Accessing prime real estate assets remains a challenge. Listed property companies and REITs offer a solution, writes Maikel Speelman
When structured and managed correctly, real estate can offer a stable source of income and capital appreciation to investors. However, when rental levels stagnate along with the wider economy, property values are put under pressure. But it is important to realise that this is not true for all segments of the market. The gap between the low and high ends of the market has widened significantly during the last few years. The bleak economic outlook for investors in general has led to a risk-averse approach. Therefore, lower-grade property assets along with those located in more troubled countries are more vulnerable, whereas prime assets in prime locations are seeing a renaissance of investor interest.
Arguably, besides being the most costly, prime assets are the least risky in the real estate market - and this is reflected in lower yields. Especially during times of decline, the difference in value as well as income generation of property is tested and the divergence of high and low-quality buildings is more apparent. Not surprisingly, when forced sellers appear on the market, it is their best quality assets that are sold first, having better held their value - sales completed with limited discount to book values for the sellers.
In order to maintain healthy cash flows, and ultimately to distribute income, a property needs to provide a stable rental income. Prime assets attract the better quality tenants that are less likely to default on payments. This stable rental income is also significant to the providers of debt (whether they are private or public), and as such to the capital structure of a real estate investment vehicle.
With transaction volumes of direct properties in most countries and cities at all-time lows, accessing prime assets can be challenging for real estate investors. Availability of these high-quality assets is limited and there are a high number of buyers chasing the same assets. Cash-rich buyers from across the globe are vying for the same product: income-producing assets with long-term occupancy that can insulate the asset value.
The rumoured ‘mountain of (prime) properties’ coming to the market at distressed prices following the recent crises never materialised due to the gaping bid-ask spread between buyers and sellers. Yet, this phrase has been replaced by the ‘wall of money’, waiting on the sidelines and chasing the limited supply of prime assets coming to the market.
At the market’s trough, listed property companies did offer investors access and exposure to prime assets at very attractive entry levels. A key feature of listed property companies and REITs, in comparison to other real estate investment vehicles, is their ability to change hands continually, even during the downturn, providing exceptional and desired high levels of liquidity. This meant that investors could obtain exposure to high quality real estate at discounts to net asset value (NAV) coupled with relatively high and attractive yields.
The figure displays the discount to NAV for European listed property companies as well as the one-year forward looking total return performance (based on the FTSE EPRA/NAREIT developed Europe Index).
The quality of listed portfolios
Assessing the value of a real estate asset is a difficult task, even more so when transactional evidence is limited. Establishing the value for an entire portfolio is even more complicated. We can, however, look at other indicators and examples to demonstrate the excellent quality of listed company portfolios.
Listed property companies have assembled predominantly high-quality asset portfolios in good locations. Their strategy to own quality assets and to add value through active management has allowed them to enhance their return over the long run. Their financial capabilities allow them to acquire these assets and compete with other investors through the cycles. For example, based on the PMA Retail Score 2011, 17 out of the UK’s top-20 ranked shopping centres are owned, or co-owned, by listed property companies or REITs.
A testament of their managerial capabilities is the increased number of joint ventures between listed property companies and (international) pension funds. Invariably management control is maintained by the listed companies for which they receive management fees from the joint venture partner. At the same time, the listed property company is diversifying its capital sources.
With regards to the availability of debt for real estate investments in difficult markets, owning prime assets clearly has been a prerequisite. In this respect, listed property companies were one of the very few real estate investment vehicles which retained their access to the lending market throughout the downturn. The quality of their assets combined with excellent networking and relationships meant that they were able to refinance their debt before, or on, reaching maturity. Also, several companies were even successful in obtaining substantial bank credit lines in order to take advantage of market opportunities, again providing them with healthy balance sheets.
Likewise, due to a lending landscape being shaped by new regulations such as Basel III and Solvency II, banks as traditional lenders are expected to reduce their exposure. Meanwhile, insurance companies are expected to increase lending to real estate. Although this has been widely anticipated for a while, it is now taking place. In that respect, it is noteworthy to point out here that listed property companies are winning preferred-partner status in the maiden deals of many insurance companies, such as Canada Life Investments with Great Portland Estates, Aviva with Big Yellow Group and Legal & General with The Unite Group.
It is inevitable that these new lenders would only select the best assets to enter this space in order to minimise risk. The ownership of high-quality assets has allowed these listed property companies to secure long-term debt at low interest rates from a new source of capital, further diversifying their capital structure.
On the public debt market, bond issuances by listed property companies have increased in numbers and size recently. The vast majority of issuances have been oversubscribed several times and received good ratings from the rating agencies. Demand for this product from investors is strong, as is the long-term trust in the companies and management teams that issue them. Once again, the advantage of being backed by stable and secure income streams generated by high-quality assets plays its hand; investors require lower interest rates due to lower risk.
As an example, Unibail-Rodamco, Europe’s largest listed property company based in France, recently issued a six-year €750m bond at a fixed coupon of 2.25% which was four-times oversubscribed. At the same time, the 10-year French government bond yield stood at 2.28%.
The ability of property companies and REITs to raise debt from multiple sources at low interest rates throughout the cycle suggests inherently strong income fundamentals. The quality of the underlying assets in combination with a relative high security of income reduces the risk of covenant breaches, and as such are the key ingredients in successful real estate financing.
The right investment vehicle
Listed property companies and REITs possess unique characteristics which make them ideal owners of prime properties. The tax-transparent and efficient structure of the REIT means that income from properties is exempt from tax at the company level. Instead, the dividends paid out to the shareholders are taxed. In order to qualify for REIT status, several important criteria have to be met. One of these criteria is a high pay-out ratio of net income, which guarantees the stable income return to investors and makes the combination of prime assets and REITs the ideal marriage to be embraced by income-seeking investors, including specialist real estate investors as well as general investors. The rapidly growing defined contribution pension plan market is a clear beneficiary of this structure as well.
The Jones Lang Lasalle (JLL) Transparency Index 2012 reveals that listed property companies are a huge driver of transparency within a country’s real estate market. Countries with larger listed sectors, relative to their overall real estate market, scored better in terms of the JLL transparency rankings. One reason for this is the high standard and frequency of reports produced by the listed property companies. This transparency means that investors are not left in the dark when it comes to the performance of the buildings they own, but it also means that the management teams are under constant scrutiny from their shareholders. Similarly, over 100 dedicated equity analysts are actively monitoring the listed property companies, leaving no brick unturned when it comes to reviewing a company’s performance and management decisions. This creates and alignment of interest between managers and shareholders, which ultimately ensures better long-term performance.
The listed ‘wrapper’ also provides significant liquidity benefits to the otherwise illiquid real estate market (including for prime assets) and its investors. The possibility to increase and drop exposure to the real estate market at any given moment allows for unmatched ability to jump at opportunities as soon as they emerge.
On average, all the shares of listed property companies change hands every single year (based on FTSE EPRA/NAREIT Developed Europe Index). This is significantly higher than the liquidity of direct assets, where transactions take much longer to complete as well. On top of that, transaction costs are much lower when acquiring shares as compared to acquiring a direct property.
As individual prime assets require large capital investments, diversification is hard to achieve for individual investors. The small lot size of listed property company shares caters for this as the end-investor can diversify very easily by buying shares in a large portfolio of many assets, or even by buying shares of multiple companies. The FTSE/EPRA NAREIT Developed Europe Index currently consists of 83 constituents which own a combined real estate portfolio valued at approximately €272bn, as at end of 2011. The diversification advantage increases when investors want to invest abroad and across continents, since creating a global management platform can be time-consuming and not cost-efficient.
Arguably, prime assets are the safest and most stable assets to own in the real estate market when economic conditions are tough. Listed property companies have been successful in assembling and managing large portfolios of very high quality assets. The stable income stream secured by this also allows these companies to retain access to the different debt markets at favourable conditions. The stable foundations and balance sheets which coincide with owning these assets allow them to expand more quickly, taking advantage of the markets and increasing their exposure to prime assets. As the gap between prime and secondary asset is likely to widen further, the search for reliable income continues. Listed real estate vehicles potentially are the most efficient way to obtain liquid exposure to prime real estate assets.