Booming property markets eye central bank actions

We tend to think of real estate investors being fixated on interest rates, particularly in the UK and the US, but in half of the developed world the debate is the opposite. Japan, China, the eurozone and Australia all expect further monetary loosening as the next step from central banks.

European commercial property enjoyed a particularly strong run at the turn of the year, boosted by the European Central Bank’s announcement on quantitative easing in January. Some €57.9bn was invested in the sector in the fourth quarter of 2014, the strongest quarter since Q2 of 2007, according to Knight Frank. Spain, Ireland, the Netherlands and regional property in the UK have been popular, while the Portuguese market has kicked back to life, marking the last of the peripheral markets to show signs of recovery.

Nonetheless, market focus has now switched to the prospect of interest rate rises in the US and to a lesser extent the UK. Janet Yellen, chair of the US Federal Reserve, has been at pains to point out that any delay in monetary tightening until objectives for employment and inflation are reached in full would risk overheating the economy. In the UK, predictions for the first rise have edged back to August 2016 owing to new indications of deflation, weakening economic growth in the US and concern over Greece.

“Investment opportunities, especially in the UK and continental Europe, have never been so strong,” says Pol Robert Tansens, head of Real Estate Investment Strategy at BNP Paribas Wealth Management.

In addition to high net worth clients, institutional investors and pension funds are also discovering real estate as an asset class in their hunt for yield, he explains. It offers a yield of 3 to 4 per cent compared with a risk free rate of barely 1 per cent, which is still a split of 200 basis points. This explains the demand even where the economic perspective is not so encouraging, says Mr Tansens.

The key question today is what happens when interest rates rise, he adds, knowing how the market has panicked as bond yields have risen slightly in recent weeks. 

“Our clients ask us what will happen and we say that rates may rise by 100 basis points but not over the short term. You could argue that when rates start rising, this is not necessarily bad news for property as rates may be rising because of a stronger economy, a better labour market or higher inflation.  High inflation can be good for property investors, on condition that the financing is at a fixed rate and not a floating rate,” adds Mr Tansens.

“The perception in investors’ minds is that real estate is heavily driven by interest rates and bond yields, and as we know, in listed markets, perception can become a reality,” says James Wilkinson, European chief investment officer at BlackRock Global Real Estate Securities. 

However the gradient of rate rises in the UK is likely to be gentle, and he believes the managements of most UK Reits (real estate investment trusts) have done stellar work to re-shape their balance sheets to this point in the cycle, so that they are now more conservative than in 2006 to 2007, have low loan to value ratios, high interest cover, and longer lease and debt duration. 

Most people believe interest rates will remain below 2 per cent in the UK for the medium term of five to 10 years, but a few commentators, such as financial journalist David Stevenson who recently gave a presentation on this at a Schroder client conference, have been suggesting rates may stay this low  for multiple decades.

This is critical as Reit performance closely correlates with the 10-year bond universe. Guy Mountain, portfolio manager at Sarasin, uses a chart of Reit performance plotted against 10-year bond yields in his client presentations, to show how the two move inversely. For example, at the beginning of 2014, 10-year bonds reached 3 per cent and investors thought they would rise to 4 per cent and sold down the Reit market. Consequently, Mr Mountain is “slightly wary” about the situation this year. 

“The economic picture is mixed and we are looking at September for the first rate rise from Federal Reserve chair Janet Yellen which will be designed to encourage savers to spend as it will be a signal the economy is strong,” he says.

In recent years, London has consistently held the top slot as Europe’s premier destination for real estate investors, and there is no let up in demand. For example, in April, 95 Wigmore Street, now an office block, was sold for £225m (€311m) to UBS Global Asset Management, which was at a 16.4 per cent premium to its latest valuation in April. 

Yields of between 8-10 per cent on regional commercial and industrial properties in the UK are also enticing while the high-speed rail link HS2 between London and the north of England will create demand for commercial and industrial properties in certain areas, and appeal to businesses considering relocation.

“Logistics is incredibly popular this year as it is yielding more than retail,” says Mr Tansens at BNP Paribas. “That is remarkable as 20 years ago no-one was interested in the sector but today, while logistics is not attractive for capital gains, its cash yield is higher than offices’.” 

The sector can also be viewed as  complementary to retail as it competes with e-commerce. “In my country, Belgium, e-commerce is gaining in importance after a slow start and currently accounts for around 5 per cent of consumer sales,” he says. “Belgium and France have been slightly lagging compared with the Dutch and British and will be catching up.” 

Third Avenue is also constructive on industrial real estate across all European markets.  “Companies like Segro plc that own modern logistic facilities and well-located warehouses are not only benefiting from a cyclical recovery in most markets but also a structural increase in demand for space given the rise of e-commerce and modernised supply chains on the continent,” says portfolio manager Michael Winer.

Towards the end of last year, many global investors focused on the US as a safe haven with its good growth rates, low interest rates and a strong consensus on the strength of the dollar. This prompted some of the more tactical managers to sell US and buy non-US assets. Now that there is greater consensus on Europe, some managers are also thinking of moving out of this region. 

“Six months, ago views on Europe were split,” says Jon Cheigh, global portfolio manager at Cohen & Steers.“The obvious question is whether now is the best time to move out of Europe. What were fantastic opportunities at the start of the year, are now just plain good.” 

He still thinks that France is good value, however. “Although the fundamentals are not so positive, the investment community is negative on the country and appears to be more negative than we are.”  Mr Cheigh particularly likes the quality end of the retail sector where sales are accelerating, noting that retail sales in Europe have outpaced retail sales in the US.

The GDP of the E7, the largest emerging markets comprising China, Russia, India, Indonesia, Mexico, Brazil and Turkey, is forecast to overtake the G7 by 2030. One major theme here is rapid urbanisation. The UN forecasts there will be 40 global cities by 2025, and there are already 60,000 people a day moving to cities in China and India. Long-term, this will boost the residential market in China which is already supported by government initiatives such as lower interest rates and down payments. 

Mr Cheigh also likes office space in Hong Kong, which is burgeoning from its position as a financial services hub. Over the last nine to 12 months the Chinese government has introduced many reforms leading to the liberalisation of capital markets which has driven a rally in the A-Share market. Over three to five years, the Chinese government will try to create a bigger equity culture in China with greater global ownership of stocks and increasing equity rather than debt in the corporate system, believes Mr Cheigh. 

“All these roads lead to bankers being very busy in Hong Kong and already trading commissions are increasing,” he says. “It will be a key dynamic for years to come.” 

Some funds, such as Third Avenue Management Real Estate Value, make a speciality of restructurings, reorganisations, and recapitalisations, with investments such as  Colonial in Spain (recapitalisation), IVG Immobilien in Germany (reorganisation), and Gecina in France (restructuring), enabling the fund to invest capital at prices well below private market value.

 Unlike most of its peers, the Third Avenue Value fund is largely steering clear of mainstream Reits in Continental Europe. 

“While these companies own very high quality real estate portfolios and are largely run by very competent management teams, the stock prices for most of the European Reits are trading at levels well in excess of underlying net asset value thus limiting return potential in the years ahead,” says Mr Winer.   

Focus on income

If wealth managers are clear about one thing, it is that investors should focus on income stream and not on capital growth. The property sector currently offers a dividend yield of around 3.5 per cent and should grow at an attractive rate, significantly ahead of global inflation. 

“I am advising clients to first focus on the cash income  and to consider any capital gains in the mid-future as a bonus,” says Pol Robert Tansens, head of Real Estate Investment Strategy at BNP Paribas Wealth Management. “Some investors expect IRRs [internal rate of return] of 10-15 per cent but we need to warn them these returns are unsustainable in the mid-future.”

Mr Tansens advises sticking to prime assets which will continue to do reasonably even if the market deteriorates. However, he also suggests a small portion of a portfolio could be invested in distressed but not necessarily secondary property in perhaps Spain, Ireland or the Netherlands, to complement the return of prime assets. For example a shopping mall in Madrid or Barcelona or even a regional city in the UK could generate an IRR of 10-12 per cent – higher than the 4 to 5 per cent for most prime assets. 

Listed real estate is well suited to active strategies.“It’s a bit like the small cap equity sector,” says James Wilkinson, European chief investment officer at BlackRock Global Real Estate Securities. “With both small cap and listed real estate ultimately the fundamentals will win out, but in the short term these markets are often driven by other factors. There is a lot of dislocation between fundamental value and share price. Pricing is inefficient and chock-full of discrepancies.”

Alan Higgins, CIO at Coutts,  has recently recommended the AEW UK REIT, a small fund of £100m (€138m), which invests in properties in secondary locations outside of London and  has just purchased a business park in Oxford for £8.2m, yielding 9.4 per cent.

Mr Higgins says most funds have a nationwide remit and it is hard to find a specialist slant. He adds that management skill is crucial where funds are investing in short lease and secondary property, and restoration of the property is  required.

VIEW FROM MORNINGSTAR: Impressive returns

Listed real estate companies, including real estate investment trusts (Reits), have performed well globally over the past 12 months with the FTSE EPRA/NAREIT Developed index gaining 24.2 per cent in euros (up to 2 June, 2015) on the back of rising world equity markets. 

Funds in the Morningstar Property - Indirect Global category have returned 22.2 per cent on average. The current low interest rate environment in Europe and the US continues to provide real estate companies with access to historically cheap debt financing. In the US, the macro environment has been generally favourable to the sector but the threat of rising interest rates could be a headwind going forward. 

In Europe, the Property – Indirect category posted a 21.5 per cent gain. Germany has been one of the strongest performers thanks to a major wave of consolidation in its once segmented real estate sector. The FTSE EPRA/NAREIT Germany index rose 31.3 per cent over the past 12 months.

AXA WF Frm Europe Real Estate, rated Silver, has benefited from the buoyant German market with a strong stock selection in the country. It has been one of the better performers over the past year with a 21.6 per cent progression. Manager Frédéric Tempel has been a successful investor in real estate stocks for more than 10 years. 

Three managers, organised by geographical area with one dedicated to Europe, support Mr Tempel in the analysis and management of the fund. He targets quality real estate stocks in Europe by first excluding companies with poor transparency in terms of corporate governance. A fundamental analysis then assesses the viability of the business model, the valuation and the identification of catalysts. This investment strategy has proved its worth over time with above average risk-adjusted performance since its inception in 2009. 

Delta Lloyd L Global Property, rated Neutral, outperformed the global category average over the past 12 months (23.7 per cent against 22.2 per cent) thanks to a positive overweight in Hong Kong. Manager Roy van Wechem has been at the helm since 2006, yet his experience in the global real estate sector is fairly limited, having previously run a euro credit fund, from 2001 to 2006. The team around him is small by industry standards, as there are no other resources purely dedicated to real estate markets at Delta Lloyd. Although the fund benefits from reasonable fees, the limited resources available to the fund manager limit our conviction in its long-term potential.

Schroder ISF Global Property Securities, rated Neutral, delivered results in line with peers. It is still early days for the new team behind this fund. Schroders brought the management of this strategy in-house in August 2014 and hired Tom Walker and Hugo Machin from AMP Capital to head the team. They have good-quality industry experience, albeit predominantly European-focused. 

Their Asian offering is more robust even though it has not fared very well in the past 12 months. Schroder ISF Asia Pacific Property Securities, rated Bronze, has significantly lagged the Property Indirect – Asia category over one year (19.1 per cent against 23.8 per cent). Stock selection hurt relative returns in Japan and Hong-Kong. This fund is a worthy option however. Portfolio manager Adam Osborn has dedicated his 23-year investment career to covering Asian real estate. He is ably supported by an experienced group of seven country analysts. Mr Osborn has built an impressive long-term track record with this fund. With a robust investment process and reasonable fees, this fund is an attractive way for investors to get dedicated exposure to the Asian real estate sector.

Mathieu Caquineau, senior fund analyst, Morningstar