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.
Headwinds
The stock market listed Pan European real estate sector has faced further headwinds in recent months, with core inflation levels remaining high, further dampening earlier market hopes for interest rates to partially reverse their current record pace of increases.
This increased cost of finance concern has been amplified by the failure of US regional bank, Silicon Valley Bank, raising fears on the US regional banking sector with the possibility of credit finance conditions tightening, with margins on banking lending increasing and the availability of this finance becoming scarcer.
Heavy weather
Equity markets rapidly adjusted downwards for those sectors which are reliant on the availability of finance, most notably real estate as the worst casualty of the global financial crisis in 2008 when credit markets froze. However, this market concern on real estate finance needs quantifying by geographic region and the structure of bank lending in this real estate cycle.
Sunny spells
For some regions, lessons have been learnt from the global financial crisis. In the UK and continental Europe, banks’ real estate lending has become increasingly regulated following the irresponsible lending structures that led to the collapse of several major banks in the 2008 credit crisis. This has led to the introduction of large institutions to the real estate lending market, such as pension funds and insurance companies, reducing reliance on banks for real estate finance.
In the UK, past property bubbles in the early 1970’s, late 1980’s and 2000-2007 were largely caused by banks lending at high loan-to-value ratios as property values were rocketing. At the peak of each of these property bubbles, UK bank lending to commercial property as a proportion of their total lending increased from a low point of less than 5%, towards the 10% level. Property values then tumbled as banks looked to unwind this over-exposure to real estate.
Today, looking through the Q1 2023 Savills Research it is pleasingly evident that there has been strong discipline in UK bank lending, with their commercial real estate exposure at around 5% of their overall lending. In most of Europe, it is a similar scenario with commercial real estate lending at just 7% of bank lending exposure. As such, despite the pressure on property values from rising finance costs, there has been very little sign of any stress from the banks in the UK and Continental Europe.
Storm clouds
In contrast, in the US, regional banks freed of tight regulation in recent years, have clearly been over-extending their exposure to commercial real estate lending, with an estimated 43% of all US regional bank lending to commercial real estate. It is also elevated at large US banks where this figure is almost double that of Pan European markets at around 13% according to Savills research. It is no surprise to us that we are seeing widespread commentary towards the US commercial real estate market and its potential impact on the US banking sector.
Furthermore, the sizeable US regional office market outside the leading cities is challenged by the major headwind from the trend towards working from home, with occupancy and rents in decline and very limited investor demand.
Offices in many UK and European cities also face these pressures, but the key fundamental difference here is the opportunity in these pan European cities to get change of use. This is due to the tight land supply and restrictive planning on brownfield and greenfield land, principally to residential, where there is a shortage vs demand in these urban locations.
Whilst there are of course exceptions, the characteristics of US (and many Asian) markets offer more extensive land supply and less restrictive planning on this regional urban land. This restricts the ‘safety valve’ of change of use for much of this increasingly obsolete office stock.
A positive forecast?
It is early days for this dynamic to be reflected in underlying real estate returns. We believe the fundamentals of the pan European markets, with their inflation-linked leases in European commercial real estate and a significantly better structured bank lending market to commercial real estate, will see pan European real estate shares reverse some of their underperformance verses their US peers since Brexit.
Indeed, the negative sentiment to the pan European real estate sector has seen discounts widen to around levels reached at the trough of the early 1990’s and 2007-2009 real estate downturns. This is despite property yields already increasing materially to account for the higher interest rate environment.
This deep discounting is reflected in fund managers reducing their allocations to commercial real estate to the lowest level since December 2008 according to the Financial Times, Bank of America Fund Manager survey. This was just a few months before the significant recovery in the real estate securities sector. For contrarian investors, this fund manager under-ownership is often regarded as a bullish signal. The continuing rental growth from undersupplied real estate markets, combined with the rapid correction in underlying property values, suggests to us this contrarian view may be backed up by the sound fundamentals we can see.
