Alex Ross, manager of the Premier Miton Pan European Property Share Fund, shares the importance of understanding why this next property cycle will see a different type of winner to that seen during the decade of ultra-low rates.
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 last decade or so of ultra-low interest rates provided a unique property cycle, allowing ‘easy’ income returns from real estate using low-cost debt against typically long leased property, thus benefiting from the lucrative carry-trade of a property yield well in excess of a record low finance rates, as reflected in the chart below:
UK All Property Equivalent Yields v 10 year Gilts
Source: Van Lanschot Kempen: Datastream, IPD, Kempen estimates. January 2024. Data from 31.01.1970 to 30.11.2023
Past performance is not a reliable indicator of future returns.
This provided a platform for a number of less operational, typically externally managed property investment companies, to launch on the equity market to acquire long lease property, requiring limited asset management but able to deliver an attractive dividend yield from the wide ‘yield gap’ provided by the property yield over the cheap cost of finance.
However, their business model to grow income streams from acquiring real estate through further equity raises combined with cheap financing is now challenged, as we are now entering a more normalised real estate market, where there is only limited (if any) accretion using debt. With a few notable exceptions, many of these vehicles are sub-scale and now unable to raise equity accretively, thus impairing their external growth business model. Therefore, the only option ahead will be consolidation to create scale, although even with increased scale we still question the earnings growth profile ahead for many, particularly when they are faced with refinancing existing low-cost debt in the coming years against limited income growth coming through from the long-term rental leases.
We don’t expect interest rates to decline to the low levels of the past and expect a more inflationary and higher interest rate environment than we have been used to over the last 15 years due to a number of factors, not least the de-globalisation of trade. However, many property companies have thrived in past cycles where the cost of finance was materially higher than what we have seen in the last decade and indeed for some prolonged periods where the cost of debt was materially above the property yield. In this environment, generating cashflow growth is absolutely key in delivering attractive real estate returns and this next cycle will require active management of real estate to grow these cashflows.
Typically, this would be done through strong operating platforms managing short leases in high demand assets (e.g. self-storage, student accommodation etc) to capture cashflow growth; or acquiring previously mis-managed real estate and growing the rents/reducing vacancy following asset management initiatives (with opportunities across all sub-sectors); or re-developing mis-positioned/tired real estate and capturing the prime rental tone and valuation over the previous secondary rent/valuation (with opportunities here also across all sub-sectors). The final element of real estate asset management is through clever deal making to enhance earnings, as corporate acquisition opportunities emerge both within and outside the listed sector.
Best in class, active real estate management teams will return to the fore in this environment and their operational platforms/expertise will be become increasingly valuable and sought after as investors and asset allocators better understand the importance of this in their real estate sector positioning ahead. The uniquely tight planning regimes in the UK and western European markets makes such active management particularly viable due to the dearth of competing supply options for these active management initiatives, thus underwriting the necessary supply/demand pricing power to generate significant value creation returns.
Furthermore, we expect the clear winners to be those asset managers with smaller portfolios, who are able to ‘move the needle’ on asset management initiatives, in terms of both growing earnings and net asset values. Many of these smaller and more operational property companies were off investors’ radar in the last cycle given the attractive returns available from owning long income off low-cost finance, but we expect the market to increasingly understand the need for more operational management platforms, where strong management teams are able to create value through real estate asset management. Investors seem to have overlooked the value of many of these operational platforms which is not reflected in net asset values, but where we expect the equity market to increasingly ascribe value through this more traditional property cycle ahead.
With the use of debt finance now less viable, we believe the underlying real estate market will provide a number of growth opportunities ahead as private property companies and funds approach expensive refinancings. This is the time for equity to replace debt in real estate, and real estate equities is now the logical platform for this required ‘re-equitisation’ of real estate debt. It is pleasing to see this starting to take place on the Continent, notably within the logistics sub-sector, and we are actively encouraging the best positioned companies in our sector to get on the front foot and participate in this re-equitisation opportunity to grow their cashflows and earnings. One of the barriers to this is the reluctance in the UK to raise equity at a discount to net asset value. However, if such a raise is earnings accretive with management presenting pre-identified corporate acquisition opportunities in either the public or private real estate markets, then we are highly supportive and we believe the market is increasingly becoming aware of the need to be less fixated on net asset value and more on earnings growth (with the notable exception of the London office market where net asset values are key metrics in recognising value creation through refurbishing buildings – aside from the income improvements this creates). This is how the US REIT sector has grown so significantly and the opportunity now stands before the pan European REIT. In our view, the leading and active management teams who understand this will be well rewarded in both the short and long term from growing earnings and increasing in size in a way that is, of course, fully aligned with shareholders.
Real estate asset management, whether through operational expertise or through accretive use of the corporate wrapper, is now returning to the fore and in our view this will be widely reflected in relative share price ratings ahead amongst the different listed property company structures in the sector. As the best in class managements see their ratings improve, this will in itself create the platform to further grow accretively. With most of the management teams we regard most highly typically also well aligned with shareholders through material shareholdings, they are well incentivised to grasp this opportunity and we aim to travel on this journey alongside them as shareholders.
