Interest rates, structural factors and company specifics will determine the path forward for real estate

The real estate sector has been struggling for almost three years on the back of the significant rise in interest rates. In recent months, both the Federal Reserve and the European Central Bank have started to cut interest rates. This should in theory bode well for the rate-sensitive listed real estate sector. Indeed, we have seen some recovery. Between April and September of this year, the European listed real estate sector outperformed the broader market by 10%. However, interest rates globally have risen in the past few weeks, driven by, among other factors, a stronger than expected US economy and the US presidential elections. This forced listed real estate to give up some of the recent gains. Nevertheless, there are several signs pointing to a future recovery for the real estate sector, albeit significant challenges remain, particularly for certain sub-segments of the real estate sector. To better understand these challenges, we attended several real estate conferences and also met with sector specialists in New York.

There are several reasons to be positive about listed real estate, as the worst appears to be behind us. Financing conditions are improving thanks to lower interest rates and narrowing credit spreads. Property prices are also bottoming. Moreover, valuations are historically cheap, and the sector is under-owned. Rental growth remains strong, driven by supply & demand imbalances and inflation. Occupancy rates also remain high (for most sub-segments at least).

However, there are still significant challenges for the real estate sector, mainly, the slow burn of higher marginal funding costs. Stabilizing property valuations are important, but the marginal cost of debt is still higher than the current cost of debt for most of the real estate companies. This means a negative path for earnings if top-line growth is not large enough to offset increased financial expenses. Growing earnings will be real estate’s biggest challenge going forward. It is important to note that regarding this challenge, there is a clear discrepancy between companies that adopted a long-term financing strategy and those with higher financing and refinancing requirements. Other important challenges for the sector are the uncertainty regarding the impact of Trump’s policies on inflation and the European economy, while developers are still struggling due to a lack of transactions in the market.

There is not only a large difference between companies based on their financing strategy, but also depending on the sector in which they operate, as illustrated by the graph below. This has been highlighted in previous articles. Let’s summarize below the recent developments for the most important sub-segments of the (European) real estate sector.

The best performing segment this year of the European real estate market is retail, which struggled the most in 2020 because of covid-19. Retail is unique in the sense that most of their issues are not related to the balance sheet or interest rates, but rather to structural changes (i.e. the rise of e-commerce). These issues persist going forward, as are the increasing risks of a weaker European economy (less of an issue in the US).

The residential market faced many challenges such as higher mortgage costs, construction costs and energy regulations. Housing affordability became a key issue. However, some positive signs are emerging. The house price decline in Germany seems over, albeit the time of “buying is cheaper than renting” has passed. Some uncertainty remains (e.g. for open-ended real estate funds), and partly because of a lack in transactions, but in the long run the market is still heavily undersupplied.

The logistics sub-segment was one of the winners of covid-19 thanks to the acceleration in e-commerce and the nearshoring-trend. This year is more difficult as rent growth is decelerating from peak (covid-19) levels, the European economy is weakening, and vacancy numbers have risen slightly. Logistics is also struggling somewhat in the US as too many warehouses were built in recent years and US leases are in general not inflation-indexed. Nevertheless, the long run trends benefitting logistics still seem in place.

Offices are facing structural (i.e. less office demand because of WFH) and cyclical challenges. Demand is macro-driven, but there is also a clear distinction between demand for prime/green buildings and second tier/peripheral offices. Vacancy in the Central Business Districts (CBD) of European cities remains low, implying tight supply and not at all representative of the situation in, for example, New York (where some estimates suggest a decline in value of almost 50% in the long run). The issues are more prevalent in large building blocks outside the CBD of European cities.

Finally, the healthcare sub-segment is still fighting perception, even though occupancy is improving (with significant regional differences). The long-term trend (i.e. an aging of the population) is still in place. This trend requires the expansion and modernization of healthcare infrastructure.

Real estate is clearly not a homogenous sector. There are stark differences between sub-segments, with each of these impacted in both positive and negative ways by their own combination of structural and cyclical factors. Moreover, within a specific sub-segment, there can be significant differences between companies, for example, based on their financing strategy or regional focus. The combination of all these factors will determine whether specific real estate companies will be able to grow earnings and benefit from the lower interest rates going forward.