As investors seek out real assets, stockmarket-listed real estate is set to increase in popularity. Growth in US and Japanese Reits and the European market will see this trend increasing
In an environment of increasing inflation expectations and long-term low bond yields, an increasing number of investors are likely to search for real assets. Stockmarket-listed real estate offers liquid access to such investments and currently stands out favourably amongst other traditional real asset investments, owing to its combination of both inflation hedging and, as importantly, an attractive income yield. Historically, in periods of higher than average inflation, property stocks have re-rated significantly above general equities.
However, to best capture inflation hedging in real estate it is important to analyse from a bottom-up perspective and focus on markets where there is an attractive demand (tenant demand)/ supply (developments and vacant space) balance. Areas, such as London and major cities in northern and western Europe, are ideal as there has been limited development in the last five years, ironically from a real estate perspective, as a result of the credit crisis still restricting the availability of development finance.
Another area is top-end prime destination shopping centres with high footfall, where there is strong demand from retailers who are rationalising their store footprints to focus on large ‘flagship’ stores, to complement their online and other retailing channels. On the continent, leases are typically index-linked annually and therefore have the advantage of being able to capture inflationary growth for income earlier.
Unique access to low cost debt further drives earnings growth
These index linked leases in the strongest locations in northern Europe are set to continue to deliver healthy top line income growth for the market leading real estate investment trusts focused on these regions. What is more, this top line growth will be further enhanced by a reducing marginal cost of debt for these companies.
These top rated property companies have been able to tap into alternative financing to raise unprecedented low cost, long term finance, raising finance with interest costs ranging from as little as 0.75-2.5 per cent that is fixed for five to seven years thanks to the demand from the corporate bond market. Examples of this can be seen in the table below.
The top line income growth, combined with this reducing cost of debt, will deliver attractive earnings growth for these companies. For example, the French Reit Unibail-Rodmaco has recently guided for 45 per cent earnings growth over the next five years (they have a very consistent record of outperforming their guidance). This is as a result of locking in long term, low cost finance and healthy contracted cashflow growth in their destination shopping centres. If inflation were to accelerate, the operational gearing of these prime Reits, with their broadly fixed long-term cost base, would drive significant earnings and capital growth.
Likely beneficiaries of increasing European bank de-leveraging
This access to alternative, low cost debt also places these market leaders in a position to benefit from de-leveraging banks, particularly on the continent, with earnings enhancing portfolio acquisitions. Just as US Reits significantly benefitted from access to alternative finance and acquisitions from de-leveraging US banks earlier in their cycle, so that opportunity is now arising in the pan-European market and we have seen the first evidence of this recently.
Real estate securities diversification from equities rapidly improving
The quoted property sector, with this active management, liquid access to underlying prime assets and ability to benefit from record low cost finance, is attractively positioned for investors looking at real estate. Furthermore, the high correlation of the sector to equities is rapidly diminishing as the real estate sector stabilises from the volatility of the worst property crash on record during 2007-2009.
I would expect the return of property securities offering investor portfolio diversification to improve further, as Reits deliver steady cashflow growth in a broadly flat, underlying real estate market, similar to that seen in the mid-1990’s to mid-2000’s following the previous real estate crash and recovery.
Global real estate securities have proven to be a strong investment over the last few years, benefitting from the devaluation of sterling, the strong growth in US Reits, as they re-equitised (replace debt with equity) US real estate from the rapid US bank de-leveraging, and the more recent strong return of Asian and Japanese property companies.
The US and Japanese Reit sectors now trade at a premium to net asset values. Despite Europe only making up a small segment of the global real estate securities market, I believe the sort of opportunity presented to US Reits two to three years ago is now approaching the pan-European real estate securities market, as these strongly financed sector leaders benefit from the pending European bank de-leveraging.
Alex Ross is manager of the Premier Pan European Property fund.