Alex Ross, manager of the Premier Miton Pan European Property Share Fund, looks at whether the recent uplift in the property sector is the start of a longer-term recovery.
For information purposes only. The views and opinions expressed here are those of the author at the time of writing and can change; they may not represent the views of Premier Miton and should not be taken as statements of fact, nor should they be relied upon for making investment decisions.
In the pan European real estate equities market there have been signs of an improvement in sentiment reflected in share prices steadying and, in some cases, improving from deeply distressed levels over recent months. This has tied in with increasing evidence that inflation, whilst remaining elevated well above target levels, is evidently now tracking down, particularly in continental Europe. Notably, this stabilisation has occurred since the end of the first quarter of the year during a period where borrowing costs have materially increased, which suggests equity investors are starting to look through this potential final interest rate tightening period – particularly in continental Europe which is facing less structural inflationary pressures.
Despite this, pan European real estate equities continue to trade close to their record discounts to asset values, which are at around levels only witnessed on 3 occasions in the last 40 years. The sector has been one of the worst impacted by the sharp rise in borrowing costs from their negligible levels, and we believe for those investors of the view that the increasing interest rate cycle in Europe is approaching its peak and offers scope for declines in the medium term, the sector can offer a highly rewarding recovery play on this theme. We highlight this recovery potential as property shares turn to sharply re-rate towards net asset values once equity investors believe in the ‘V’ – as in the Value of the underlying properties which the shares are priced against. After a material increase in property valuation yields over the last year, we believe the underlying properties values are becoming increasingly tangible with only limited further underlying real estate value corrections likely ahead, based on current market interest rate expectations, in spite of the deep discounts shares are trading to current property values.
A key catalyst we are seeking to trigger a recovery in share price ratings is increasing transactional activity in the underlying real estate markets. We are now seeing increasing evidence of this in certain sub-sectors following the sharp increase in property yields, most notably in the warehouse market. Most of these buyers are institutional cash buyers, but we note that in continental Europe the more limited upside to finance costs combined with the increase in property yields is now starting to make real estate viable again using finance. There is less clarity in the UK given the continued stickiness to inflation data, but in continental Europe borrowing costs are substantially lower than the UK (e.g. European 5 year swap rates are in the region of 3.3% currently vs UK 5 year swap rates at around 4.9%, source Bloomberg 11.08.23) and this, combined with the increased property yields available and annual rent clauses, also allowing for immediate cashflow growth, starts to make real estate viable again for finance buyers in the Continent, which we expect will lead to increasing transactional evidence close to current asset values.
Furthermore, whilst borrowing costs are no longer at negligible levels, the availability of bank finance for good quality borrowers is still there in pan European markets. With the exception of Sweden, lessons have been learnt from the irresponsible lending that led to the global credit crisis, and thus banks still have significant capacity to lend – a very different situation to where we were in 2008 when securing new finance was almost impossible. Negative sentiment towards real estate has clearly been exported across the pond from the US, where the lack of regulation in regional bank lending combined with an office market now haunted by the widespread urban sprawl, has understandably generated daily negative headlines. We believe this key differential and ongoing access to real estate finance will be reflected in European real estate markets stabilising earlier than the market expects.
The recent decline in borrowing rates due to weakening global economic data raises the question as to how real estate will perform in a recession/weak economy. The nature of this property market downturn has differed to most previous major downturns, in that it has been characterised solely by the negative impact of rising yield requirements in property valuations, with no negative impact from rental declines for most areas of the real estate market (the one exception being brown offices). Indeed, we have seen a positive impact from rental moves throughout this downturn, which has helped do some of the ‘heavy lifting’ in increasing property yields to a level where they become attractive in a higher debt cost environment. Ultimately, this rental resilience has been achievable due to the lack of development supply going into this downturn.
In our portfolio exposures, we remain confident on the resilience of the rental income in a mild recessionary environment as we have deliberately positioned our exposure towards those key areas of real estate that are seeing structural tenant demand which is ‘needs-based’ rather than economic growth driven demand. In rented residential, there is a major structural shortage of supply, particularly in Germany where supply is not viable due to most of the rental housing stock being valued below replacement cost. Changing demographics are driving structural demand for modern healthcare facilities. Warehouse demand is increasing due to the structural changes in the global supply chains, with near shoring increasingly required for both cost and environmental reasons. In offices, there is structural demand from major corporations to consolidate to energy-efficient, green offices to meet carbon footprint targets. We don’t see this structural demand materially changing in a recession and this demand is meeting extremely low vacancy in all our core geographic markets in these sub-sectors. The limited supply will be further constrained due to the sharp increase in the construction cost of these needed buildings – which will require high rents to make them viable, thus setting higher prime rental tones.
Given the uncertainty to earnings in general equities in such a weak economic scenario, we believe this tangible rental income will become increasingly sought by investors, particularly with the pan European real estate sector relative price to earnings ratio at the lower end of its historical range. Furthermore, if we start to see the high current borrowing costs decline due to a weaker economic environment, the real estate sector will also see some benefit from lower refinancing costs ahead helping the already high earnings yields – a reversal of the environment in which real estate securities have been such a poor performer.