Henderson: European property equities: at a crossroads

European property equities have so far endured a turbulent year, with the sector giving investors an uncomfortable rollercoaster ride, rather than the more stable returns expected from property. Macroeconomic and political uncertainty has significantly impacted the sector, with UK property stocks bearing the brunt of ‘Brexit’ and, more recently, a Trump presidency adding fuel to a market narrative that we have reached a turning point in bond markets and are set for a pickup in inflation.

Taking a balanced view

This has weighed heavily on defensive income-producing sectors such as real estate. So, we find ourselves at a crossroads, with the market currently turning decisively in the direction of a change in the monetary backdrop. However, our view remains more balanced. While we see scope for bond yields in Europe to continue to move higher, we struggle to see a significant shift in the prevailing dynamic of lower growth and lower core inflation, which will limit the magnitude of any rise. As a result, while we may be looking at slower returns ahead than in recent years, we continue to expect the attractive characteristics of real estate, namely providing secure income from a real asset, to be sought after. In other words, while it may not be exciting, we can easily envisage more of the same, with the road carrying straight on as investors again embrace the value of predictable and growing income streams.

Real estate fundamentals remain strong

While real estate equities have whipsawed in recent months, underlying property markets have proved incredibly robust. Transactional evidence across most European markets highlights ongoing demand from both domestic and global equity investors. Although this leaves prime yields at or close to historical lows in many markets, a lack of alternative sources of income, coupled with heightened market volatility and meagre bond and equity returns, have enhanced a secular shift toward real assets.

From a listed market perspective, we have typically sought exposure to those companies best placed to grow their income streams, through a combination of being in attractive locations and sectors, where the balance of supply and demand favours landlords. This has led us to favour markets such as Sweden, and sectors like German residential and commercial, prime shopping centres, as well as recovering markets such as Spanish and Paris offices.

Seeing value in the UK

In the UK, while much uncertainty remains following the result of the EU referendum in June, real estate transactions have generally shown stronger pricing than initially anticipated. A weaker sterling appears to have done much of the heavy lifting, with international capital looking to take advantage of around 20-30% cheaper prices since June. While we still expect prices to moderate, particularly in the London office market where rents are likely to decline, overall capital declines are slowing following the sharp drop in July and August. We increasingly see value against this backdrop given listed real estate stocks continue to price in more aggressive asset value declines.
 While we understand the equity market is forward looking and discounting an opaque future, the disconnect between physical and listed real estate markets is increasing and may present opportunities for investors looking to establish a foothold in the UK market. We have focused on areas of structural growth such as logistics, self-storage and student accommodation, but more recently made our first new investment since Brexit in a London-focused company where we think the equity market is overlooking the intrinsic value of the real estate.

Conclusion

So, while the fog of geopolitical headwinds will likely continue to make the road ahead difficult to navigate and the case for a change in direction may seem more compelling than the status quo, we believe that the less exciting road well-travelled offered by real estate, namely an attractive income yield with predicable growth characteristics, should continue to deliver attractive real returns. Against this scenario, the current pricing of European real estate stocks looks increasingly attractive after the recent market pullback.