Like other riskier asset classes, real estate investment trusts (REITs) have witnessed a volatile period since the end of July. While REITs have done somewhat better than equities, one might have expected a stronger performance, taking into account the lower government bond yields. But real estate is more than a pure play on government bond yields; the asset class has also equity characteristics that react to economic expectations.
Rising credit yields impacted real estate over the summer
Favourable credit conditions for real estate companies
Real estate companies have been able to make use of favourable trends in the bond market to finance or refinance themselves at attractive rates and to lengthen the average maturity of their debt, making them less sensitive to swings in the corporate bond market. Unibail-Rodamco, one of Europe's biggest commercial property companies, said in its half-year report that it lowered the average rate on its debt from 2.6% in 2014 to 2.3% in the first half of 2015. It also extended the average maturity of its loans from 5.9 years to 6.4 years. Loan-to-value rates remained stable below 40%. The same trend is visible throughout the sector.
Retail sales growth benefits Eurozone real estate
At the same time, rental growth is running ahead of inflation, thanks to the combination of higher growth in retail sales and rent renewals at higher rates. Rental growth of above 2.5% per year over the next five years is expected.
Growing at a rate of 3.6% over the past 12 months, the trend in retail sales is strengthening in the Eurozone. The drop in energy costs is certainly a welcome tailwind for spending power, as is the improvement in the labour market. The weakness of the euro also has a positive impact on certain export-sensitive markets and finally consumer confidence has also increased. Trends in Southern Europe are especially promising.
Large pipeline of retail property developments
A benign rate environment and an improving economic outlook have boosted confidence in the sector. This is visible in the new development pipeline. The committed expansion pipeline in retail property is 8% of the value of projects, but the total pipeline, including planned projects, is 14% which is equivalent to almost EUR 12 billion in the Eurozone. There are however large differences between countries. Belgium and France will see the biggest relative additions, whereas in Spain new development growth will be fairly limited. However, according to Green Street, 85% of these new retail property developments are unfunded, which may not be an immediate risk factor but if credit markets freeze up, financing will become much more difficult and expensive.
Underlying fundamentals remain supportive
Within our tactical asset allocation, real estate is neutral, following the recent rise in market volatility. However, underlying fundamentals remain supportive: stronger labour data, better consumer confidence, positive impact of oil prices on retail sales and rising house prices. Real estate remains the biggest beneficiary of the search for yield from institutional and private investors. Within real estate we have a small overweight European real estate. The ECB’s ongoing quantitative easing program and a strengthening labour market should offer some support. Pricing is not excessive.