Paul Reuge
European Equities Portfolio Manager
Will inflation and rising interest rates nip the post-pandemic property market recovery in the bud?
Having just emerged from the health crisis, property markets now have to deal with the return of inflation and its counterpart, the tightening of financial conditions. Is the asset class well-positioned to face these new challenges?
The observation of the stock market behaviour of American real estate companies, compared to "generalist" shares during periods of high inflation (we do not have a long enough history in continental Europe), shows a rather favourable record. Indeed, real estate companies have generally outperformed the S&P 500(1) during inflationary surges, provided that there is a minimum of growth (2%).
Annual performance of US real estate companies relative to the S&P 500 by growth and inflation
Source: Bloomberg, Rothschild & Co Asset Management Europe, May 2022.
This result is not surprising as most leases(2) have indexation clauses allowing lessors to collect inflation. This mechanism makes it possible for the increase in construction costs to be reflected in rents, and thus to preserve the financial balance of construction programmes. Rents are therefore supposed to grow at least by inflation, adjusted for the excesses of real estate/economic cycles.
This is the case for office rents in the central business district of Paris.
Evolution of Prime office rents in Paris over the long-term
Sources: INSEE, CBRE, Bloomberg, Rothschild & Co Asset Management Europe, May 2022.
La performance, depuis presque un demi-siècle, est ainsi bien supérieure à l’inflation. L’écart n’est ni plus ni moins que la croissance économique, si bien que les loyers ont reflété la croissance nominale (prenant en compte l’inflation).
C’est plutôt un constat rassurant que de savoir que le revenu locatif représente, au minimum, la croissance nominale, en retraitant des effets de base sur une période de 5 ans glissants :
Rental performance versus nominal growth, rolling 5-year period
Sources: INSEE, CBRE, Bloomberg, Rothschild & Co Asset Management Europe, May 2022
However, this result does not apply to markets that do not benefit from land scarcity (e.g. the office market on the outskirts of cities) which are victims of their substitutability. In this case, the indexation is collected during the lease term but is usually returned to the tenant at the end of the lease through competition.
Finally, the obsolescence of buildings is also an important criterion to be taken into account and is not reflected in rental statistics. A landlord who has not invested sufficient capital in preserving the value of his building will not be able to claim the highest rent when re-letting it, regardless of its location.
If the property investor can therefore hope, subject to the aforementioned elements, to collect inflation, can the concomitant rise in rates cancel out this benefit?
The rise in interest rates has two main consequences: the first is a potential drop in the value of buildings, and the second is a definite increase in the financial costs of property companies, most of which use leverage(3) to finance their development.
The net debt to asset value ratio is thus, on average, 40%(4) for the sector, with a maturity of more than 5 years, synonymous with a slow diffusion of the increase in financial costs to the income statement. Inflation will also help to absorb the increase in financial costs, so for property companies with a reasonable level of debt, the transition to a world with a higher capital costs should be smooth.
Average cost of debt and maturity of hedges
Sources: Kempen, Bloomberg, Rothschild & Co Asset Management Europe, May 2022.
Regarding the sensitivity of the value of buildings to rising interest rates, if the latter is in line with inflation, the theoretical consequence is a zero-sum game.
Indeed, the increase in yields can be fully compensated by the indexation of rents. For example, a building with a yield of 6% without indexation has an equivalent value (over the long-term, more than 15 years) to a building purchased on the basis of a yield of 4% but whose rents benefit from a 2% annual indexation.
In the case of a rise in interest rates that is higher than inflation (rise in real interest rates), a high-risk premium (difference between the yield on the buildings and the risk-free rate) is the best protection against a fall in the value of the buildings.
Implied rates of return on assets (valued by the stock market)
Sources: Bloomberg, Rothschild & Co Asset Management Europe, May 2022.
The R-co Thematic Real Estate fund's overweight position in retail stocks (since the beginning of 2021), which benefit from a high-risk premium and the reopening of shops following the health crisis, has helped to desensitise the fund to rising rates. Conversely, values in the residential and logistics sectors have conceded between -20% and -30% since the beginning of the year(5).
Is this the time to return to these sectors while retailers and consumers will have to deal with inflation on the retail side?
In the absence of wage adjustments, consumers' purchasing power will suffer from inflation. Although the savings reserves built up during the health crisis and the aid put in place by politicians sensitive to the issue of purchasing power should mitigate the effects, we can nevertheless expect a trade-off in household spending.
Retailers will have to deal with rising costs, a likely slowdown in demand and, for some, inventory issues. This is notably the case of Target (United States), which, due to the difficulties encountered in the supply chains last year, preferred to "overstock" products that are currently less in demand (television sets, etc.). However, there are still winners, notably the DIY stores, such as Home Depot (USA), which have benefited from consumer arbitrage.
The "basket" of brands present in the shopping centres will limit the risk of consumer arbitrage between one sector or another. However, the ability of lessors to pass on inflation (albeit contractually) will be affected by the overall dynamism of consumption.
The valuation of retail property companies remains defensive, despite the performance of the shares, as it is well below its historical average (10.5x cash flows(6) 2022 compared to 15x(7)). The valuation gap between listed and private markets is still significant, increasing the likelihood of financial transactions. This is evidenced by the offer to buy Deutsche Euroshop (made public on 23 May) in cash at a price of €21.5(7) per share, representing 44% more than the price of the old company but a 60% discount on the last published net assets!
We maintain our cautious target of a return to 12x cash flows for retail property companies and maintain a significant allocation, albeit significantly reduced since the beginning of the year (from 49% to 35%(8)). The reallocation of capital was mainly to German residential (6% to 15%(8)), whose undervaluation now seems excessive (40% discount and 14x cash flows, compared with an average of 20x(7)). Housing property companies have suffered from low yields in the context of rising interest rates, investors' fears about their ability to pass on inflation to tenants (who are already exposed to rising costs) and excessive debt.
In the long-term, however, inflation should be collected by landlords, as the rental market remains tight (vacancy rate already very low, at less than 2% in major cities(9)), the level of construction is insufficient and cannot produce new dwellings if the increase in construction costs is not passed on to rents.
Vacancy rate and construction level of the housing market
Sources: Savills, Bulwiengesa, UBS, Rothschild & Co Asset Management Europe, May 2022.// * Census, no data for 2011
As far as logistics are concerned, the sector remains expensive even though rising construction costs could limit development margins and the ability of landlords to pass on large rent increases remains uncertain.
