Market Sector Update

• The fourth quarter of 2019 marked a definite breakout for most equities. Unfortunately, investors shunned income producers like real estate and utilities. However, real estate investment trusts (REITs) delivered solid returns for the year ended Dec. 31, 2019, advancing 26%, as measured by the FTSE NAREIT Equity REITs Index, the Portfolio’s benchmark.
• We believe the economy is poised to do modestly better in 2020. The consumer continues to drive growth with low unemployment and higher wages supporting spending. Although the stage is set for stronger growth in corporate America, the turn has not fully materialized due to weakness in the manufacturing and energy sectors.
• Still, the outlook appears brighter for 2020 as the shock from recent tariffs recedes. Corporate earnings should improve amid more stable global growth and easier year-over-year comparisons. In addition, a recession next year seems unlikely given economic fundamentals like unemployment at a nearly 50-year low.
• With macro-economic and interest rate conditions remaining favorable for real estate, the prospect of improved corporate earnings and continued consumer strength is likely to support a healthy backdrop for operators. We believe 2020 earnings growth for REITs will approach 5% as landlords enjoy the benefit of contractual lease obligations from their tenants and today’s ultra-low interest rate environment is providing a refinancing boost to the expense structure. This expected earnings growth should set the stage for another solid year of dividend increases across the sector.

Portfolio Strategy

• The Portfolio delivered a positive return for the quarter, but underperformed its benchmark.
• The Portfolio’s overall performance for the period is attributed to favorable stock selection and sector allocation across many of the property types. Most notably, stock selection among owners of net lease, data centers, and health care facilities contributed the lion’s share of the Portfolio’s performance.
• An overweighting to owners of cell towers and single-family residential (SFR) also contributed favorably. As the clouds overhanging economic growth began to lift, we shifted to a less defensive position with certain portfolio holdings by increasing our weighting to hotel owners and decreasing exposure to certain net lease REITs. We also modestly reduced exposure to the health care, which badly lagged the benchmark as “risk on” sentiment overtook the market.
• Net lease REITs delivered positive performance for the quarter, despite the “risk-on” environment and interest rate headwinds. Driving the segment’s performance were two gaming REITs, which own, but do not operate casinos. We have increased our exposure to these companies as they offer very attractive valuations relative to other net lease REITs, yet are expected to deliver significantly higher earnings growth than those REITs.
• Datacenter REITs slightly trailed the broader index for the quarter. The Portfolio’s overweight position to the group hindered performance, but favorable stock selection meant the group was still supportive of relative performance. Demand for space remains strong, with the continued enterprise migration, edge and cloud computing, and artificial intelligence all expected to provide tailwinds to the group for the foreseeable future. We continue to see the space as attractively valued when considering its growth prospects, and the Portfolio remains overweight to this sector.
• Health care REITs fell for the quarter, as interest rates walked back from their mid-2020 low and the “risk-on” environment took hold. The Portfolio’s underweight allocation to the sector and stock selection aided the Portfolio’s performance for the period. Occupancy continues to suffer for senior housing due to new supply, and labor cost pressures persist. Skilled nursing also suffers from a labor cost perspective, but a more constructive regulatory approach may provide some relief. REIT tenants in both segments continue to encounter rent coverage deterioration, some requiring lease restructure. Medical office buildings continue to deliver slow, steady organic growth and appear to be back in favor with investors.
• SFR REITs outperformed the benchmark for the quarter. We were overweight to the segment, which contributed to the Portfolio’s performance. We increased our SFR position during the period on the belief there is a long runway for growth.
• Hotel REITs and operators benefitted from a broad risk-on shift for the market. While the portfolio’s underweight position to the space detracted from relative performance, good stock selection led to the sector being a net positive contributor. We continue to expect that new supply and higher labor costs will limit earnings power for the next several quarters and we continue to remain underweight this group.

Outlook

• Macroeconomic conditions remain favorable for real estate operators. Occupancies across most every property segment remain at historically high levels, and speculative construction continues to be held in check with few exceptions. We believe 2020 earnings growth for REITs will be positive as landlords enjoy the benefit of contractual lease obligations from their tenants and the current ultra-low interest rate environment is providing a refinancing boost to the expense structure.
• The big question investors have is whether this year’s returns are justified or if we have simply pulled future returns forward. We previously acknowledged that if the Fed’s insurance cuts were effective, conditions would be good for risk assets. This scenario certainly was realized, and the market is pricing in a return to a Goldilocks economy where both growth and inflation are measured. This sets the stage for continued demand for risk assets.
• Within the commercial real estate space, we broadly expect stable operating trends to continue across the sector with the recognition that today’s occupancy levels and tempered rental rate increases will result in modest earnings growth. We remain optimistic as we see few material concerns emerging, as in previous cycles. Bank lending, commercial construction, equity allocations, and overall pricing metrics remain much healthier than was often the case in previous cycle peaks. Ultra-low interest rates, continued favorable operating conditions, and dependable cash flows have emboldened investors to see real estate as a relative “safe haven” in today’s low-growth, low-rate environment.

The opinions expressed are those of the Portfolio's managers and are not meant as investment advice or to predict or project the future performance of any investment product. The opinions are current through Dec. 31, 2019, are subject to change at any time based on market and other current conditions, and no forecasts can be guaranteed. This commentary is being provided as a general source of information and is not intended as a recommendation to purchase, sell, or hold any specific security or to engage in any investment strategy. Investment decisions should always be made based on an investor’s specific objectives, financial needs, risk tolerance and time horizon. Past performance is not a guarantee of future results.

The FTSE NAREIT Equity REITs Index is designed to present investors with a comprehensive family of REIT performance indexes that spans the commercial real estate space across the U.S. economy. The FTSE NAREIT Equity REITs index contains all Equity REITs not designated as Timber REITs or Infrastructure REITs. The S&P 500 Index is a float-adjusted market capitalization weighted index that measures the large-capitalization U.S. equity market. It is not possible to invest directly in an index.

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. Not all funds or fund classes may be offered at all broker/ dealers.

Annuities are long-term financial products designed for retirement purposes. Annuity and life insurance guarantees are based on the financial strength and claims-paying ability of the issuing insurance company. The guarantees have no bearing on the performance of a variable investment option. Variable investment options are subject to market risk, including loss of principal. There are charges and expenses associated with annuities and variable life insurance products, including mortality and expense risk charges, management fees, administrative fees, expenses for optional riders and deferred sales charges for early withdrawals. Withdrawals before age 59 1/2 may be subject to a 10% IRS tax penalty and surrender charges may apply.