These days, you rarely hear anyone mention European real estate securities. And they’re certainly not on the radar here in Asia.
[REITs]Within the global listed real estate universe, the UK and Europe only make up 11 percent of the market capitalisation of the sector (according to MSCI Indices). They make up only 6 percent of the market capitalisation of the 50 largest real estate stocks globally.
Asia, by contrast, makes up 42 percent of the global real estate market capitalisation and accounts for 46 percent of the top 50 stocks in the sector.
But this overlooked sector offers a growing opportunity right now.
Let me explain…
Europe is playing catch-up to the U.S.
After the global financial crisis (GFC), the U.S. took quicker and more evasive action to avoid a deep and long recession. For example, the U.S. very quickly established its program of quantitative easing (QE) in January 2009 and began a program of working out the mountains of non-performing loans and distressed real estate.
Europe did not move so quickly. In fact, it did not start its own program of buying QE until March 2015, more than six years after the U.S. Federal Reserve launched its own program. This earlier action in the U.S. led to a faster rebound in its economy and financial and real estate markets. Europe reacted slower… so its recovery is about two years behind that of the U.S.
But all the signs point to Europe’s recovery now being well underway and sustainable. After years of weak economic performance, third quarter growth for Europe came in at a solid annualised 2.5 percent and the fourth quarter is expected to be a repeat performance. This is a bit higher than the U.S., which is at 2.3 percent. It’s the first time since the crash in 2008 that Europe is growing faster than the U.S.
For 2018, growth in Europe is likely to be around 2.2 percent. And the European Central Bank (ECB) is still buying bonds under its multi-year quantitative easing program. That’s scheduled to be slowed down (though not stopped) in coming months. This continued money printing should continue to support liquidity and investment in the Eurozone.
Inflation is also likely to rise close to the ECB’s target of 2 percent in 2018. Unemployment is falling in most countries (Eurozone unemployment fell from a peak of 10.9 percent in 2013 to 7.6 percent by the third quarter of 2017) and aggregate investment is accelerating. (Aggregate investment has grown from minus 3.3 percent in 2012 to 3.7 percent in 2016 and is expected to grow further in 2017.) So the recovery is building momentum.
Still, as a result of its slower recovery, European stocks as a whole have massively underperformed the U.S. since the 2009 recovery kicked in. In U.S. dollar terms, the European market (as measured by MSCI) has recovered by approximately 88 percent since the 2009 trough. The U.S. market, by contrast, has moved up approximately 260 percent since the trough.
And European real estate stocks have underperformed U.S. real estate stocks significantly. U.S. real estate stocks have rebounded by close to 280 percent, while European real estate stocks have risen by approximately half that amount since the 2009 bottom.
But things are starting to turn around for Europe’s real estate market…
An overview of European real estate
Right now, there are several themes impacting European real estate companies and real estate investment trusts (REITs).
First, the European real estate sector is seeing a generally low level of new construction (with the odd exception, such as residential real estate in central London), and low to modest vacancy rates – especially in the office markets in central business districts of major capitals or financial centres. Low vacancy rates mean landlords have increased ability to raise rentals as potential occupiers compete for limited available space. This in turn can increase earnings of property owning companies and the value of buildings, and the values of the companies holding them.
Meanwhile, the growth in online retailers is hurting retail properties in Europe, just as this sector has been hurt in the U.S. Some 50 percent of the growth in retail spending in Europe in the coming year or two is expected to be online. But this trend is a strong positive for the warehouse and logistics real estate companies.
Real estate consultant CBRE tells us that globally, industrial property prices are rising at close to 7 percent, faster than global office prices (4.5 percent) and retail prices (2.5 percent). It is likely that industrial property is benefitting from the slowdown in growth in traditional retail real estate as a growing share of retail spending is done online.
The global trend towards flexible work spaces is also impacting office markets. This concept allows individuals and companies to occupy shared office space in specially designed buildings. Typically, the occupier does not have to commit to taking out a dedicated long-term lease, so it reduces the risk for the business. Investment management company Jones Lang Lasalle’s (JLL) research suggests that in London, flexible work space operations are now accounting for about 16 percent of new office take up in terms of floorspace. That was around one percent in 2010. JLL reports that globally, growth of office rents is accelerating, and this is led by growth in western Europe. This growth includes both traditional rental models as well as flexible space models.
Another big trend set to affect European real estate is Brexit. In simple terms, what is likely to be London’s loss will be many other cities’ gain. Many financial houses have already started plans to relocate staff and certain operations out of London to cities like Frankfurt, Dublin and Paris. Stock exchanges, clearing houses, lawyers, accountants and insurance companies will follow suit. And then we’ll see the manufacturers, exporters and trading companies also relocating parts of their operations.
I don’t for a moment believe that London will be hollowed out. But even small numbers of jobs moving from there to these cities can have a big effect on office and residential markets. These markets are quite tight in terms of supply anyway. So even modest amounts of new demand appearing in an already tight market is likely to increase rentals and prices.
Then there are interest rates…
Rising interest rates could lead to higher prices
When we think about prospects for real estate markets and stocks, we often circle back to interest rates. You see, rising interest rates raise the costs of debt in real estate companies, and can hurt profits. But in today’s extremely low interest rate environment, the impact of rising rates on the bottom the line of most real estate companies is minimal.
More important is the impact that rising interest rates have on property yields and capitalisation rates used to value properties. There is sometimes a relationship between the yields that investors are prepared to accept for property investments and the cost of capital.
In short, when interest rates rise, investors may require a higher rental yield on their property investments. For a given rental income then, they would expect to pay less for that property.
The yield/price relationship for real estate can be similar to that of bonds. When interest rates go up, the price of bonds comes down. (The key difference in real estate, of course, is that rentals can change over time, whereas as for bonds the coupon is typically fixed.)
This is the situation we see in much of Europe right now. Rental prices are rising, so investors can expect to receive higher rental yields on their properties. And that expectation of rising income might encourage higher prices for real estate acquisitions.
But European real estate is still cheap
The spread between bond yields and rental yields on property can be an indicator of how cheap or expensive real estate markets are. For most forms of prime office, warehouse and certain residential markets in Europe, the spread between property yields and government bonds can be as high as 5 to 6 percent.
For the overall real estate market in the U.S., the spread of property yields over 10-year government bond yields is around 200 basis points (2 percent), according to investment bank UBS. That is around the long-term average. For Europe, that spread is 400 basis points (4 percent).This spread is 100 basis points higher than the long-term average.
This tells us that European real estate is cheap relative to the U.S. market on this metric, and cheap relative to its long-term history.
And the European interest rate environment looks fairly benign at this point in the cycle. The U.S. Federal Reserve has embarked on a path of raising short term interest rates. But even the most extreme forecasts suggest that short-term rates will not rise by more than 100 basis points over the coming year.
In Europe, the spread between 10-year German government bonds and the two-year bonds are still a little wider than the long-term average. If that spread approaches zero, or goes into negative territory, it tells us that markets are expecting a recession, or at least a significant economic slowdown. That is far from the case at this point.
In addition, there is very little expectation of the ECB raising rates anytime in the next six to 12 months. The ECB has not yet stopped QE.
The ECB is way behind the Fed in the QE stakes. The Fed confirmed ceasing of its bond buying program in October 2014. Meanwhile, in December 2016, the ECB announced plans to cut the monthly amount of bond purchases from €80 billion to €60 billion in the first half of 2017. And this October, it announced there would be further cuts in January to €30 billion per month.
But just as the end of QE in the U.S. has had little negative impact on financial markets, I fully expect a similar outcome in Europe when the ECB finally stops its QE.
So overall, European real estate markets are in a good space right now. They’ve substantially underperformed U.S. real estate stocks – and even Japan and Asia-Pacific real estate stocks. They’re also trading at much lower earnings multiples than their U.S. peers. And on top of that, the dividend yield for the sector (at around 4 percent) is higher than it is for other major markets (like the 3.3 percent yield in the U.S.) So European real estate stocks are a good place to see decent lower risk returns in the coming year or so.
Good investing,
Peter Churchouse
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Article by Stansberry Churchouse
