Alex Ross
Premier Miton Pan European Property Share Fund manager
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.
Neither a borrower nor a lender be?
The recent demise of Credit Suisse and the cycle of interest rate increases by the European Central Bank (ECB) have thrown into question the level of European bank lending to the commercial real estate sector.
Unbundling these concerns a little, in most European real estate markets lessons have been learned from the global financial crisis (GFC), where poor real estate lending standards caused huge distress to the banking system.
Looking at where we stand today, bank lending in this post GFC cycle to real estate has been restrained due to high regulation because of the fall out of the banking crisis that arguably instigated a seismic global recession. For example, in the UK, commercial real estate lending as a proportion of the banks’ loan books is at around record low levels and at around half the previous peaks which caused the real estate crashes of the late 80’s and in 2008.
Looking at Europe on aggregate, the only area in our markets where bank lending to real estate has been excessive is in Sweden, but this is partly compensated for by the strong rental fundamentals and a market that is way ahead of the rest of the world in the delivery of sustainable buildings.
Let the inflation trend be your friend
Looking at the Pan European property market through the lens of borrowing costs and bond yields, we can see that to account for the higher borrowing costs and bond yields today – because of increasing interest rates – real estate yields need to also move higher. This expectation is starkly reflected in the deep discounts to asset values in Pan European property share prices.
However, importantly the UK commercial property market has already seen steep value falls to reflect this higher yield requirement following its fastest pricing correction on record, with values down 20% in the second half of 2022 in a fall which has now almost matched that of the 3-year falls in the early 1990’s.
In continental Europe, borrowing costs are still lower than for the US and UK, but there is also a requirement for higher property yields. This is where the inflation-protection characteristics of European commercial property come to the fore. Much of this increased yield requirement is occurring simply through most European commercial rent leases being linked to inflation, with the immediate and contracted higher rental income leading to a higher property yield. With expectations of inflation remaining relatively high through much of this year in Continental Europe, further property yield increases can be expected this year from this higher continued inflation-led rental growth.
A real hidden value in real estate
In our opinion, the rising rental income stream is the real hidden value in real estate today. What is unique about this current real estate downturn, relative to the last 2 major downturns of the last 35 years, is the limited development leading into this crisis across Europe. Brexit, the Covid-19 pandemic, low economic growth and the Russian invasion of Ukraine have meant limited appetite for property development and in our mainly supply constrained markets this means there is no oversupply.
This means we are still seeing pricing power in the hands of landlords across key markets, even in segments of the much-maligned retail property market. In the UK, retail property has already undergone a huge fall in rents and values in the UK over the last 4 years because of the seismic shift to online shopping.
However we are now seeing pockets of rental growth from a much lower rebased retail rents.
The office is dead, long live the office!
The post Covid rise of hybrid working has been hard to miss, the knock-on effect for the office market has been to throw into question the viability of office buildings.
However, in our view we will see a polarisation of demand like never seen before: Energy inefficient ‘brown’ offices will see very limited tenant demand, but modern, well-located energy-efficient green offices are seeing increased demand. This demand is coming from major companies who will require smaller (due to hybrid working) but better-quality sustainable office space, as they seek to both improve their carbon footprint and attract the best employees who will increasingly also demand a sustainable workspace.
It may surprise some, but we are still seeing rental growth within most European capital cities for best-in-class buildings, and the viability of the future supply of these will require tenants to pay higher rents as construction costs continue to increase.
A final word: record discounts, but why?
We have worked through what some would consider solid fundamentals in this note. Yet sentiment around pan European stock market listed real estate is deeply negative to a degree that we have, arguably, not experienced since the depths of the last financial crisis.
This negativity is reflected in the listed pan European real estate market now trading at around a record discount to its underlying net asset values. This is despite the inflation protection characteristics of real estate over time and the structural rental demand for property in key markets such as European capital city prime offices, logistics, storage and healthcare.
We believe such a level of discount pricing offers an attractive opportunity for investors who are comfortable absorbing the high volatility we see in the pan European real estate equity market. We expect the sector to deliver a sustained recovery once we see major underlying property transactions return (we note this has recently started in the UK, most notably in the logistics sub-sector) and firm evidence that bond yields and borrowing costs have reached their upward peak.
