With a marked change in sentiment it is now time to rebalance the portfolios, say Kiran Patel and David Richards

According to some estimates, the losses in the unravelling US sub-prime lending market could potentially reach as much as US$100-200bn (€69-€138bn).
The recent sharp rise in swap spreads, as measured by credit derivatives linked to the US residential mortgage market, demonstrates that the default risk premium demanded by the market has increased dramatically since the beginning of July 2007, even for the less risky AA and AAA rated debt.

In addition, figure 1 illustrates how risk aversion has increased markedly for lending in the market for short term asset backed commercial paper. The loans typically roll over every few months and are used to buy highly rated, but high yielding assets. The yield on AA 90 day asset backed commercial paper rose to 6.15% at the end of August compared to 5.27% at the end of July, as the scale of potential future losses associated with likely sub-prime mortgage defaults became more apparent to the market.

In line with growing risk aversion, there has been a flight to quality, and at the same time as yields on 90-day asset backed commercial paper have risen, so yields on treasury bonds for the same duration have fallen sharply. The yield on 10-year US government bonds has also been following a declining trend since July as investors desire to avoid risk overtakes concerns about rising inflationary pressures.

One of the key problems with sub-prime mortgages is the lack of transparency regarding which financial organisations have exposure and what level of losses can be expected. This lack of transparency is further compounded by the high leverage employed by hedge funds and other investment vehicles which are heavily invested in assets exposed to the sub-prime market. There is no clear information as to the full extent to which banks are exposed to the potential losses. The net result has been a very significant increase in risk aversion in interbank lending, supposedly one of the safest and most liquid areas of the financial markets.

Taking Germany as an example, figure 2 shows how the three-month euro interbank rate has risen steeply during the sub-prime crisis and demonstrates how internationalised financial markets can transfer the default risk in a relatively narrow sector and geography, such as US sub-prime mortgage loans, more widely around the financial system.

The environment of higher risk aversion to mortgage-backed securities on the part of both the banks and fixed income investors could reduce the availability and increase the cost of debt available to real estate in the short term. In the longer term, the credit markets may learn from the mistakes that have been made in the US sub-prime sector and future mortgage debt is likely to be priced more appropriately to reflect the true risk of default. The interest rate policy response from the key global monetary authorities, particularly the US Federal Reserve, will be a key factor in determining the level of risk aversion which is sustained in global credit markets during the remainder of 2007 and 2008.

As the sub-prime loans are dollar denominated, lower US interest rates would immediately reduce the stress on borrowers and help support house prices (the loan collateral) and thus help alleviate the sub-prime loan crisis to some degree. The US has already seen interest rate cuts, while interest rates in the UK and Europe have been put on hold but there remains a divergence of opinion on the future direction of short-term monetary policy.

The US sub-prime mortgage crisis could act as a catalyst for a re-pricing of risk in the asset-backed bond market, and if this is sustained, then this could represent a threat to current pricing in the commercial real estate investment market.

Real estate is, in effect, a bond/equity hybrid with the fixed income ‘bond' element deriving from the rent, which is guaranteed by the tenant for the duration of the lease contract, and the equity element linked to potential future rental growth. In addition, real estate is a relatively illiquid asset with comparatively high transaction costs.

During recent years, cheap financing costs and weight of money targeting the sector have driven European real estate yields to historically low levels and the risk premium on offer has consequently diminished. Figure 3 shows office yields compared to borrowing costs and illustrates how real estate pricing has become more stretched.

Yield compression has been a key feature of the European office market in recent years as shown in figure 4. However, there is a relatively new trend of progressively fewer markets experiencing yield compression since the end of 2006.

The sub-prime crisis could increase risk aversion to collateralised debt in both credit and lending markets and at the same time, increase the requirement for liquidity.
The overall result will be less debt capital targeting commercial real estate coupled with tighter lending criteria which will directly reduce the scope for further yield compression.

The UK market is most at risk from tighter lending conditions as it is more advanced in its yield compression/interest rate cycle. The pressure on pricing has already been building with upward yield shifts expected for some prime and most secondary assets across all the main commercial sectors. Across continental Europe, interest rates are lower and real estate yields are generally higher, so there is consequently less stress on leveraged real estate assets than in the UK. Nevertheless, an increase in risk aversion from lenders is likely to have some impact on the market with further yield compression likely to be drawn to a halt and secondary yields possibly showing some weakness during 2008 and beyond.

The local markets at greatest risk of re-pricing are those which are higher up the risk curve, which have also seen yields driven down to historically low levels by weight of money. These include the major central and eastern European office markets and some secondary office locations across western Europe.

In addition, the larger office markets where yields have already fallen to among the lowest in Europe, and where occupier demand is driven to a significant degree by financial sector employment, could also be at some risk. These centres, including the City of London, are also likely to see either a halt to further yield compression or modest upward yield movement during the coming months.

The key risk factor to the continuing recovery in European rental growth is the concern that falling credit markets associated with the sub-prime crisis may trigger a wider slowdown in economic growth. The main risk would appear to stem from the possibility of a withdrawal of the provision of credit, which could constrain growth in spending and output, particularly in the US.

In response to the increased downside economic risks, central banks are expected to relax monetary policy to some degree to help reduce the stress in credit and lending markets. Lower five-year swap rates, both in the US and Europe, since the beginning of July indicate that the market has started to price in a slightly more benign interest rate environment.

This will undoubtedly help support continuing global economic growth in the short term, although there is arguably greater downside risk attached to the narrower financial and business services sector.

In contrast to the last five years in real estate when yields converged among various property types, we now believe - similar to the corporate bond market - property yields should start to show a widening divergence. All property types should encounter rising yields and hence this will have an adverse effect on capital values, but secondary property is likely to be most affected.

In this respect, core plus and value-added are most at risk. This is where investors have been piling in, discounting risk associated with one or more of the following: off-pitch locations, weaker covenant strength, shorter income duration, and poorer specification whereby capital expenditure is required to offset depreciation. Risk aversion will consequently lead investors to require a higher premium (or yield) for not so prime property. A flight to quality is therefore recommended.

Equally, history tells us that in times of difficulty the inefficiency in real estate pricing increases. Yields often overshoot and this is no different in a rising yield environment than when yields are falling. Investors should also pay particular attention to the various forms of real estate and look to exploit arbitrage opportunities which may arise between:

Debt; Derivatives/ETFs; Direct holdings; Unlisted holdings and secondary pricing; Listed securities/REITS.

Some of the arbitrage already exists today with some listed securities trading at 20-35% discounts to NAV. The unlisted or direct forms of real estate are yet to reflect any discounts to NAV. Both pricing levels cannot be right. Secondly, the derivatives market in the UK is pricing nearly zero returns for 2008, eg, based on the pricing in August a 2008 contract is priced at Libor minus 400/450bps. Two months previously the derivatives market was pricing the UK IPD 2008 return at Libor minus 55bps.

However, the latest pricing compares to the IPF consensus forecast (only released last month) at 4.3%. Again, both levels of expectation cannot be right. Thirdly, real estate debt is exhibiting excellent spreads, albeit volatile, and can form a good substitute for core direct or indirect property but with greater liquidity attractions. In addition to core activities, a portfolio bias towards opportunistic investments would be a good way to create alpha enhancement. The above should be put in context with respect to a timeline.

Our recommendation to investors is to start to reflect the above changes to their portfolios today in anticipation of a price adjustment that we forecast to gradually evolve during 2008 and beyond. Given the illiquidity of real estate sector as a whole, it is very difficult to rebalance portfolios in a matter of weeks. Therefore, time is required. It should also be highlighted that there remains an overhang of existing capital in the market from earlier fund raising initiatives which is still targeting real estate and in particular, the weight of money will continue to positively impact real estate prices, particularly for prime. Add to that the very positive fundamentals of supply and demand supporting immediate prices. It is the period after 2009 that we foresee to be more difficult.

Key points to consider:

US sub-prime contagion likely to be felt at the macro level; Real estate illiquidity premium anticipated to rise; Risk aversion in global credit and lending markets is likely to reduce debt availability to European real estate; Overweight recommendation now downgraded to ‘neutral' for European real estate; Don't panic: Fundamentals of demand and supply in the occupier markets remain broadly supportive; Expect positive and strengthening short term rental growth; Given current trends, anticipated future relative real estate pricing could become over-stretched; We are forecasting some downward pricing pressure in prime real estate for the core euro-zone countries beginning in 12-18 months time; Given the illiquidity of the asset class a proactive stance is required; Adopt a ‘barbell investment strategy' combining core and opportunistic investments; Risk aversion could lead to a short term flight to quality which might favour prime real estate with robust rental growth fundamentals; Consider taking profits in secondary locations and assets where the risk premium has been driven down; Investors should also pay particular attention to the various forms of real estate, debt, derivatives/ETFs, direct holdings, unlisted holdings and secondary pricing, listed securities/REITS, etc; Look to exploit arbitrage opportunities across the various real estate structures; Selective development/refurbishment activity could also reap rewards and generate alpha.

Kiran Patel, global head of research & strategy and David Richards,European property analyst, AXA Real Estate Investment Managers