Does the case for investing in pan European property still stand up?
Fund manager of the Premier Miton Pan European Property Share Fund
Pan European property shares are pricing in significant asset value falls
Pan European real estate shares have suffered painful share price weakness not seen since the global financial crisis, materially underperforming general equities, and dislocating from historic trends where increasing inflation has driven higher relative equity market ratings for real estate securities. So, what is the rationale behind the collapse in share prices for the real estate securities sector in this increasingly inflationary environment?
Despite initially performing well as inflation increased in Q1, the sector started its absolute and relative falls shortly after the Russian invasion of Ukraine as energy prices soared, which – when combined with increasing supply and labour shortages – saw inflation soar to damaging economic levels not seen for many decades. The ensuing surge in interest rate expectations and finance costs, from previous ultra-low levels, particularly in the UK since the ‘mini budget’, will require higher property yields to make real estate investment viable.
As such, the attractive income profile within pan European real estate securities, with largely fixed financing and rents either directly linked to inflation indices or indirectly through market rental growth, has been superseded by the outlook to capital values as the central banks grapple to control the rampant inflation through further interest rate rises.
There is clearly deep uncertainty about how far and for how long central banks will need to increase interest rates, and this uncertainty has been reflected in pan European real estate shares inversely tracking higher bond yields to trade at deepening discounts to asset values and also reflecting significant earnings yields.
The Importance of Fundamentals
We believe the relatively resilient earnings yields across the well-financed companies in the sector will be a key attraction of the sector winners as economies weaken. But in the short term, the focus of the market will be on asset values and balance sheet strength. Frustratingly, share prices have been marked down across the board in the sector, with the macro news dictating share prices and limited focus on property fundamentals leaving few defensive areas to protect on the downside in recent weeks. However, underlying property fundamentals will rarely be so important in the months ahead, as this will dictate the extent of property write-downs for many companies, despite the universal increase in property yield requirements.
Here we see hidden value in the sector, through the ability of a number of companies to materially limit the impact of rising valuation yields through the healthy increase in the property yield from compounding rental income growth. This is most evident on the continent, where commercial property leases are typically linked to annual inflation indexes (with fewer caps on this indexation vs the UK), and where in many cases we expect to see high single digit increases in the rent as a result of this indexation. Compounding this indexation for this year and next year’s expected inflation will in itself generate a significantly higher property valuation yield, materially offsetting the capital decline impact from a higher property yield requirement from rising bond yields and interest rates.
The overhanging question mark on this ability to charge indexation comes down to pricing power and the ability to pass on all, or a significant portion, of this indexation given the economic weakness/recession we are likely heading into. What gives us confidence here is the nature of this cycle where, unlike prior market crashes of the early 90’s and late 2000’s, development has been limited and there is very low vacancy across all our core sectors outside retail (including prime, modern energy efficient offices in capital cities).
Vacancy in these sub-sectors, such as logistics, prime offices, healthcare, rented residential, is at around record low levels and whilst there will doubtless be a pick up in vacancy in a recession, the well let assets in which we are invested should prove relatively resilient, even in our offices exposures, where the churn of tenants from inefficient brown buildings on lease expiries will provide ongoing structural demand despite a weak economy. Furthermore, as a result of the sharp rise in construction costs combined with ongoing supply issues, new development supply will require higher rental levels for development to be viable off higher development costs and higher exit yields on development. Hence, importantly for capturing rental increases, we do see decent pricing power for landlords in the strongest assets.
The attraction of real estate securities
Looking forward, the attraction of real estate securities following times of deep uncertainty is the equity market’s ability to attempt to ‘price in’ such widespread negative sentiment, with shares trading at around record high discounts to current underlying property values and high earnings yields.
These are the key recovery catalysts we see for this re-rating of our sector:
- Evidence that current extreme inflationary pressures are easing (and hence lower market interest rate expectations).
- The sector’s inflation protection qualities, during potentially elevated but more limited inflationary years ahead, receives due recognition at earnings results as the benefits of structural rental income growth (for both values and earnings) from our landlords with genuine pricing power is demonstrated.
- Our holdings evidence the net asset values of their quality real estate through disposals (even at reasonable discounts to current book values given the deep share price discounts to asset values).
Volatility will remain elevated, but for investors able to take a longer-term view, we believe the unprecedented widespread discounts to asset values and high earnings yields will prove highly rewarding as and when the sector re-rates. On an expected fall in real estate pricing, the quoted real estate sector takes the pain upfront through rapidly falling share prices, but also historically recovers well ahead of the underlying real estate market improving. What is now increasingly evident is the improved transparency in pricing compared with previous cycles, which we would expect to be reflected in the faster marking to market of lower real estate asset values (as already reflected in the rapid discounting of share prices to asset values in recent months), but also a faster recovery as we see the above key catalysts come through.