Sector note: listed Eurozone real estate

The steep drop in property companies’ shares so far this year has raised their discounts to net asset value (i.e., based on the valuations on direct real-estate markets) to almost 45% as of the end of September⁽¹⁾ , a high since the great financial crisis of 2008. So, when subtracting debt, a market-listed building is worth 30% less than its appraised value on the property market⁽²⁾ !

Why this gap?

Through the current discount, the financial markets are pricing in both the spectacular rise in financing costs on the year to date (from 1% to more than 4% within nine months on the bond markets⁽³⁾) and the decline expected to occur in building prices to align rental yields with higher government bond yields.

When applied blindly to property companies’ P&Ls, higher financing costs would lower cashflows by about 30%⁽⁴⁾. This would lower their cashflow yields from 8% to 5.6%⁽⁵⁾ as of 29 September. As the sector’s average risk premium since 1990 is 1.9%, this would imply a valuation of 10-year government bonds of 3.6% (vs. 2% currently)⁽⁶⁾.

It is quite hard to call a peak in long bond yields, but current valuations do look overdone in several ways. First, property companies’ debt is covered and has an average maturity of 6.5 years⁽⁷⁾. Assuming that financing costs currently seen on the bond markets were to become the new norm, full dissemination of those costs into cashflows would be spread out over time. And second, property companies are able to diversify their sources of financing. Covivio, for example, announced the signing of a 485 million euro credit line in early September at an average cost of 2.5%, far below the bond market rate⁽⁸⁾.

So, there is little likelihood that cashflows will be driven down by 30% by the impact of higher financing costs. Moreover, the market seems to be forgetting that higher interest rates go hand-in-hand with inflation, which property companies capture in part through their indexation clauses.

Have the markets forgotten indexation?

Indexation of leases will be a powerful driver of rents next year. Property companies will benefit even as increases in financing costs are moderated for the aforementioned reasons. Cashflows will therefore rise automatically. Even in the event of a major economic downturn, we estimate that it would take a 30% reduction in renegotiated rents to erase +3% indexation (based on an annual 10% renewal of the rental base)!

Is liquidity risk scaring the markets even more than the cost of money?

Less than 20% of the sector’s debt matures by 2024⁽⁹⁾. Only Northern European property companies outside the Eurozone, are facing stretched balance sheets that are likely to lead to dilutive recapitalisations.

Debt ratios are, on average, acceptable at 40%⁽¹⁰⁾ for the loan-to-value⁽¹¹⁾ and 10.7%⁽¹⁰⁾ for net debt/EBITDA⁽¹²⁾ and leave enough room to avoid breaching covenants⁽¹³⁾ and precipitating a dilutive market call.

A risk to capital that the discount tends to lessen, combined with attractive carry

On average, dividends account for 6% of the sector’s market cap and more than 10% in the case of some companies⁽¹⁴⁾. This distribution is economically sustainable and will benefit from indexation.

The current discount will most likely serve as a parachute to falling valuations. Higher interest rates will, without a doubt, show up in private market valuations, like it is implicitly priced in public market while rents will benefit from indexation, is highly pessimistic and leaves some upside on the sector, once bond market stress has receded.

The sector’s performance relative to conventional shares during previous periods of rising interest rates, suggests a return to better days

An analysis of property companies’ performance vs. the broader market during previous phases of rising interest rates shows that the companies initially tend to underperform “conventional” shares and then to outperform them in the three, six and 12 months following the rate increase. This is what seems to be happening now.

Conclusion

Listed property company valuations are close to their all-time lows. The markets are paying undue attention to higher interest rates while ignoring the positive side of those rates – inflation, as they assume that the economic slowdown triggered by the end of accommodative monetary policies will not allow landlords to pass inflation on to tenants.

We believe that this view is overly pessimistic. While property companies will not be able to pass on all of inflation, they will be able to put through a generous indexation, which will support cashflow growth in 2023 and should accordingly be reflected in company valuations. Meanwhile, patient investors can benefit from the fund’s attractive 5.9% carry⁽¹⁵⁾.

Completed on 29 September 2022