Kirsty Riddle
Co-Fund Manager, Premier Miton Pan European Property Share Fund
2022 – a perfect storm for property shares
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.
Let us first go back to the beginning of 2022 to set the scene. Elevated inflation resulting from COVID induced supply constraints was initially perceived to be positive for real assets such a property, but the commencement of the Ukraine war pushed inflation to economically damaging levels and subsequently caused central banks around the world to start hiking rates at a rapid pace from historically low levels.
This caused bond yields to spike and exert upward pressure on property yields, as well as materially increasing debt costs for this capital-intensive sector. This negatively impacted not only property valuations, which move conversely to property yields, but also potentially earnings yields.
NAV valuation and NAV growth % Pan-Europe
Source: Company data, Datastream, Morgan Stanley Research, published 03.01.2023.
Wider macro and political concerns, as well as uncertainty around where rates could settle, spooked investors and direct property transactions were halted, building further uncertainty around real estate valuations. The result: share prices of listed REITs (Real Estate Investment Trusts) and property companies fell to trade at deep discounts to net asset values, we can see this clearly in the chart above.
Clearly there are a couple of ways the gap could close in this disconnection; share prices could recover or asset values could fall, or a combination of both. Share prices tend to indicate where investors believe valuations are heading, and whilst we acknowledge that property valuations will, and indeed are, falling quite materially, we believe that such corrections are already more than factored in to share prices. Shares, in our view, are still trading at discounts to our forecast ‘trough’ asset values, and fortunately appraisers are acting swiftly to reprice assets rather than dragging out this process to reach trough valuations.
Reasons to be cheerful
So far, so gloomy – but we did promise a positive article and on that promise we will deliver. We do not believe that property values will fall as much as implied by the market for two reasons:
- Firstly, rental growth will often be boosted by inflation, as inflation linked contractual leases are typical in European commercial rental agreements, and this will partly offset some of the negative impact from rising property yields.
- Secondly, we do not expect property yields to rise at the same pace as bond yields and property values should therefore be able to absorb some of the impact from rising rates. We note that property yields did not compress to the same degree as bond yields post the Global Financial Crisis, and a longer look back shows a far narrower spread between the two, particularly during periods of higher inflation and rates, as we can see in the graph below:
Property yields vs 10-year gilt yields
Source: Landsec Group, Half Year 2022 Report, 30 September 2022. Bloomberg, MSCI.
Demand remains robust
We also take comfort from the operational strength and resilience that management teams of the listed property sector are reporting. Demand for high quality, well-located property space has remained robust and importantly often driven by structural rather than cyclical drivers. Whilst supply has remained constrained, this has resulted in low vacancy rates and subsequently upward pressure on rents across most property subsectors.
The increasing focus on ESG (environmental, social, governance) has also exacerbated this demand/supply imbalance, with tenants increasingly looking for ‘green’ space to help meet their own carbon reduction targets. However, only a small proportion of the property market currently meets such requirements and significant capital expenditure is needed to future proof the rest. As a result, we are seeing an increasing divergence in rental growth between the most sustainable assets and secondary ‘brown’ assets.
Rising rates have been managed
Rental growth is needed to help absorb some of the impact from rising interest rates and debt costs to try and protect earnings yields. Fortunately, the listed property sector has been proactive over the last few years at fixing or hedging low debt costs for the medium to long term, and as such the impact from higher interest rates will be felt gradually.
The effect of higher interest rates will be felt either from the proportion of debt not hedged or fixed, or from refinancing debt as it approaches expiry or issuing new debt to fund growth. This phasing effect gives property company management teams the opportunity to capture multiple years of rental growth before the full impact of higher interest costs is fully felt.
Balance sheets are typically strong too, with leverage at more conservative levels, as management learnt lessons from heading into the global financial crisis over-levered. This not only limits the impact from rising interest rates, but also reduces the likelihood of being a forced seller or being forced to raise equity at steep discounts.
Ripe opportunities as conditions turn
We favour those companies with strong balance sheets and optimal debt books operating within structurally supported property sectors. The macroeconomic landscape has clearly changed quite rapidly since the start of 2022 and tailwinds from falling yields are clearly behind us. We are regarding with caution property investment strategies based on financial engineering, reliant on external growth funded by low debt costs, and focus going forward will be on those companies that can generate alpha.
Whilst the more challenging environment we find ourselves in will drive out some investors, it will also create opportunities for those highly skilled management teams, ripe within the listed sector, to create value.
We believe the current dislocation in the listed real estate space offers an attractive entry point to access these opportunities, and we see 2023 as carrying the potential for a share price rerating as inflation, interest rates and property values start to find stability. Certainly, there are more reasons to be positive on property than we were seeing in the middle of the 2022 perfect investment storm!
