European markets
The peak in the EPRA Europe (UK restricted) Index coincided with the publication of Land Securities’ full year results. At its worst, the index fell by 11.9%; at the time of writing, it has recovered to be 8.0% off its high.
The MSCI Europe index has fallen by 10.2% over the same period (9 May to 20 June, 2006).
The US REIT sector has tracked 10-year interest rates rather than the Dow throughout the recent turmoil, and it is perhaps surprising that European property stocks have performed so poorly.
Simplistically, property stocks performed very strongly in the first four months of this year and the stock market is now saying that property is a play on interest rates; the theory being that interest rates are rising and consequently property values will fall. It is also fair to say that a much larger proportion of the US REIT universe is held by specialist investors than is the case in Europe, and property shares are consequently more exposed to stock market volatility than their REIT cousins.
The market sell off has probably also exposed the degree to which property shares have attracted momentum investors who have done well over the last three years and are now trying to book their profits.
Short-term interest rates may be rising, but this is already largely discounted in bond markets and it is noticeable that five-year swap rates, which are the reference point for the pricing of most property finance, have so far moved in relatively narrow bands in the UK and the Eurozone.
Looking at the underlying property markets, we are of the view that very little has changed.
In the UK — which accounts for 53% of the portfolio — the investment market is now dominated by institutions and petro-dollar investors who are happy to outbid the leveraged investors who have dominated the market for most of the last 10 years. More importantly, we believe that the central London office market is entering a period of sustained rental growth. The fund is positioned to exploit this, with 20% of the underlying property portfolio in central London offices through holdings in Land Securities, British Land, Hammerson, Derwent Valley, Great Portland, LMS and Minerva. It is also worth noting that the fund’s UK retail exposure is almost exclusively held in prime shopping centres and retail warehouse parks, which are highly prized by institutional investors, and where rental levels are likely to show the strongest growth.
In continental Europe, we continue to see downward pressure on investment yields as investors seek to lock in the arbitrage between property yields and the cost of money. In Germany, for instance, quality property in all sectors of the commercial market can be acquired at yields in excess of 6.5% and financed at interest rates below 5.0%. This is attracting property entrepreneurs and opportunity funds who can adopt the same highly-leveraged
approach as they used so successfully in the UK. It is also attracting the new breed of listed investment funds which can offer an instant 6% dividend payout together with medium-term capital growth as the German economy recovers. The fund is already positioned to exploit this yield arbitrage in a number of markets—such as Italy and Sweden—and we are building positions in Germany when the opportunities arise.
Some of the key continental European office markets, namely Paris, Madrid, Barcelona and Stockholm, are comparable to London. An upswing in the rental cycle is in prospect and the fund is positioned accordingly.
Fund performance
While the core strategies of the fund remain valid, the fund has underperformed the EPRA Europe (UK Restricted) Index during June. There are a number of reasons for this.
Four factors have contributed to the majority of June performance:
- The fund is underweight in Spain. Metrovacesa is the subject of a battle for control between two shareholding groups. This is sustaining the share price at what we continue to believe is a significant premium to NAV. The shares appear overvalued and we do not wish to expose investors to a such a situation just to provide a benchmark weighting. The fund was also underweight in Inmobiliaria Colonial (Spain’s second largest property company) ahead of the bid from Grupo Inmocaral, which boosted the share price of Colonial and its listed French subsidiary SFL.
- The German, Swedish and Italian stocks have performed poorly, with the Swedish stocks particularly hard hit by a round of mutual fund redemptions.
- House building stocks have de-rated as investors have reflected on the outlook for residential sales.
- The fund’s Central European holdings have fallen as investors have withdrawn money from emerging markets.
Dealing with each in turn, the Spanish bids are a one off, which account for the fund’s underperformance in March and part of the underperformance in June.
The Swedish stocks are trading at or below book value with NAV growth to come, and the Italian stocks are now cheap. The German stocks have been strong in anticipation of REITs, with significant hedge fund participation in the market. We have cut a couple of small positions in stocks which we continue to believe to be overvalued.
We remain committed to central Europe in the belief that the fund’s holdings are well positioned to exploit the emerging office, retail and residential markets.
We have generated very significant outperformance from house builders, particularly in the Nordic region. House sales continue to hold up well and there is no evidence that prices are falling; however, investor sentiment is running against these stocks.
Finally, it is worth reiterating that while the very strong performance shown by property shares over the last three years is probably unrepeatable, property shares should, in future, track direct property returns more closely. Here we remain optimistic and our 12-month total return forecast for the EPRA Europe (UK Restricted) Index is currently running at 15%.
Performance Update 21 June, 2005
Adrian Elwood
Associate Director, Property Securities
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