Barclays: 'myopic focus' on base rate cuts misses that swap rates have a greater bearing on CRE

In a follow up to a report in December when analysts questioned what if rate decline expectations were too optimistic, the team has come forward with an update.

With the European Central Bank (ECB) reducing rates on 6 June, Barclays equity research analyst, Paul May, and colleagues, say: ‘We continue to think it is overly optimistic to hope that base-rate cuts will come to the rescue of commercial real estate (CRE) asset values and real estate landlords’ balance sheets.’

‘Mid-swaps (longer term funding costs) drive real estate values and investment decisions to a greater degree than base rates, yet despite swap rates already reflecting materially lower base rates, real estate transaction volumes remain depressed.’

The key rate to watch is the 5-year swap rate, as this is the most relevant financing reference rate for real estate investment.

Last week’s 25bps EBC base rate cut resulted in an approximate 4bps increase in the 5-year swap rate on the day of the announcement. The swap rate was up 9bps the following day as well albeit this was following a better-than-expected non-farm payrolls figure. Indeed, swap rates are back to year-to-date highs.

While there are many reasons for this (including US non-farm payrolls last Friday), the reaction in swaps post base-rate cuts has surprised many investors.

The research analysts say: ‘To us, this shows that the gap remains between optimistic ask prices (balance sheet book values) and bid prices. While there are always exceptions to the rule, and we have seen some transactions occurring at book value, we surmise these have either: 1) had their book values written down ahead of sale or 2) been the target of a motivated buyer for very specific reasons.’

They continue: ‘We think the myopic focus on base-rate cuts means the impact on earnings from eventual refinancing at marginal all-in cost of debt is being overlooked by the market.’

‘We actually see risk that forward rates could move higher compared to current levels as base rates may not be cut to the extent of the c. 150-175bps that are priced into swap rates, assuming historical term premia are reinstated. Our base case is that as base rates are cut, we should see a steepening of the current, abnormal, inverted yield curve, so forward rates would be largely unchanged and all-in marginal finance costs would remain at c. 4-6% (depending on geography, sub-sector and company leverage profile).’

The team continues: ‘We don’t see bid prices increasing as base rates are cut. We therefore believe the risk is that asset values (as reported on balance sheets) are artificially too high, and could decline further if transactional evidence suggests a fall in values. An increase in transactions towards the end of 2024 and into 2025 could be driven by debt and equity maturities forcing/motivating existing owners to dispose of assets, thus increasing supply, without a material increase in buyers.’

‘The positive is that this creates an opportunity for those with capital to invest, to acquire real estate assets at attractive returns. Assuming we are right, we believe those companies who have raised equity capital are poised to pounce if and when these opportunities emerge.’

The European research team covers the best known listed real estate companies in Europe from Aroundtown and Vonovia in Germany, and Landsec in the UK, to France’s Gecina, Spain’s Merlin, and around 40 more.

May says he sees listed real estate companies as the natural owners of core and core-plus real estate assets in the current all-in finance cost environment. He explains: 'However, while some companies are well placed to take advantage of the material opportunities they expect to emerge for the sector to grow through accretive acquisitions, not all are ready to pounce.'

While the opportunity for acquisitions is possible, he is concerned that listed European real estate companies, on average, have limited financial headroom to act on the attractive acquisition opportunities expected to emerge once base-rate cuts materialise.

‘While many commentators expect base-rate cuts to lead to a stabilisation and even potentially increases in asset values, as mentioned we do not expect this to be the case. If anything, it is perversely a greater existential risk for the listed real estate companies if asset values materially appreciate due to yield compression, as this would make it difficult to justify asset acquisitions, something we see as being the main driver of earnings growth over the coming years.’

Buyer’s market
The team's stance is all the more interesting as Barclays does see Europe as entering into what it calls a 'buyer’s market', but that opens the question as to who will those buyers be?

‘We are entering a buyers' market and we advise investors to buy the buyers: We expect increasing volumes of real estate to be brought by sellers to the market as we progress through 2024 and into 2025, due to debt and equity maturities. We think the companies in a position to buy should be able to take advantage, and in a buyers’ market we advise owning the buyers, not the sellers.’

‘Companies which sell assets to protect the balance sheet are shrinking and are unlikely to be appealing to investors, who we believe will increasingly prioritise growth investments. To the contrary, we believe those which raise capital and invest in good opportunities at attractive prices will be well-received by the market. In other words, we would advise owning the well-capitalised, relatively expensive stocks in a buyers’ market, not the over-leveraged, optically cheap stocks.’

‘While we find all stocks are impacted by the different scenarios around swap rates, there are varying degrees to which earnings, NAVs and LTVs react to the scenarios. We generally find UK and Nordic earnings are less impacted as the delta between current/forecast finance cost and marginal finance cost is less than for Continental European companies, and for the UK the quantum of leverage is significantly lower than for both the Nordics and Continental Europe. German residential companies screen poorly, but they do have relatively good hedging profiles, so arguably have more time to adjust.’

Further decline in values might help 
‘We believe a more attractive proposition is that asset values see further declines, thus making acquisitions more attractive for listed real estate companies, who we believe have a cost of capital advantage compared to the majority of private investors.’

‘From our discussions, we understand that PE and Sovereign Wealth investors have a geared return (IRR) hurdle of 15%+, while pension funds are generally over-indexed to real estate and have become over-funded due to higher discount rates, and are thus in general looking to reduce exposure to real estate. Insurance companies are more opaque, but we also understand they are over-indexed to RE and are not looking to increase exposure. Whereas we see the total return level for listed real estate companies (or cost of capital) of c. 7-8%, based on long-run equity market total annual returns of c. 7-8%. This gives listed RE companies an advantage when it comes to pricing RE acquisitions. This is opposite to the 14 years post the GFC when listed RE companies were largely priced out of acquisitions by more highly levered PE or lower cost of capital pension and insurance companies.’

The analyst team runs various scenarios and pointed to the likes of Landsec, LondonMetric, Catena, Tritax Big Box, WDP, UTG, Klepierre and Big Yellow Group as ‘screening well’ in the What If scenarios, but also as well-placed buyers.

Conversely, Cofinimmo, VGP, Vonovia, Wallenstam, Aroundtown and Colonial screen poorly in Barclays’ analysis and generally have relatively ‘stretched balance sheets’.

It also notes that Gecina and Icade would not screen well, should debt refinance at current/higher rates.