The European real estate sector is trading at stressed levels reflecting the multitude of headwinds it faces – real estate bonds are currently at the largest discount versus the broader EUR IG index since the Global Financial Crisis in 2008-09
There are several reasons for the widening with rising interest rates arguably the most pertinent. High inflation means that central banks have pivoted into tightening mode – an environment that creates stiff headwinds to most real estate business models. Real estate companies have, in many, instances relied on debt funded acquisitions to drive growth, a business model that is now being questioned as the cost of debt has increased significantly. Elevated interest rates also mean investors demand a higher yield from real estate assets which combined with higher costs of capital impacts on profitability, loan-to-value (LTV), leverage and liquidity.
Real estate spreads versus EUR IG
Source: Bloomberg
Wider spreads across investment grade markets mean that financing costs have risen sharply and effectively closed capital markets to many real estate businesses. At the same time, their alternative route to finance – the banks – have likely retrenched following recent events in the banking sector. It’s not a recipe for success and comes at a time when there remain background rumblings from short sellers around accounting standards, the true value of assets held on balance sheets and governance of select real estate names.
Faced with these challenges, many issuers in the space have turned to asset disposals to raise capital, shore up balance sheets and raise liquidity. Selling assets makes sense from a deleveraging perspective and can add value to share and bondholders alike, but it does raise concerns longer-term. Can firms sell properties at a decent price? And what impact will disposals have on future earnings, especially if a company’s prime assets are being sold to solve short-term issues? Will they, for example, be left sitting on lower quality assets to support the remainder of their debt?
There are also technical headwinds for a sector populated with relatively small issuers with a comparatively limited investor base and for those companies that turned to the corporate hybrid market to raise capital. Against a backdrop of widening spreads, these riskier issues have come under pressure.
The concerns driving spread widening are clearly legitimate but to what extent do they over or underestimate the fundamental headwinds European real estate is facing? 2022 earnings releases for example, reflected some of the negative impacts of higher interest rates but were, on balance, less severe than expected. It seems that some valuations at least reflect a more negative outcome than is transpiring.
Europe is a diverse geographic and economic region, and the real estate sector is comprised of several sub-sectors, each with their own fundamentals. Understanding these and considering that the impact of broader headwinds will vary between the likes of residential, logistics, datacentres, offices, hotels, and leisure subsectors allows opportunities to be identified. Even amidst broader negative sentiment, there are real estate segments with supportive demand/supply imbalances, regulation, inflation-linked rental growth and pricing power. Just now for example, fundamentals for northern European residential are holding up better than is reflected in valuations. Elsewhere, select logistics and datacentre issuers are characterised by low levels of leverage and continue to fund growth and acquisition activity in a bondholder friendly way. From our perspective, these and other carefully chosen opportunities offer scope for attractive risk-adjusted returns underpinned by strong (and overlooked) fundamentals.
