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Magazine Issues » July 2009

PROPERTY: on the (high) rise

European property shares have rallied ahead of global equities since March. Vicky Watson, of Scottish Widows Investment Partnership, looks at the drivers behind this...

highrise.jpg“Green shoots of recovery” are the current financial buzzwords. After the banking crisis of last year, which threw markets into freefall and forced global economies into recession, weary investors are now looking for the nascent signs of a turnaround.

Investors in the European listed property market (or real estate investment trusts) are no exception. Property shares have suffered their fair share of woes since the downturn began over two years ago. The FTSE EPRA NAREIT European (UK Restricted) index has fallen 54% since March 2007, compared to a drop of 25% from the wider European equity market (MSCI Europe index). As the downturn deepened, investors became more risk-averse and fled the sector, troubled by property companies’ debt levels, balance sheets and inability to refinance.

Since the stock market lows of early March, though, European property shares have rallied ahead of global equities – up 32% compared to 26% for the MSCI Europe index. Much of this new-found optimism stems from the view that the worst of the recession may now be behind us. Bank bail-outs and stimulus packages have soothed investors’ nerves and brought a degree of stability and confidence back to the markets. Recent economic data has also not been as bad as expected. As the European listed property market relies heavily on financing, it has benefited more than most from the improved sentiment. It may still be too early to say whether this is just a short-term rally or the start of a long-term upswing, but there is no doubt we have seen greater market buoyancy in recent months.

The European listed property market has fared much better than its UK equivalent during the downturn. Since the start of the decline in March 2007, the FTSE EPRA NAREIT UK index has fallen an enormous 71%. Pan-European property shares can be less volatile, as they benefit from a wider geographical base. The underlying property market in the UK has also seen a far sharper and more extensive downturn in capital values. Since hitting their peak in June 2007, average UK property values have tumbled by over 40% – the fastest rate of decline ever witnessed. European values have also declined, but to a much lesser extent.

The unprecedented fall in the underlying value of UK properties has meant that many UK property shares have been close to breaching their loan-to-value banking covenants. As a result, there have been a number of rights issues since the start of 2009, raising over £3.8bn (€4.5bn). Fortunately, the European listed property market has seen very few of its companies making cash calls.

In the current economic climate, rents remain under pressure in Europe and in the UK; we expect this to continue until 2010. Tenants are holding back on expansion plans as they wait to see if the global economy stabilises. However, rents in Europe are generally much cheaper than in the UK and are less of a cost burden for tenants. From an income perspective, the lease structure can be more favourable for European landlords: rents are reviewed annually (compared to every five years in the UK) and are linked to inflation.

Landlords also have far greater access to information on their tenants’ profits, making it easier and quicker to spot those in difficulty. As the corporate structure of the European retail sector is more diversified than the UK – with more independent owners and fewer chains – Europe has not seen any of the large-scale tenant failures, such as Woolworths and Zavvi, that have affected the UK market.

Why listed real estate?
Despite the recent difficulties, European property shares have many advantages when it comes to attracting investors. One is that the underlying properties offer a guaranteed income stream for the term of the lease. This gives property shares greater visibility of future earnings and greater stability; companies will always meet their rental payments before they pay a dividend. This security of income has also meant that European property shares have historically paid higher dividends than the wider equity market. There is also a significant breadth and depth of stocks available. Investors can select by geography – thereby avoiding pockets of severe economic distress, such as Spain – or choose specialist property companies or those which have portfolios balanced between sectors.

Property shares are also flexible and easily tradeable, and have lower dealing costs than buying actual properties. They can also increase the diversification of property investments through investment in different countries and in niche markets. Unlike global equity markets, which tend to move in a similar manner to each other, property markets are less synchronised in terms of when and to what extent changes in the global economic environment affect local markets. This differentiation can help investors to make tactical allocation decisions. Listed property can also be a useful diversification tool, as the underlying property market has a low correlation with other asset classes such as equities and bonds. Despite following the wider equity market over the short term, over the long term property companies still tend to follow the growth in the underlying property market.

The key performance indicator at the moment is balance sheet strength. Companies with favourable loan-to-value ratios and good levels of liquidity remain attractive, and will continue to do so in the upturn. Unibail Rodamco, a pan-European shopping centre owner, displays all of these characteristics and is one of the strongest listed property companies in Europe. It is in an enviable position of having strong cash holdings, which means it is well placed to make acquisitions. The firm also has a substantial potential development pipeline, which it should benefit from during the recovery.

With capital values continuing to decline, the ability to preserve income with good management skills is essential. Companies that look after their tenants and are creative about rent deals will often fare better. We continue to favour firms with the healthiest occupancy rates and the longest, unexpired lease terms.

We currently have no specific geographical preferences in Europe, and continue to look for stocks company by company. In a downturn, though, it is wise to avoid areas of economic weakness like Spain and Central and Eastern Europe. The latter is very development-led, which raises the prospect of oversupply in the future. There is also no local investment base to support the market.

Reliable retail
Within Europe, retail continues to be our preferred sector. Many of the retail property shares we hold have been trading for years. It has taken these firms time to build up the right kind of portfolio, and they are in a stronger position because of it. They have also survived previous economic downturns, which means they are more resilient and adaptable. Moreover, retail is typically a more defensive sector – people still need to eat and buy clothes, even in an economic downturn! The office market in Europe, though, has been highly leveraged, particularly in countries like Germany; most of its tenants are in the financial sector, which has suffered more in the downturn.

Despite the recent signs of improvement in the listed property market and in the European economy, an element of caution is still warranted. As such, our portfolio remains largely defensive. There is still a disconnection between the pricing of riskier stocks, which have risen significantly in recent weeks, and more secure, defensive companies. One thing is certain, though: yields on property are at historic highs, meaning it’s a good time to redirect money back into property shares. With interest rates at record lows across Europe, investors are now looking for areas that offer greater return prospects. Property shares are trading at significant discounts to NAVs (around 20% to the last published property price) across Europe. Canny investors know this is the time to be getting back into European property shares – before momentum starts to play its part and the window of opportunity closes.

• Vicky Watson is investment director, European equities, at SWIP

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