Following more than a decade of favourable financing conditions and debt-financed growth, a much larger European real estate sector finds itself in a far trickier operating environment. Now the third largest industry sector in the European investment grade market, real estate has sharply underperformed during 2022 in recognition of higher nominal interest rates, reduced access to capital, and higher sector and market risk premiums. Once a darling of the European investment grade market, sentiment has flipped as investors begin to fully appreciate the potentially potent combination of elevated balance sheet leverage as well as ongoing capital access and funding dependency.
Real estate’s weighting in the European investment grade market is now roughly 7%, up from a paltry 2% in 2015. The sector’s growth largely mimicked the bull market in European rates, underscoring fertile financing conditions (Figure 1), an abundance of acquisition targets, and a receptive investment grade debt syndicate.
Figure 1
Growth of European Real Estate Bonds Outstanding against German Bund Yield
PGIM Fixed Income and Bloomberg.
Years of cheap financing and easy access to capital conspired to drive-up continental property values and push down rental yields (rental income relative to property value). The reversal of the low interest rate regime has flipped the fortunes of European real estate. We expect that the magnitude and pace of interest rate increases will drive property value declines across the sector. The resultant value unwind will be amplified by the impact of depressed starting rental yields. While the sector in its entirety will experience some level of broad-based discomfort, we expect that a disperse set of outcomes—based upon varying demographic trends, regulatory regimes as well as company-specific funding profiles and capital structures—will create winners and losers.
Swedish residential real estate is highest on the risk spectrum. During the past decade of low interest rates, strong investment demand for regulated residential assets underpinned by secure cash flow streams in undersupplied markets inflated asset values. Swedish residential property companies levered heavily on these unrealized gains to support portfolio growth and, thus, entered 2022 in a highly interest-rate sensitive position. Industry bodies project declines of 10-15% in these assets within 18 months, which will put further pressure on balance sheets and impact access to funding. Figure 2 illustrates issuer sensitivity to declines in property values, with Swedish firms SBB, Heimstaden Bostad, and Balder as the most vulnerable.
Figure 2
Sensitivity of Loan-to-Value (LTV) Ratios with Property Yield Increases of 25 bps and 50 bps, Respectively1
Issuer reports and PGIM Fixed Income Estimates.
Location, Location, Location
A material increase (>100 bps) in property rental yields would likely indicate a shutdown of credit supply from banks and credit funds, forcing issuers to aggressively sell assets to meet debt redemptions and short-term liquidity issues. At this point, we expect 50-150bps of yield expansion depending on geography and asset class, with Nordic residential and peripheral office assets at the higher end of the range. This will begin to impact reported figures with a lag from Q3 2022 as property appraisals are backward-looking and highly dependent on comparable transaction prices. Therefore, in a market that is anaemic with few transactions, valuations are likely to change gradually in the short term until we begin to see forced sales at large discounts to book values.
Is the Credit Ceiling Falling In?
Interest rate increases pose a longer-term problem for the sector, as some property companies will face bond financing rates above property rental yields. As these yields adjust to market conditions with a lag, this creates a market environment where real estate companies are consistently pressured into negative cash flows. As a result, many issuers are once again turning to banks to access lower-cost secured financing. We think banks are generally willing to lend given their improved capitalization levels and the general reduction in property portfolios’ LTV ratios relative to 2007. In addition, with record issuance levels shown in Figure 3, property companies have taken advantage of favourable market conditions to refinance secured debt with unsecured bonds over the years, leaving large portions of their portfolios available to pledge as collateral for bank funding in tight credit conditions. This has meant that companies have been able to access bank loans at low rates without impacting their interest coverage. However, secured financing is not a longer-term solution to companies in the public markets, as bond covenants have limits on issuers’ secured leverage.
Positively, we see continental European companies as well positioned with long-term debt maturities and no significant refinancing needs. Figure 4 shows that over the last decade, companies have termed out debt to an average of seven years at an average cost of debt of 1.6%.2 As a result, this gives them a buffer of time to ride out the current market volatility and inability to access bond financing.
Figure 3
Annual Issuance of European Real Estate Debt (€ in billions) and Figure 4: Change in Average Cost of Debt and Maturity of Debt across Public Real Estate
PGIM Fixed Income and Dealogic.
Unsurprisingly, landlords with the largest portfolios in the real estate universe—Vonovia, Unibail-Rodamco-Westfield, and Heimstaden Bostad—have the largest volume of bonds to refinance within the next three years. However, management teams have shifted their focus to curbing acquisition spend, accelerating disposals, and internally generating cash flows in order to reduce reliance on bond markets for refinancing.
Nordic companies are in a more challenging position, as local loans are predominantly floating rate and shorter term. Therefore, these companies have short-term refinancing needs. Among the Nordic companies, we have a strong preference for those with large, institutional shareholders that can support balance sheets through the contribution of equity. Concerns are highest for those like SBB and Balder, where the property-magnate private owners lack the ability to provide liquidity, thus raising questions around potential forced asset sales to support balance sheets.
Home Improvement
Erosion of credit quality may catalyse broad-based negative ratings action. Higher funding costs relative to other sectors is not new to real estate. Historically, market-implied real estate bond spreads have traded one notch wider than an issuer’s credit rating due to the sector’s higher empirical beta and the high volume of new bond issuance. Since the step-up in rate and credit market volatility in early 2022, real estate bonds have traded one additional notch wider.
The need for issuers to access the debt capital markets underscores a certain circularity; the longer the selloff / elevated credit risk premium in the market, the longer the unsecured market may be unattractive or unavailable and the higher the refinancing risk, all of which leads to even more negative sentiment and higher risk premia. One offset is that the cost of capital penalty associated with falling below investment grade is so onerous that companies are heavily incentivized to avoid it at all costs (Figure 5). However, given the volatile economic and market backdrop, the typical toolkit of asset disposals and equity (or hybrid) issuance may be difficult to efficiently execute or prove far too punitive to investors / owners. Dividend reductions and suspensions are an obvious lever that may be pulled, but dividend distributions are often relatively low compared to gross debt loads and, therefore, less meaningful from a liquidity and de-leveraging standpoint.
Figure 4
The Punitive Cost of Falling Below BBB May Prompt Many Issuers to Act
PGIM Fixed Income and Bloomberg as of 02 November 2022.
Conclusion
The European real estate sector has entered a new paradigm following years of cheap capital and debt-financed M&A. Higher financing costs, a deteriorating economic backdrop, and imminent expected asset value declines necessitate a return to defensive corporate strategies as the pressure is unlikely to abate anytime soon. Even so, there will be varied balance sheet and earnings outcomes amongst market participants, underscoring the importance of issuer-level due diligence and active security selection.
1SBBBSS is Samhällsbyggnadsbolaget (SBB), HEIBOS is Heimstaden Bostad AB, BALDER is Fastighets Balder, ULFP is Unibail Rodamco Westfield, BPPEHX is Blackstone Property Partners Europe, ARNDTN is Aroundtown, GYCGR is Grand City Properties, HMSOLN is Hammerson, ICADFP is Icade, ANNGR is Vonovia, LEGGR is LEG Immobilien. LOGICR is Logicor, LIFP is Klepierre, SCGAU is Scentre Group, VVOYHT is Kojamo
2Based on PGIM Fixed Income calculation via company reports.