Ivy Real Estate Securities Fund

12.31.16

Market Sector Update

  • Real estate securities overall had a negative performance in the quarter versus the positive return for U.S. equities. The U.S. presidential election, global central bank actions and expectations for economic growth added to volatility in the real estate sector.
  • The U.S. Federal Reserve (Fed) on Dec. 14 announced a 0.25-percentage-point hike in the fed funds rate to 0.75%. That action and bullish economic sentiment after Donald Trump’s presidential win led to an increase in 10-Year Treasury yields and a move away from real estate investment trusts (REITs) and into higher growth investments.
  • Within REITs, assets with shorter lease durations fared best while retail REITs struggled on fears of e-commerce hurting long-term viability.
  • Hotel REITs led the sector, entering the quarter at a large discount to net asset values after several quarters of positive but slowing growth. Most outperformance followed the election, as expectations for greater economic growth increased and REIT-focused money shifted to sectors with shorter lease duration.
  • Fundamentals for the office sector mean many expect them to outpace most other REIT sectors, based on strong job growth and increasing lease rates. Multi-family REITs regained some ground from the move to shorter lease duration assets. Retail stocks fared poorly, with declines in shopping center and mall REITs. The growth of e-commerce has raised concerns about brick-and-mortar retailers in the long term. Health care and triple net lease facilities fared the worst, as these are the most bond-like and their valuations declined as the 10-Year U.S. Treasury yield rose.

Portfolio Strategy

  • The Fund had a negative return during the quarter and trailed the negative return of its benchmark index.
  • Large-cap REITs underperformed small caps and again were a key factor in the Fund’s underperformance. The small-cap REITs typically own lower-than-average quality properties but have aboveaverage balance sheet risk. Investors seeking yield have pushed them to valuations we consider too high.
  • The Fund had a more offensive tone, particularly after the election. We increased weightings to hotels and to Sunbelt and suburban offices, and decreased exposure to malls and triple net lease REITs. We remained overweight to owners of student housing and manufactured housing.
  • The Fund remained overweight to industrial warehouse owners. We think operating conditions are strong, driven by e-Commerce businesses and better economic growth. Stock valuations are no longer “cheap,” but top-line revenue has begun to accelerate.
  • We also remained overweight data center REITs. We think earnings growth is possible in the future as technology needs evolve and more businesses outsource data centers. We believe valuations were compelling, with stocks trading at earnings-multiple discounts to both REITs and recent private market transactions.
  • We pared exposure in the Fund to Class A regional malls and have limited exposure to lower-quality malls. This sector is trading at one of the largest discounts to net asset value among REITs, and concerns about slowing store sales, department store closures and flows away from REITs led to the underweight. We think high-quality mall owners can combat these trends.

Outlook

  • Steady economic and employment growth coupled with disciplined lending and construction activity have propelled the real estate recovery into its seventh year. While the recent election results have caused optimism in capital markets and the business community, details remain unknown. Investors await evidence that policy changes can affect growth in gross domestic product and employment. We do think a pro-business posture can aid business confidence and prompt continued real estate demand.
  • We think REIT fundamentals will continue to benefit from an improving economy, although the pace of growth likely to be muted by new supply in sectors such as apartments, hotels, and self-storage. Despite signs of decelerating cash flow growth, we think the landscape for commercial real estate and REITs remains constructive.
  • Capitalization rates for private market transactions continue to support REIT valuations and suggest to us that REITs trade at a discount to net asset value. We think REIT pricing compared to broader fixed income and equity markets, and historic averages, also is attractive.
  • It is hard to argue that Fed policy hasn’t boosted financial asset valuations, including real estate. Although we think current valuations are justifiable, a sustained reversal in record-low interest rates (particularly in the long-end of the curve) would be likely to pressure REIT share prices. We saw evidence of this relationship in the second half of 2016 when 10-Year Treasury yields rose sharply.

The opinions expressed in this commentary are those of the portfolio managers and are current through Dec. 31, 2016. 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 not a guarantee of future results.

Risk factors. 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's prospectus.

IVY INVESTMENTSSM refers to the financial services offered by Ivy Distributors, Inc., a FINRA member broker dealer and the distributor of IVY FUNDS® mutual funds, and those financial services offered by its affiliates.

Before investing, investors should consider carefully the investment objectives, risks, charges and expenses of a mutual fund. This and other important information is contained in the prospectus and summary prospectus, which can be obtained from a financial advisor or at www.ivyinvestments.com. Read it carefully before investing.