SPEU - European Real Estate: Ready For Value Hunters?
Summary
- Since the Global Financial Crisis, growth in the European real estate sector has been largely fueled by debt.
- The central bank's response to record inflation in 2022 through rate increases and the reversal of QE had a profound impact on REIT issuers in two ways.
- Finally, several issuers have taken the creditor-friendly measure of using equity to reduce outstanding liabilities, and as the stock market rebounds, this becomes a more attractive option.
By Thomas DeSouza
After a decade of debt-fueled growth, rising rates, macroeconomic volatility, and activist pressures have left many European issuers scrambling to assuage investors' concerns.
Since the Global Financial Crisis, growth in the European real estate sector has been largely fueled by debt. While property yields since 2010 have fallen across much of Europe, real estate companies recognized that low interest rates could have a positive impact on their equity returns as long as borrowing costs remained below the net rental income level of a portfolio. By 2021, the weighted average coupon for the sector had fallen to 1.72% as rates remained negative and the European Central Bank supported the corporate bond market through quantitative easing, allowing issuers to increase leverage to grow their portfolios. While effective, this strategy was dependent on a steady increase in property prices, access to capital markets, and the ability to pass on higher costs through rent increases. For nearly a decade, this was not a challenge, with bonds on real estate investment trusts trading at a modest spread premium to senior corporate peers.
The central bank's response to record inflation in 2022 through rate increases and the reversal of QE had a profound impact on REIT issuers in two ways. First, rising rates typically lead to lower property prices, causing a deterioration of the loan-to-value (LTV) ratio that many use to assess credit quality. Second, the ECB's withdrawal of support from the corporate bond led to a rapid widening of credit spreads, implying higher borrowing costs for issuers. Reports by short sellers have accused certain issuers of artificially inflating property prices and masking true leverage numbers, causing the bonds to trade at nearly distressed levels. While many real estate issuers have long-dated maturity profiles without near-term funding concerns, many will face tough decisions in coming years given the high cost of refinancing and challenges of deleveraging.
Spreads for REIT bonds are currently at around three times those of senior corporate peers, and with rent increases in Europe limited by both regulation and the weaker economy, refinancing existing debt could be uneconomic. Issuers could look to asset disposals to decrease leverage, but that wouldn't guarantee liquidity, while selling properties at a discount could further affect LTV metrics. Finally, several issuers have taken the creditor-friendly measure of using equity to reduce outstanding liabilities, and as the stock market rebounds, this becomes a more attractive option. At current levels, we believe the real estate sector remains attractive, but investors will need to carefully evaluate the quality of portfolios, capital market conditions, and managements' willingness to take measures to preserve credit metrics.
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European Real Estate: Ready For Value Hunters?