commercial real estate sectors hasn’t improved enough to spur new construction. We think this will continue in 2014.
The opinions expressed in this commentary are those of the Fund managers and are current through Dec. 31, 2013. The managers' views are subject to change at any time based on market and other conditions, and no forecasts can be guaranteed. Past performance is no guarantee of future results.
Matthew K. Richmond of Advantus Capital Management, Inc. (subadvisor) was named a portfolio manager on Jan. 2, 2014, replacing Joseph R. Betlej.
Risk Factors. As with any mutual fund, the value of the Fund's shares will change, and you could lose money on your investment. An investment in the Fund is not a bank deposit and is not insured or guaranteed by the Federal Deposit Insurance Corporation or any other government agency. Investment risks associated with investing in real estate securities, in addition to other risks, include rental income fluctuation, depreciation, property tax value changes and differences in real estate market values. Because the Fund invests more than 25% of its total assets in the real estate industry, the Fund may be more susceptible to a single economic, regulatory, or technical occurrence than a fund that does not concentrate its investments in this industry. These and other risks are more fully described in the Fund prospectus.
Investors should consider the investment objectives, risks, charges and expenses of a fund carefully before investing. For a prospectus, or if available a summary prospectus, containing this and other information for the Ivy Funds, call your financial advisor or visit us online at www.ivyfunds.com. Please read the prospectus or summary prospectus carefully before investing.