European vs US real estate: why Europe is winning

Premier Miton’s Alex Ross, manager of the Premier Miton Pan European Property Share Fund, shares why Europe is leading the way thanks to stringent planning rules.

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.

The property cycle at a glance 

The last property cycle was unique. That’s because record low finance costs meant highly attractive income streams could be generated against a backdrop of limited competing bond-like income.

With weak economic growth, this was particularly relevant to owners of prime property where a secure property income could be combined with low-cost financing to deliver attractive returns to investors. In addition, this income return was further complimented by capital growth, with prime property increasing in value from widespread investor demand for these assets.

We believe that while interest rates may reduce from here, we are unlikely to see rates anywhere close to the lows of the last decade. Therefore, we are likely to see a very different and more traditional property cycle ahead.

The winners of the last cycle were the owners of bond-like prime real estate and several of the very large US REITS were clear beneficiaries of this.

Three strategies for success in a higher interest rate environment 

In a more normalised higher rate environment, real estate can be very successful, but it typically requires strong real estate asset management initiatives. These are necessary to create value or grow the cashflow to deliver attractive returns against the now more competitive income returns available from the fixed income market.

There are three typical asset management-driven value-creation strategies:

  1. Re-generating or changing the use of an existing asset, e.g. converting office space to residential or a tired ‘brown’ office to an amenity-rich ‘green’ office.
  2. Acquiring a previously mis-managed building with high vacancy in a location where there is pre-identified tenant demand and using asset management initiatives to then let the vacant space, often through light refurbishment.
  3. Cashflow growth from operationally intensive real estate assets, typically with short leases but where there is structural tenant demand for space where tenants need to be to then regularly grow the cashflow. This might, for example, typically be in self-storage, private rented accommodation, flexible workspaces, or student accommodation.

How tight planning in the UK and Europe is a factor

To successfully execute on these strategies requires strong pricing power and this is where, selectively, the pan-European market now offers a uniquely favourable operating environment. This is due to the highly attractive supply vs demand dynamics in these markets.

Historical capital city centres across western Europe such as London, Paris and Madrid have stringent planning requirements that restrict the supply of available development land and new building permits. They have not suffered the levels of urban sprawl of office space seen in many major US cities.

Here is how each of the three value-creation strategies above now provide opportunities in our pan-European markets specifically.

Regenerating assets

This tight availability of developable land, when combined with competition for land from a chronic shortage of residential housing across these European cities, means new business space supply can now typically only occur when regenerating or redeveloping an existing building. This needed supply is also becoming increasingly challenging with escalating sustainability requirements.

This tight supply of developable space provides leading property management teams with the opportunity to regenerate a building to potentially alternative use such as residential or hotels, or to a modern, amenity-rich green office building.

Major corporates are increasingly migrating towards these fit-for-future buildings to improve their carbon footprints and help attract the most talented young workers, for example.

This strategy offers the leading real estate regenerators the opportunity to capture the very attractive value-creation arbitrage of acquiring a lowly-valued, low demand building and converting it into a high demand, high value building.

Acquiring a previously mis-managed building with high vacancy

The rapid changes in tenant requirements mean that passive owners of real estate are likely to see their vacancy rates rise. This provides opportunities for leading asset managers to step in where their operational platforms identify re-letting opportunities following light refurbishment.

This is particularly the case in more fringe locations where there is still strong demand for flexible and invigorating workspace for emerging companies.

Unlike in the US, where regional cities saw extensive urban sprawl of office space which is now facing structurally extensive vacancy rates and therefore limited pricing power on acquiring higher vacancy assets, the situation is different in Europe.

There is limited vacancy in this type of high quality and collaborative workspace across pan-European office markets. Where there is vacancy, it can provide attractive change-of-use opportunities, for example, to the deeply undersupplied market for residential property in pan-European cities. 

Case study: Sirius Real Estate’s acquisition of London portfolio

A recent example of an opportunist real estate deal involving acquiring a high vacancy, but good quality building is the Islington/Camden portfolio in London which was acquired by Sirius Real Estate in November 2023:

  • Multi-let studios in three buildings, acquired for £33.5m from a closed-ended fund;
  • 30% vacancy with clearly identified re-letting potential;
  • Acquired at a 7.3% Net Initial Yield (NIY), with potential to increase to >10% yield post asset management;
  • Further underwrite from a capital value per sq ft of just £322 in a desirable residential area.
 

Source: Sirius November 2023 presentation.

Cashflow growth from operationally intensive real estate assets

There are several more alternative sub-sectors that require significantly more asset management than mainstream institutional real estate.

This is due to short leases, but this also provides this increasingly important cashflow growth potential.

Areas such as self-storage, student accommodation, flexible workspace, and private rented residential require significant in-house resource and operational platforms. However, the constant annual re-lettings can be highly rewarding, and necessary in a higher rate environment when there is strong pricing power.

Across our pan-European markets, these sub-sectors tend to be less mature than in the US. This provides opportunities to either create this space to meet the needed new supply or utilise their established platform to grow cashflow from the attractive supply/demand imbalance.

By way of example, there is 11x more self-storage space per person in the US vs the UK and 42x more in the US vs continental Europe*.

These real estate value creators were less relevant when attractive returns were available from owning prime real estate income offering a yield well above finance costs and fixed income yields.

But we are confident the previously high market ratings ascribed to the best-in-class value creators will return to the fore once again as the market starts to recognise the attractive underlying real estate returns diverging again towards these real estate asset managers.

Across a wide number of sub-sectors, we have positioned our portfolio towards many of these highly active and quality management teams in both the UK and continental Europe.

What next?

At today’s level of interest rates, we now expect highly rewarding potential real estate returns to play out from a combination of improving underlying asset values and earnings from these value creation strategies combined with a significantly improved share price rating against these higher values/earnings ahead.

As investors start to understand the drivers of this next property cycle, they will seek exposures to what we believe will be global leaders in real estate value creation from the highly supportive tight planning regimes across our key pan-European markets.

The rapid changes in tenant requirements and hence use of the real estate, combined with environmental and technological changes, further accelerates these opportunities for active real estate companies – to create value, both environmentally and financially, by actively aligning buildings to be relevant for tomorrow’s tenant requirements.

We are now entering the next real estate cycle across pan-European markets, and it is very rare to have such a favourable supply/demand backdrop after a major property downturn.

We expect this to materially surprise investors in a pan-European sector that is heavily under-owned, but we emphasise our high conviction that the winning real estate companies in this cycle will be very different from the winners of the ultra-low-rate environment.

Source: *Big Yellow September 2023 Interim results presentation.

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Risks

The value of stock market investments will fluctuate, which will cause fund prices to fall as well as rise and investors may not get back the original amount invested.

Property values can rise and fall sharply depending on the strength of a country’s economy.

Forecasts are not reliable indicators of future returns.

IMPORTANT INFORMATION:

For Investment Professionals only. No other persons should rely on the information contained within.

Whilst every effort has been made to ensure the accuracy of the information provided, we regret that we cannot accept responsibility for any omissions or errors.

Reference to any particular investment does not constitute a recommendation to buy or sell the investment.

Issued by Premier Portfolio Managers Limited, (registered in England no. 01235867), authorised and regulated by the Financial Conduct Authority, a member of the Premier Miton Investors marketing group and a subsidiary of Premier Miton Group plc (registered in England no. 06306664). Registered office: Eastgate Court, High Street, Guildford, Surrey GU1 3DE. 013359/280624

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Investment products referred to on this website may not be sold or transferred to a US citizen, or an entity taxed as such or required to file a tax return as such under the United States federal income tax laws (a “US Tax Resident”).

The information in this site is solely for the purpose of acquiring information as, or for, an Institutional Investor (a corporate or other non-retail investment professional acting for their own account). This information must not be used or relied upon by anyone that may be considered a “retail investor” by the home regulator of the country from which this site is accessed.  

The information contained in this website is directed at persons who are resident in the United Kingdom and complies with appropriate UK legislation and regulations and is not directed at, nor intended for distribution to, or use by, persons in any jurisdiction in which the dissemination of such investment related information is not permitted.

The information or opinions contained herein should not be construed as an offer, or solicitation to deal in any investment or fund nor shall any such investment products or services be offered or sold to any person in any jurisdiction in which such offer, solicitation, purchase or sale would be unlawful or in which the person making the offer solicitation is not qualified to do so or to anyone to whom it is unlawful to make such offer or solicitation.

Premier Miton Investors has expressed its own views and opinions on this website, and these may change and there is no obligation to update them. Nothing in this website should be construed as investment, tax, legal or other advice. The information contained herein is subject to change without notice.

Neither Premier Miton Investors nor any of its group companies or affiliates accepts any liability for any losses arising directly or indirectly from any information accessed from this website, to the fullest extent permitted by law.

By clicking accept you acknowledge that your use of this website is subject to our privacy policy, cookie policy and our general legal and compliance information available on our website.

THE UNITED STATES OF AMERICA: The investment products referred to on this website have not been and will not be registered under the United States Securities Act of 1933, as amended. They may not be offered or sold in the United States of America, its territories and possessions, any State of the United States of America or the District of Columbia or offered, sold or transferred to US Persons (as defined below). The investment products referred to on this website have not been and will not be registered under the United States Investment Company Act of 1940, as amended. Premier Portfolio Managers Limited has not been and will not be registered under the United States Investment Advisers Act of 1940.

 “US Person” generally includes the following: (a) any natural person resident in the United States; (b) a partnership or corporation organised or incorporated under the laws of the United States; (c) any estate of which any executor, or administrator, is a US Person; (d) any trust of which any trustee is a US Person; (e) any agency or branch of a non-US entity located in the United States; (f) any non-discretionary account or similar account (other than an estate or trust) for the benefit or account of a US Person; (g) any discretionary account or similar account (other than an estate or trust) held by a dealer or other fiduciary organised, incorporated or (if an individual) resident in the United States; and (h) any partnership or corporation if: i. organised or incorporated under the laws of any non-US jurisdiction; ii. formed by a US Person principally for the purpose of investing in securities not registered under the 1933 Act. In addition, a Shareholder must qualify as a “Non-United States Person” as used in the US Commodity Futures Trading Commission (“CFTC”) Rule 4.7.

 Investment products referred to on this website may not be sold or transferred to a US citizen, or an entity taxed as such or required to file a tax return as such under the United States federal income tax laws (a “US Tax Resident”). If those investment products are held by a US Person, a US Tax Resident or a person who does not qualify as a “Non-United States Person” within the meaning of CFTC Rule 4.7, Premier Portfolio Managers Limited shall be entitled to redeem such Shareholder’s entire holdings.