Credit quarterly newsletter: Finding opportunities in the European real estate debt market
Rapid growth over the past decade
Ten years ago, we wouldn’t have even been talking about corporate bonds issued by European real estate firms as there basically weren’t any – back then, only a few European real estate firms had issued senior unsecured bonds. But around 2011, the universe began to grow rapidly, such that by the end of August this year the number of companies that had issued debt had risen from ten to almost 60, the number of bonds outstanding had increased from around 25 to nearly 250, and the total amount of debt outstanding had surpassed EUR 130 billion¹.
So real estate bonds have become a relatively large constituent of the European credit universe, and one that investors can’t afford to ignore. In fact, it’s now the fifth-biggest sector in our benchmark in terms of risk.
Source: ICE Bond Indices; data as per 31 Oct 2020
Why has it grown so much?
The market’s growth has mainly been driven by real estate firms’ need to diversify away from their traditional source of funding – bank lending – since the financial crisis. At the same time, investors have increasingly been looking for new sources of yield in the low-yield environment, and senior unsecured bonds issued by real estate companies have been of considerable interest to them. And when other real estate firms saw their peers’ bond issues meet with considerable success, this led them to issue themselves.
“We believe the sector will continue to grow over the coming years as real estate firms are still keen to issue debt and investors are becoming more familiar with investing in this sector.”Alain van der Heijden, Head of Fixed Income team
The current state of the real estate debt universe
The real estate debt universe is deep and well diversified, and provides a wide range of opportunities for active investors to exploit.
There are several large real estate companies with five or more bonds outstanding. But there’s also a long tail of firms with only one or two bonds outstanding. That means it’s a broad universe that provides lots of outperformance opportunities for investors willing and able to perform in-depth credit analysis.
At Kempen we split the real estate debt universe into five clusters: residential, retail, offices, logistics and “other” (which includes hotels, data centres and health care). And of course a few companies are diversified in nature and hold properties in more than one of these categories. All of these clusters are well represented in our investment universe.
The sector is also well diversified at the country level:
- a significant proportion of the universe comes from France, mainly in the office and retail spaces
- Germany is increasingly represented, mainly through residential firms
- the Scandinavian market is growing because these countries’ domestic investor bases aren’t big enough to help the region’s companies fund the growth they want to achieve, so they need to access the euro markets. They see the debt markets as a good way of doing so.
- there are also bonds issued by firms domiciled in Eastern Europe, Spain, the Netherlands and the UK.
We also see several global real estate firms issuing debt in the euro markets. These include Prologis, a global logistics firm headquartered in the US; Scentre Group, an Australian retail property firm; and Digital Realty Trust, a US data centre company.
The majority of the firms in the universe fall in the BBB rating bucket. This is related to the fact that real estate firms generally have capital-intensive business models and employ a fair amount of leverage. They typically have fairly high spreads for their rating, which can make them attractive potential investments. Also in the Euro High Yield market we have seen new companies tapping the senior unsecured credit market.
Kempen: a real estate specialist
At Kempen we’re well known as a real estate franchise – not just because of the capabilities of our asset management division, but also our merchant banking unit. As a result we were well placed to start covering real estate bonds when the market started to grow back in 2011. We know the universe very well and have benefitted a lot from all the opportunities it has had to offer over the years that have followed.
When analysing real estate bonds the members of our credit team work closely with our real estate equity colleagues. We have ongoing dialogue with them, sharing knowledge and ideas, and when we’re covering the same companies we meet those firms together, which provides an interesting dynamic to the discussion. And of course we keep each other up to date as soon as developments occur: if a company suddenly decides to issue debt, that’s very useful information for our colleagues in our real estate equities team.
The impact of the pandemic on the European real estate debt market
The pandemic has hit certain segments of the real estate sector very hard, but perhaps what’s been most apparent is that it’s accelerated certain trends that were already underway.
For example, residential was already seen as a good investment due to the effects of urbanisation and for the stable yield it provides in a low-yield environment, while logistics was already prospering because of the growth in e-commerce. There was steady demand for bonds issued by office companies, especially those with a portfolio of offices in good locations. Retail, however, was already struggling due to the growth of e-commerce and oversupply of shops and malls in certain regions.
Then the pandemic hit, and these trends were amplified.
Residential garnered even more interest because of its defensive nature – people’s rent is the last thing they stop paying in a crisis – while logistics powered ahead as everyone was working from home and had to buy things online when the shops were closed.
Offices were hit as people were working from home, so investors were asking – and are still asking – whether there’s going to be more acceptance of flexible working in the future, reducing demand for office space. People will probably have to go to the office less overall on average in the future, but at the same time there should still be demand for high-quality offices – spacious, in good locations and focused on the environment. Tenants have long leases, and are generally continuing to pay their rents, so problems shouldn’t arise in the short term.
Of course retail was hit very hard as shops were forced to close, so their revenues slumped and they had severe difficulties in paying their rents. Many retailers entered discussions with their landlords – the companies whose bonds we invest in – about rent-free periods, deferrals or changes to the structure of their leases.
And it goes without saying that within our “others” cluster, hotels suffered very badly from the drop in occupancy.
How did the debt and equity markets respond?
It’s interesting how the debt market has responded to the pandemic. Bonds of representative companies in the main clusters we follow have moved since the start of the year as follows (in basis points, bp)².
Residential – spreads up 0-10bp
Logistics – spreads up 10-25bp
Offices – spreads up 25-60bp
Retail – spreads up 70-500bp
So the different clusters have reacted quite differently, and there’s also been a sharp divergence in performance within clusters between strong and weak companies. A rated firms have widened less than BBB companies, with investors clearly taking into account the strength of each firm’s balance sheet. From this angle, the repricing has been rational.
We’ve seen a similar trend in the equity markets to a certain extent. Residential firms are up by 20–25% year-to-date and logistics firms by 15–20%³, making them the real winners. But the stocks of office firms have been hit much harder than their corporate bonds, slumping by 30–40%³. Retail is all over the place, but the stocks of some firms have fallen by well over 50%³.
There’s clearly been greater divergence between the haves and the have nots in the equity markets, and our colleagues in our real estate equities team point out that the repricing has been indiscriminate, with little regard for the strength of the firms’ balance sheets.
So what’s going on here? Why the difference between the debt and equity markets? We believe it’s mainly the result of the ECB’s actions to prop up the markets in the wake of the pandemic, and in particular its corporate bond purchase programme. This programme has really supported spreads in the European credit markets. By contrast, liquidity in the equity markets has been very sparse, and practically non-existent for smaller companies – hence the much sharper swings in performance.
What’s the outlook for real estate debt from here?
The coronavirus pandemic has created some good opportunities. When the pandemic hit, spreads widened across the whole European credit market, but those of real estate bonds widened more on average. In the subsequent sharp rally we’d have therefore expected real estate to rebound more than the broad market, but in fact it continued to underperform. From a valuation perspective, this has made real estate quite interesting, making a good case to overweight the sector.
Within the sector, we still like residential, where we’re finding a lot of interesting opportunities. We’re also overweight logistics, where spreads have performed well but we believe they still have scope to rise further. Despite the problems facing retail we’ve started to very selectively add to stronger retail names that have taken steps to strengthen their balance sheets through measures such as suspending dividends, disposing of assets and capital raising; for example a name we like is Scentre Group. Scentre Group has also issued hybrid bonds to strengthen its balance sheet.
We’re most cautious on the office segment as we’re wary of the longer-term impact of working from home on structural demand for offices. However, there shouldn’t be a sudden shock as most firms are still paying their rents in the meantime.
To conclude, the European real estate debt market has evolved into a significant, diversified part of our universe providing many opportunities we aim to continue to exploit.
- ICE BofA Bond Indices; data as per 31 October 2020
- Source: Bloomberg Finance L.P., spread move from period Jan 1st to October 31, 2020.
- Source: Bloomberg Finance L.P., spread move from period Jan 1st to October 31, 2020.
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