With healthy fundamentals and attractive valuations, European real estate securities, in our opinion, are positioned to deliver meaningful relative real returns despite rising interest rates and slower growth, writes Rogier Quirijns (pictured), head of European real estate at Cohen & Steers.
Russia’s invasion of Ukraine created a commodity supply shock that has driven up inflation and raised concerns over the pace of global growth in 2022. Continental Europe is particularly exposed, as those countries are more reliant than the US or the UK on Russia-Ukraine commodities.
The European Central Bank has lowered its 2022 forecast for economic growth in the eurozone to 3.7% from 4.2%, reflecting the impact of the war on energy prices, consumer confidence and trade.
If the disruptions to energy supplies and confidence last longer than expected, and global supply chains remain strained, regional growth could slow further to 2.5%, according to the ECB.
Because listed real estate can perform well relative to traditional asset classes in periods when economic growth is slowing and inflation is rising, the biggest upside risk to the outlook for European real estate, in our opinion, is recession.
The chance of a eurozone recession depends largely on the flow of natural gas from Russia. While most European countries have created plans to dramatically cut back on their reliance on Russian gas, energy independence will take years to reach.
For real estate companies, the impact of the war is indirect, and hinges on the economy. We believe the crisis creates a unique buying opportunity, especially given the fact that the asset class still has short-term upside potential from the pandemic re-opening trade.
The near- and long-term implications of the war for the economy may ripple across real estate sectors but, at the same time, the re-opening trade will likely have a short-term positive effect on some sectors.
For example, near term, consumers might spend less disposable income because of higher costs, potentially impacting the retail sector. However, retail sales data held up well through the Covid crisis and we expect them to remain so for the long term.
Longer term, migration and manufacturing trends could result in incremental logistics and housing demand in certain markets. Further deglobalisation and investments in efforts to reduce Europe’s energy dependency could lead to structurally higher inflation and more on-shoring.
Learning from past crises
A look at the performance of real estate relative to equities in the aftermath of other significant crises, such as the global financial crisis or the European debt crisis, can provide some perspective on the resiliency of real estate.
Historically, European-listed real estate securities have recovered in line, or better, than European stocks in the months after bottoming in the wake of global crises.
Real estate fundamentals remain sound
Despite the possible impact of slower growth and higher inflation on listed real estate securities, we believe real estate fundamentals in Europe remain healthy.
Demand growth in certain sectors creates favourable supply-demand characteristics, which can allow developers to translate higher development costs into higher rental levels. In some areas, rising occupancy levels may allow landlords to raise rents.
Construction starts in many sectors have been delayed by labour shortages and higher costs for building materials, reducing supply pressures. This dynamic has allowed landlords to raise rents, leading to above-average cash flow growth. Meanwhile, listed real estate has continued to offer attractive levels of secure and long-dated inflation-linked income relative to traditional asset classes.
In 2021, the economic recovery and supply-chain disruptions combined to drive inflation higher than central bank targets. Supply shocks brought on by Russia’s invasion of Ukraine accelerated the rise of inflation. In the EU, consumer prices increased by a record 7.5% in March, driven mainly by energy, food and wages.
To combat inflation, central banks, including the Bank of England and the Federal Reserve, have begun to raise interest rates. The ECB is likely to follow suit, although at a somewhat slower pace than the UK and the US, given Europe’s exposure to the crisis.
Importantly, European real estate securities have proven to be resilient in periods of rising interest rates.
Even as central banks raise rates, we believe inflation is likely to remain higher than it was over the last economic cycle, and that the risk of stagflation is increasing as the war takes a toll on the economy.
Potential inflation buffer
Listed real estate has distinct characteristics that can provide a buffer to inflation. For example, sectors with shorter lease durations—such as self storage—have the ability to reset rents promptly as conditions change. In case of slow growth—or even recession—longer inflation-linked rental contracts offer relatively strong and steady income growth potential.
Most commercial leases in Europe explicitly tie rent increases to a published inflation rate. When inflation is extremely high, commercial landlords can increase rental growth income from new tenants and also help them negotiate new and improved lease agreements with existing tenants.
Better lease contracts can have a positive effect on investment values, even when interest rates are rising. We believe this characteristic is potentially a strong positive factor for rental and cash-flow growth for European real estate companies in 2022 and 2023.
Listed real estate securities may also provide a potentially sturdy backdrop if the economy tips into stagflation, with economic growth slowing while inflation remains elevated. Historically, European Reits have performed well relative to stocks and bonds in stagflationary periods.
Potential to provide attractive levels of income and growth
European real estate securities also offer attractive yields (with growth potential) relative to traditional asset classes. In addition, they have historically paid high dividends, resulting from their cash-flow-oriented business models and tax-advantaged distributions.
Across Europe, real estate securities currently offer meaningful premiums relative to long-term government bond yields, which we believe is an indication of potential value.
Valuations at 10-year lows
Real estate securities in Continental Europe and the UK have continued to trade at relatively attractive discounts to their NAVs. With a discount to net asset value (as of 31 March, 2022) of 22.4% and 23.3% for Continental Europe and the UK, respectively, real estate securities are trading near the lowest levels in a decade.
Discounted valuations have historically been a buying opportunity for European Reits.
Defensive posture with upside potential
In today’s environment—marked by rising inflation, slowing economic growth (with the potential for recession) and heightened geopolitical risk—we believe European real estate securities offer defensive growth opportunities.
Logistics, towers, healthcare and self storage are among defensive sectors that also have structural growth characteristics. Examples of potentially recession-proof sectors (due to long-term contracts, among other factors) include healthcare, retail, senior housing and German residential.
We also believe student housing is potentially “recession proof” despite the use of short-term contracts, mainly because the sector is extremely undersupplied, as is most rental housing across Europe.
We believe that specialist managers with the resources and experience to understand the market—economic factors, country dynamics and sector characteristics—can most effectively position and, if and when deemed necessary, shift portfolios appropriately and potentially enhance risk-adjusted returns.
Listed real estate as a value and growth complement to core private
In addition to a still-healthy economic backdrop, inflation-hedging characteristics, strong income and growth prospects, and attractive valuations, listed real estate may be supported by activity in the private market, where several buyouts of listed companies have occurred in sectors such as office, logistics and residential. These deals suggest that investors continue to see value across the real estate market in Europe.
Listed real estate can also serve as an effective foundation for a comprehensive real estate strategy, complementing direct investments and targeted opportunistic or value-add private real estate funds, in our opinion.
One reason is performance. Over the past 10 years, European listed real estate has outperformed core open-end private real estate funds by 420 basis points annually.
Reits have achieved this return premium while providing daily liquidity and generally employing relatively low-risk core real estate investment strategies, with a focus on high-quality, stabilised assets.
Reits also typically employ modest leverage of 30–40%, in line with many core private real estate funds.
Diversification through listed and private allocations
We believe both listed and private real estate may deserve a place in a strategic asset allocation. The precise mix between listed and private will be driven by investor-specific factors, including (but not limited to) the need for liquidity, preference for income versus total return, general risk tolerance, aversion to mark-to-market volatility and fee sensitivity.
Overall, we believe European listed real estate is poised to play a potentially meaningful role in defending against inflation, while offering solid relative yield and secure income potential—even if recession hits Europe and long-term interest rates start to peak.
This article was written for Portfolio Adviser by Rogier Quirijns, head of European real estate at Cohen & Steers.