Real estate rebounds as recovery takes hold

Europe’s real estate market has staged a strong recovery, with the FTSE EPRA/NAREIT Europe index gaining 6.6 per cent over the year to end May, as investors flooded into the sector and particularly prime property. These are attractive returns compared with alternatives such as bonds, and the arguments for investing in the asset class remain intact.

 “The European market is well positioned for global cash, benefiting from outflows from Asian regions,” says Paul Van De Vaart, manager of Aviva Investors European Real Estate Securities fund, who does not believe the market has overheated. “The largest companies are still trading at or around NAV – not at huge premiums.”

Take Unibail-Rodamco, widely considered Europe’s highest quality Reit (real estate investment trust), which yields 4.5 per cent, compared with typical spreads on European government bonds of 250-300 bspts. “Although in the short term this looks a little expensive, I don’t foresee a large correction in Reit prices, and looking 12 months ahead at income streams, today’s valuations look attractive,” says Jan Willem Vis, manager of Parvest Real Estate Securities World fund, at BNP Paribas Investment Partners.

“With more QE from central banks, 10-year bonds will stay low for a long time, and on that basis, these companies are still the right place to be.”

Many fund managers are nonetheless considering whether to reduce their funds’ overweight to Europe and take profits.

“Our focus is still on the so-called income countries where dividend yields are at significant spreads to 10-year bond yields,” says Mr Vis, who at the time of writing had just decided to retain his 300 bspt overweight to Europe.

“The spreads were large because of uncertainty about rental levels and their ability to maintain dividends. Now Europe is moving out of recession this income is more secure and so spreads are coming in, and Spanish and Italian five year bond yields have moved close to UK and US levels.”

As concern about a correction in Europe recedes, the debate is turning to whether investors should switch to secondary and tertiary properties. “Around the globe everyone is interested in high quality long leases and steady valuations but when everyone is looking at the same products, that is the time to find the next leg,” says Mr Vis.

However, he says this is easier to express through direct investment. “If I personally was a direct investor in real estate, I would now be selectively picking buildings in the secondary market, but the fund invests in listed stocks which have already priced in that improvement.”

Making a meaningful investment in the secondary market is also more easily achieved in small funds where one major property purchase can be a game changer.

In retail property, scale is still king, with funds chasing the biggest and best quality shopping centres, although there may also be a place for local neighbourhood style shopping centres.

The UK is ahead of the curve on internet shopping but UK shopping centres appear mispriced and cheap versus their continental counterparts, says Matthijs Storm, head of Kempen’s real estate securities fund management team. The UK continues to attract Asian companies such as China’s Dalian Wanda Group, which plans to invest up to £3bn (€3.75bn) in regeneration projects in Britain.

 “Food retail in the UK has not been that big online, other than Ocado, but it has massive scope and as food retailers represent a major part of shopping centres, some could be rendered obsolete, particularly on the continent,” adds Mr Storm. “In France for example shopping centres are often anchored by food retailers such as Carrefour. Without the need to food-shop, customers would not go there.”

There has been a lot of hype around the Spanish property market, but its shopping centre market is oversupplied, and the nation’s recovery is not driven solely by consumer spending. Only the best quality shopping centres will survive and those cards have already been reshuffled, leaving new participants with lower quality assets.

Rainer Scherwey, manager of Credit Suisse Real Estate Fund International, likes the Spanish office market, but points out that office space in Madrid has vacancy rates of 4-5 per cent in the city, compared with 10-20 per cent vacancy rates in office parks in the surrounding neighbourhoods.

“We like offices for their stable long-term cash flows,” he explains. “However despite this cash flow security, there is risk in offices if not enough care is taken with the location.” In the UK, for instance, the fund holds property in secondary markets such as The Princes Exchange in Leeds but, in that micro market, as he points out, it is prime property.

Opinion is split on the raft of IPOs in the sector such as Hispania Activos and Gruppo Lar. Some European companies have been laggards for several years, and a float can be seen as a good opportunity to raise cheap equity for those that need leverage. However, the management team may not be able to secure the right assets at the right price, leading to comparisons with August 2009 when most UK vulture funds subsequently underperformed existing structures.

One of the most fancied markets is Paris. “Paris is a key market as it is closer to the bottom of the cycle, so there is more room for improvement and there is a supportive financing environment and improvement in occupancy,” says Frédéric Tempel, fund manager at AXA IM. He likes office space in the Paris region, which is on low valuations.

The Reits market itself is also rich in scope for relative value plays. “Investors have an opportunity to benefit from the strategic shift in Europe’s listed real estate market,” says Rogier Quirijns, senior vice president at Cohen & Steers Capital Management.

“The challenges facing the region have created a ripe environment for a restructuring of European Reits, comparable to the US following the savings-and-loan crisis in the early 1990s.”

Over 20 years, US Reits have returned 10 per cent yearly on average, whereas the UK and Europe have lagged, he explains.

“Some European Reits have responded to the crisis by adopting important reforms that should improve shareholder returns over time,” says Mr Quirijns. “European banks continue to deleverage their balance sheets and this process is accelerating after the recent ECB actions, creating a substantial funding gap that must be addressed. These issues will necessitate a growth evolution of the Reits in Europe, and together with better structured Reits in Europe, this should benefit shareholders.”

Some European Reits have already begun implementing reforms, such as an increased focus on a specific sector or region, efficient capital raising, and stronger alignment between management and shareholders via compensation based on total shareholder return versus peers. “Companies that resist reforms will likely be left behind, as their cost of capital will remain relatively high and their shares are more likely to trade at a discount to NAV or peers,” argues Mr Quirijns.

He cites how Hammerson, Klepierre and Corio sold off their office properties and non-core assets to focus on prime retail in the UK and Europe, and how Land Securities reforms and rotates the portfolio, helping to reduce its loan-to-value ratio and the portfolio size, while creating a more profitable development pipeline. French Reit Gecina also reduced its loan-to-value ratio from close to 50 per cent during the crisis to below 40 per cent and increased its focus on Paris offices by diluting its residential portfolio and selling industrial assets.

With less than 10 per cent of commercial property in the hands of listed Reits, developing broad knowledge is an advantage, and managers are increasingly using data vendors such as Local Data Company which looks at shopping centres in the UK or Codata in Belgium which offers a similar service. This is replacing some site visits and beginning to play an important role, particularly because most mispricings in European property occur on an asset level.

This fluid backdrop suits the small minority of highly active funds that can short stocks. For example, when the Federal Reserve announced the taper last year, F&C Real Estate Securities fund’s managers shorted around 9 per cent of the overall fund exposure. Most of the sector follows the FTSE EPRA/NAREIT Developed Europe index which is highly fragmented, consisting of around 85 stocks, of which 54 have very small weightings.

 “With two thirds of the stocks accounting for only 25 per cent of the index market cap, it includes a long tail of small caps,” says co-manager Alban Lhonneur. “Most traditional funds can’t display a negative view on these small cap weightings.”

Self-storage is a popular niche, particularly in the underdeveloped UK market. “Many investors put this in the same bracket as the housing market and housing transactions, but generally it is more linked to GDP growth and demographics,” says Cohen & Steers’ Mr Quirijns.

“As a result of the growth in London’s population, the mayor and boroughs have to deliver new homes on a scale not seen since the 1930s. As such, London is growing faster compared to other global cities. Occupancy of self-storage was 85 per cent pre-crisis and is now 75-80 per cent, while in the US it is 90-95 per cent.”

The UK is a rather immature market with strong growth prospects, he explains – for the next five years around 230 towers are planned, of which 113 are approved, and 72 proposed and 45 under construction. And these are only the towers, of at least 22 floors. 

Identifying themes

“We are recommending client portfolios have an increased weighting in UK commercial property to 4 per cent, up from 2.5 per cent, at the expense of other alternative investments, as it represents a pure play on the nation’s recovery, is a hedge against inflation and offers a good yield,” says Stephen Williams, equity analyst at Brewin Dolphin.

The secondary retail property market has seen a lot of demand from overseas investors but Mr Williams is  not looking for this asset class to “shoot the lights out”, especially as equity markets are fairly positive overall.

He likes the Scottish Widows/Aberdeen property fund, with its heavy weighting in warehousing, benefiting from strong demand and covenants. The company constantly looks for interesting themes which have included the new retail distribution model, student accommodation, the health sector and “re-shoring”, where companies bring  back-office functions back to the UK from overseas.

Companies benefiting from Crossrail, such as Derwent London and British Land, also appeal.

Enrico Mattoli, head of ultra high net worth business (UHNW) for investment products and services Apac at UBS, says clients can access real estate by listed vehicles, funds (often private equity) and direct offerings, which may be Club Deals or segregated mandates. UBS’ global real estate arm runs segregated mandates for clients with $200m (Ä147m) to invest in this asset class. The UBS Campden Family Office Survey reveals UHNW individuals invest 16 per cent of their portfolios in physical real estate.

In 2013, the US housing market recovered from all-time lows creating an opportunity for investors. But buying physical assets has complicated tax implications for non-US residents. Neuberger Berman designed a product for IPS APAC based on a big mortgage book and active engagement with borrowers, which attracted $500m.

Mr Mattoli says the house view is that 10 year Treasuries will yield 3.1 per cent this year and 3.2 per cent in 2015. “As rates rise, we see a challenge for US Reits that have done well this year.”

He sees a similar recovery story in Europe now, and he likes peripheral Europe such as Spanish offices. London property continues to attract large inflows looking for trophy properties, but there is still room for added value.

Japanese Reits could benefits from rising yields, believes Mr Mattoli. Year to date, Japanese Reits are down 9.8 per cent, much of this being down to hedge fund repositioning.

UBS has also developed a capability for investing in farmland, through owner-operation models, in Australia and New Zealand.

Solid returns

In 2013, European funds investing in property-related stocks outperformed their global counterparts. On one side, European funds were helped by the average UK component in their portfolios, while global funds were negatively impacted by North American exposure.

Over the past 12 months, the Property-Indirect Europe category performed best across regions, having posted solid returns (+15.73 per cent in euro terms as of the end of May 2014).

During the first half of 2014, many companies in the sector published solid annual results which, combined with low rates, have continued to fuel investors’ demand for higher yield investments. During the first four months of 2014, funds in the category gathered more than €350m in net inflows from investors around Europe.

AXA WF Framlington Europe Real Estate Securities was one of the top performers over the past 12 months. Companies with little transparency in terms of governance are excluded, and the fundamental analysis involves assessing the viability of the business model, valuing each company and identifying catalysts for revaluation. The fund investment universe was expanded from the eurozone to the whole of Europe in Jan 2009, and since then the fund has outperformed its category every year other than 2010.

The ING Invest European Real Estate fund clusters shares with high mutual correlation to achieve better diversification. These are often companies investing in subsectors, such as shopping centres or offices. Despite somewhat disappointing recent results, historically the fund has managed to outperform its peers.

Álvaro de Liniers, fund analyst, Morningstar Spain