Guy Barnard, Manager of the Pan European Property Equities Strategy and Co-Head of Global Property Equities, comments on how the sector has been affected by the market rotation from growth to value stocks. He also discusses how the strategy is benefiting from this shift as the team is discovering more mispricing opportunities, and continuing to target countries, cities and sectors that offer attractive growth potential.
We spoke in November 2016 of markets being at a crossroads, with the investor mindset shifting from one dominated by income and growth, to one in which value and cyclicality prevailed. This rotation began in summer 2016 and accelerated following Donald Trump’s US presidential election victory. Against this backdrop, property equities have lagged wider equity markets, despite recovering in recent months.
Market rotation creating mispricing opportunities
As investors in property equities, we always try to balance our views on direct (physical) property markets with what is priced into shares. As a result, we may be overweight countries or sectors with relatively weak fundamentals if we think shares are pricing in too much negativity. Likewise, we are mindful of overpaying for growth. From our current standpoint, we are increasingly seeing opportunities to buy into growth stories at discounted prices, as the market rotation, in many cases, is overlooking strong real estate fundamentals. We used this mispricing opportunity to benefit our portfolios in recent months.
Targeting pockets of growth
Although the European political backdrop may create more volatility in equity markets this year, we continue to believe that property equities' offer of an attractive income yield with predictable growth characteristics should be able to deliver attractive returns to investors. Furthermore, while market-wide capital growth is likely to slow in 2017, there are pockets of growth that we can target at a country, sector or city level. As chart 1 highlights, not all markets and sectors across Europe move in sync with each other.
Chart 1: opportunities from divergence in rental growth outlook
Source: BofA Merrill Lynch Global Research, Jones Lang LaSalle (JLL) at January 2017.
Current favoured country/sectors include:
Spain – rental growth potential
Our largest country overweight through the second half of 2016 was to Spain. Political uncertainty had weighed on share prices, and appeared to be overlooking a strong economy, a real estate market seeing strong investor demand and the first signs of rental growth. Our focus on companies exposed to the Madrid and Barcelona office market has served the portfolio well, and while we have taken some profits we think there is still more upside in the year ahead.
Chart 2: Spanish offices poised for rental growth
Source: Morgan Stanley Research, Bloomberg, at August 2016. Trough-to-current, peak-to-trough rental values.
Stock picks: Inmobiliaria Colonial, Merlin Properties
Germany – residential landlords benefiting from demographic trends
German property stocks were among the weakest globally during the market rotation in the final quarters of 2016. This was particularly true for stocks exposed to the residential sector, which were seen as a key beneficiary of falling Bund yields. While valuations looked stretched in the summer, a circa 20% pullback in the shares, combined with underlying fundamentals strengthening further, gave a good opportunity to increase exposure to the sector in November/December. We expect residential landlords to continue to benefit from strong population growth in urban areas supporting the rental outlook (see chart 3). We are also still positive on the fundamentals in the commercial sector (office and industrial) and remain comfortable with our overweight here, particularly to the Berlin market.
Chart 3: growth in German urban populations to benefit listed landlords
Source: Destatis, ABN AMRO Equity Research
Stock picks: Deutsche Wohnen, ADO Properties, LEG Immobilien
UK – focus on structural growth
The UK property market proved far more resilient following the ‘Brexit’ result than expected by most. Although capital values fell by 3-4% between July and September, they have been rising steadily since. A weak sterling, lack of distressed sellers, and policy action taken by the Bank of England, have all supported the market. Although we expect further capital declines in certain parts of the market, notably London offices, driven by a weaker rental outlook, other sectors, such as industrial, look set for continued capital growth (chart 4).
While we see value in many UK property stocks today, which continue to be heavily discounted despite high quality assets and balance sheets, we remain cautious given ongoing ‘Brexit’ uncertainty. Instead, we continue to focus on areas of structural growth such as industrial, self-storage, student accommodation, and residential land outside London. This, coupled with some selected value names, we think, provides a well-balanced exposure to the market.
Chart 4: structural shift in industrial sector is beginning
Stock picks: SEGRO, Safestore Holdings
Although European assets and the property sector may be out of fashion with investors today, we think the stocks held in our concentrated portfolios still offer attractive prospects, either from a growth, value or income standpoint. With listed real estate stocks continuing to trade at a discount to net asset value (NAV), it remains cheaper for investors to buy property through shares than physical real estate. While growth is moderating, we still forecast circa 5% asset value growth this year, albeit with wide divergence by country and sector. More importantly, the income streams of the property sector remain incredibly robust, with the sector’s current dividend yield of almost 4% forecast to grow by 7% p.a. for the next two years.
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