European Real Estate Debt: Where Next?
Significant Opportunity for Nonbank Lenders to Grow Market Share
The global REIT market continued to benefit from the re-opening, reflation and re-calibration themes in the second quarter. In the United States., REITs outperformed the broader equity markets by approximately 200 bps. In Europe, REITS outperformed general equity markets by over 300 bps in the quarter. Geographic regions that made the most progress in vaccination implementation outperformed those regions that were slower to roll them out. As a result, U.S. and European REITs outperformed Asian REITs in the quarter. The quarter, however, was not without volatility as investor concerns around the COVID-19 Delta variant, triggered by new states of emergency in parts of Asia Pacific and Europe, weighed on investor sentiment about the timing of the re-opening.
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The U.S. REIT market gained 11% in the second quarter of 2021, outperforming the S&P 500 by over 200 bps for the second quarter in a row.
The highly successful vaccination effort in the country has pushed daily COVID-19 cases to the lowest levels witnessed since the onset of the pandemic over a year ago. The economic re-opening continues to gain momentum, driving demand for commercial real estate across the board. In addition, long-term rates have largely stabilized after an initial spike earlier this year, providing additional comfort to the REIT market and creating an ideal scenario of improving growth and limited rate movement. Year to date, the U.S. REIT market is up 21.2%, roughly 600 bps ahead of the S&P 500.
The U.S. REIT market remains well positioned for the second half of 202 and into 2022. Despite the recent recovery, valuations remain attractive at a 4.6% implied cap rate, or roughly 320 bps spread to the 10-year. While this spread is consistent with the long-term average, given most REITs’ current depressed NOI levels, we would expect this spread to compress much further before reverting to its long-term average. Despite some near-term disruption to NOI growth in certain sectors, we expect FFO per share growth of 4.6% in 2021, followed by an impressive 8.4% in 2022. The recent improvement in REITs’ equity valuations has allowed many REITs to get back on offense with new equity issuance going towards acquisitions and development. A favorable cost of capital and faster pace of reopening bode well for upside to our nearterm earnings expectations.
June marked the fourth month in a row in the green for European real estate…but only barely.
However, European real estate’s two-month streak of outperformance was broken as the sector lagged both regional equities and the global real estate index. Nevertheless, Europe did catch a re-opening bid as vaccine programs ramped up through the second quarter, which seemed to generally trickle down to incrementally positive commentary from management teams in first quarter earnings. European real estate posted a 0.4% total return (-2.7% USD) in June, lagging both the broader Stoxx 600 index (-110 bps) and the EPRA Global real estate index (-390 bps USD).
Broad dollar strength weighed on Europe’s relative USD performance as the greenback gained 3.0% vs the euro, 2.7% against the pound sterling, and 3.1% vs the Swedish kroner. 2021 is likely to be a tale of two halves as vaccine efforts continue to ramp up through the summer, thus paving the way for a broader economic re-opening later this year. Current valuations reflect this divergence. UK real estate is trading around a 1% discount to NAV versus continental Europe which has widened slightly to a 9% discount, although the range remains very wide across individual sub-sectors. In terms of implied cap rates, the UK is at 4.7%, a 410 bps spread to 10-year gilts, and continental stocks trade at 4.5%, a 480 bps spread to 10-year bunds. These spreads remain attractive versus long run averages of 330 and 450 bps for the UK and Europe, respectively.
The Asian real estate equity market rallied 3.5% in the second quarter of the year, after a 6% return in the preceding quarter.
Sentiment in the second quarter was dampened by the spread of the COVID-19 variant, in spite of the accelerating vaccinations. The risk-off sentiment was also reflected by the outperformance of the REITs against developers in the quarter. Australian REITs led the pack (+7.9%5 in USD terms), followed by J-REITs (+7.5%) and Singapore (-0.1%). Within the developers, Japan rose +0.1%, while Hong Kong and Singapore developers lost -0.5% and -1.5% respectively. The relatively muted performance in Singapore was partly attributable to the new movement restrictions measures put in place from May 16 to June 13 to curb a spike in COVID-19 community cases.
We are optimistic for 2021, premised on economic recovery aided by economic stimulus and the gradual easing of restrictive movements with successful vaccine development. The outbreak of COVID-19 has ushered in a period of unprecedented global monetary easing and fiscal stimulus as countries coped with the economic fallout. With Asia virus caseloads dwindling over the past few months, the focus is now on re-opening and the delivery of an effective vaccine. Sectors that witnessed a significant contraction in demand (such as hospitality and retail) will likely see strong recovery in the coming months. In the near-term, the following themes could be in focus: The COVID-19 and vaccine impact on society and economy; Economic stimulus; Bond yield spike on inflation expectations; Recovery in retail and hospitality; and finally, U.S.-China relations.
For more details, read the full Market Review and Outlook, which is available for financial professionals.
PGIM Real Estate discusses wide range of opportunities for real estate investors from improving sentiment and rebounding demand.
Past performance is no guarantee of future results. The views expressed herein are those of PGIM Real Estate investment professionals at the time the comments were made and may not be reflective of their current opinions and are subject to change without notice. Neither the information contained herein nor any opinion expressed shall be construed to constitute investment advice or an offer to sell or a solicitation to buy any securities mentioned herein. This commentary does not purport to provide any legal, tax, or accounting advice. Certain information in this commentary has been obtained from sources believed to be reliable as of the date presented; however, we cannot guarantee the accuracy of such information, assure its completeness, or warrant such information will not be changed. The information contained herein is current as of the date of issuance (or such earlier date as referenced herein) and is subject to change without notice.
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1048050-00001-00 Ed: 08/2021