Guy Barnard, Co-Head of Global Property Equities and Manager of the Pan European Property Equities Strategy, discusses the outlook for European property stocks following a tumultuous start to 2016 for global equities. While the asset class was caught up in the recent sell-off, he argues that current valuations, favourable company news and solid demand for property merit a more positive outlook.
Global macroeconomic uncertainty, driven by a combination of slowing economic growth expectations, plummeting commodity prices and credit market dislocation have driven many global equity markets into bear market territory over the last few months.
In Europe, this has resulted in higher prices for core sovereign bonds, while European equities (STOXX 600 EUR Index) have lost around 12% from the start of 2016 (to mid-February). Meanwhile, the European real estate sector (FTSE EPRA/NAREIT Developed Europe Capped EUR Index) was down circa 10% over the same period. Note past performance is not a guide to future performance.
While European real estate is not immune from the impact of slower growth and rising credit spreads, we would argue that the sector continues to offer a reasonable hedge against volatility in financial markets. This reflects real estate’s comparatively high earnings visibility and the prospect that central bank policy will remain supportive, offering additional benefit to asset prices.
Recent company news flow has remained encouraging. Unibail-Rodamco, the largest listed real estate company in Europe, generated 3.2% like-for-like income growth from its portfolio (principally prime shopping centres) in 2015 and has issued guidance for 6-8% underlying earnings growth in 2016. This highlights the company’s confidence that European commercial property can deliver an attractive and growing income stream in the current market.
Unibail-Rodamco currently has a dividend yield of 4.4%, and is forecast to grow this in-line with earnings. We see this as increasingly attractive as bond yields and interest rate curves continue to drift lower. Overall, we think it is possible for the Pan European property equities sector to deliver double-digit earnings growth and dividend growth of 6-7% in 2016.
Healthy demand and attractive valuations
We also expect continued robust demand for real estate assets as pension funds, insurers and other equity-led buyers increase exposure to real estate. A good example is Japan’s largest financial institution − Japan Post Bank, which will launch a division to channel much of its $500bn (€440bn) fund into property investments in the UK, mainland Europe and the US, given the currently low returns on its bond portfolio. We do, however, expect to see sovereign wealth funds and some emerging market-domiciled investors selling assets to crystallise gains and return these profits to domestic markets. On balance, while we do not expect further yield compression, current demand should support property yields at or around current levels in most markets through 2016.
From a valuation perspective, equity markets have quickly de-rated stocks, reflecting current macro uncertainty and slower growth expectations. This has resulted in many property companies now trading at discounts to net asset value (NAV) − see chart below, and dividend yields not seen since 2011. While it is right for the equity market to discount a slowing rate of growth in underlying real estate markets in 2016 and beyond, we think current valuations reflect this, and more, in many cases. This creates the potential for some positive market repricing when markets stabilise.
Pan-European quoted property sector: discount to NAV & NAV growth
Source: Morgan Stanley Research, as at 12 February 2016.
Taking advantage of market volatility
Further market volatility is likely to affect property stocks in the short term. But we see this as a favourable environment for the strategy’s bottom-up stock picking approach with a long-term horizon.
The current valuation of UK large caps, an area we have been underweight, appears increasingly attractive following the recent market sell-off. In the UK, Land Securities and British Land currently trade at 25-30% discounts to NAV, implying underlying capital value declines of 15-20%. This is an outcome we did not expect, particularly given that a UK interest rate hike now appears unlikely in the near term. While uncertainty around a British withdrawal from the European Union (‘Brexit’) is a concern, both these companies have long-dated income profiles and conservative leverage, providing reassurance and flexibility. We therefore see re-rating potential in the months ahead.
Uncertainty in Spain, following the political stalemate has also caused significant equity market weakness. We anticipate this will have an impact on economic growth and consequently rental growth expectations. However, current share prices, we believe, offer an attractive entry point for the medium term, leading us to increase the positions in Inmobiliaria Colonial and Merlin Properties.
Clearly, equity markets are forward looking and the current sell-off reflects an increasingly opaque outlook. However, at least on a relative basis, we would expect the predictable income streams and dividends of property companies to remain attractive.
These comments are for illustrative purposes, and are not indicative of the historical or future performance of the strategy or the fund’s chances of success. References made to individual securities should not constitute or form part of any offer or solicitation to issue, sell, subscribe or purchase the security.