Continental European real estate

Transcription

1 October 216 For professional investors only. This material is not suitable for retail clients 1 Schroders Insurance Asset Management Insurance Strategy Continental European real estate The right time to capitalise on stable rental income The rental income offered by Continental European real estate has remained stable despite extraordinary monetary policy pushing yields down elsewhere. This together with improving economic conditions and a lack of supply means the asset class now looks attractive, particularly for insurance companies. The rental yield, adjusted for capital charges, generated by property is over 2 higher than that of corporate bonds Real estate income is very stable Supply and demand dynamics are supportive of property valuations Continental commercial real estate why now? Real estate is not a new asset class for insurance companies although its relative attractiveness, measured here by its yield advantage over corporate bonds, is now at historically high levels. The figure below illustrates the divergence in yields that has occurred in recent years. Average yields for government bonds, corporate bonds and Continental European office buildings European office rental yield European 1 year government bond yield European corporate bonds (7-1 years) 215 Source: October 216. Bloomberg, Cushman, Schroders. Corporate bonds are represented by the BofA Merrill Lynch Euro Corporate Bond Index. Rental yields are for offices of average grade. European 1 year government bonds are an equally weighted average of French and German government bonds. 216

2 2 To help insurance company CIOs decide whether they should take advantage of this relative value opportunity we answer the following three questions. 1. How is real estate treated under Solvency II? 2. Is the European commercial real estate market in bubble territory? 3. Is the rental income from commercial real estate stable? Question 1: How is real estate treated under Solvency II? When comparing yields across different assets it is important to consider differences in their capital treatment under Solvency II. Direct property investment attracts a Solvency Capital Requirement (SCR) of 25 under the standard formula, whereas corporate bonds attract charges that vary depending on the bond s credit rating and duration. The chart below shows the same comparison of corporate bond yields and rental yields presented earlier but this time the necessary adjustments have been made to reflect differing capital requirements. The analysis shows that despite attracting a higher capital charge, commercial real estate could offer a healthy pick-up over corporate bonds over 2 in the case of European offices. Capital requirement adjusted comparison of bond and real estate yields European office rental yield adjusted for SCR charges European government bonds ( capital charge) European corporate bonds adjusted for SCR charges Source: October 216. Bloomberg, Cushman, Schroders. Corporate bonds are represented by the BofA Merrill Lynch Euro Corporate Bond Index. Rental yields are for offices of average grade. European 1 year government bonds are an equally weighted average of French and German government bonds. The SCR charge for corporate bonds assumes an 8 year duration, credit quality of single-a and that the asset is matching a liability so that only spread capital charge is considered. Rental yield has been adjusted assuming a 25 Solvency Capital Requirement. Diversification benefit is ignored. Cost of capital is assumed to be 6. Diversification In a portfolio context, real estate provides diversification which is recognised in the standard formula SCR calculation. For example, adding a 1 property allocation to a European government bond portfolio with a seven year duration would generate a diversification benefit of 2, reducing the overall SCR from 7 to 6.8. This is due to the interest rate risk being treated as uncorrelated against property risk within the Solvency II capital calculation. Diversification is not only useful in the context of reducing overall capital requirements. An allocation to real estate in a predominantly fixed income portfolio has additional attractions. For example, real estate yields and bond yields have different drivers and although over the long-term real estate yields are linked to bond yields, but provide an additional premium for illiquidity, depreciation, etc., there is often little relationship between the two in the short to medium term. The main reason for this, of course, is that real estate is not a fixed income asset and yields are also heavily influenced by investors expectations for future rental growth. Thus, real estate yields in continental Europe rose sharply during the financial crisis as investors worried about potential tenant failures, even though the ECB cut interest rates and bond yields in core Eurozone countries fell by between 27 and 21. Conversely, it is possible that if Eurozone bond yields start to rise over the next few years, as the economy strengthens and the ECB becomes concerned about inflation, that real estate yields may not react, because investors may simultaneously upgrade their assumptions for future rental and income growth.

3 3 Question 2: Is the European commercial real estate market in bubble territory? In addressing the concern that property prices might drop we use data for offices because they are the most liquid and transparent portion of the European real estate market. As one might expect, the market value of commercial real estate, such as an office building, is fairly sensitive to overall economic conditions. The chart below shows how the amount of office space rented in the major European real estate markets fell in the wake of the financial crisis but has now recovered. Occupier demand for European office space Four quarter moving average (, square meters) Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q Source: JLL, Schroders. October 216. Country figures based on major markets. In contrast to the renewed demand for office space, supply looks modest by historical standards. In fact net additions last year were the lowest in twenty years. This reflects the reluctance of banks to lend on speculative developments, following the introduction of tighter capital requirements after the financial crisis. Building activity remains subdued Germany France Italy BeNeLux Iberia Sweden Office completions (, square meters) Forecast Net-Additions ( of Stock) Germany France Italy Spain Benelux Nordic Central Europe Other Net additions (LHS) Source: PMA, Schroders. October 216, Note forecasts should be regarded as illustrative of trends. Actual figures will differ from forecasts. The natural result of increased demand and better economic conditions is an increase in rents which is exactly what we are seeing across several major European cities. The chart below shows that a growing portion of the 29 major European markets we analysed are recording increasing rental values. Higher rental values are the foundation of higher commercial property valuations. For this reason we believe that European real estate prices have further upside.

4 4 Percentage of cities recording an increase, or decrease in prime office rents Source: PMA, JLL, Schroders. October 216. It is based on 29 major office markets across Europe. Data excludes UK. Brexit fallout should be contained within the UK Given the impact of the decision to leave the European Union on investor sentiment in the UK real estate market, some may worry about spill over into the European market. We do not see any cause for concern. Sentiment for core European offices continues to strengthen as shown in the chart below and most funds that cater to institutional clients avoided the liquidity related issues suffered by retail funds. Investor sentiment Increase No Change Decrease 8 6 Sentiment strong Sentiment weak Q1 216 Q3 Core Euro Offices UK Offices Source: PMA, October 216. While the UK s vote to leave the EU may dent business confidence in the Eurozone in the short-term, we doubt it will halt the recovery. Brexit means that investors will pay more attention to political risk in future, however we doubt it will reduce their appetite for real estate in core Eurozone countries. Given real estate s attractive relative valuation we foresee insurance companies increasing their allocation to the asset class. Investors looking to take advantage of weaker sterling may chose to invest in UK real estate while others may look to capitalise on the strong momentum and attractive market backdrop of Continental European real estate.

5 5 Question 3: Is the rental income from commercial real estate stable? Part of the total return expected from real estate is derived from increased asset values but it is the high income return that has attracted so much attention from insurance companies. In the figure below, total return is broken down into its income and capital components. The dark blue bars in the figure below show how little volatility is associated with income return which has historically remained very close to 5. Europe ex UK office performance Total returns 2 15 Forecast Total Returns End 216 End 22 6 p.a Capital growth Income return Total return Source: IPD, Schroders. October 216. The forecast should be regarded as illustrative of trends. Actual figures will differ from forecasts. Income return = the return due to rental payments. Past performance is not a guide to future performance and may not be repeated. Although leases in continental Europe are typically shorter than those in the UK, the income return on real estate has been very stable. This reflects two main factors. First, there is naturally quite a lot of inertia among commercial occupiers and tenants in continental Europe are correspondingly more likely to renew their lease when it expires, than tenants in the UK. Second, most continental European leases include an element of indexation to inflation. Furthermore, unlike corporate bonds where an insolvency will often result in investors losing some or all of their money, buildings can be re-let in the event that the tenant becomes insolvent, creating a replacement stream of income. Conclusion We believe that European commercial real estate can offer a compelling combination of comparatively high rental income and potential for capital appreciation. The main advantages include: a stable income return of around 5 asset values are likely to be supported by limited supply and strong demand a forecast total return of 6 per annum between end-216 and end-22, excluding the UK. Schroders has managed real estate since We are one of the largest managers of European pooled real estate funds and listed real estate companies. We manage 8.6 billion* of direct real estate investments throughout Europe. Our European direct investment teams structure, acquire and manage single assets, portfolios and funds for clients wanting to take advantage of the breadth of Schroders real estate expertise. Over the last three years, 73 of Schroders direct real estate assets in Europe have outperformed*. Please feel free to call Schroders Insurance Asset Management to discuss this opportunity in detail. *Source: IPD Global Property Fund Index, Schroders. June 216. Real estate level returns net of fees, with exception of private equity and absolute returns funds. Absolute return funds compared against performance target.

6 6 United Kingdom Charles Matterson, Client Director, Insurance Asset Management Phone: charles.matterson@schroders.com Continental Europe David Thompson, Client Director, Insurance Asset Management Phone: david.thomspson@schroders.com United States Andrew Terry, Institutional Director, Insurance Asset Management Phone: andrew.terry@schroders.com Asia Pacific Chris Howells, Client Director, Insurance Asset Management Phone: chris.howells@schroders.com Important information: For professional investors and advisors only. This document is not suitable for retail clients. The views and opinions contained herein are those of Schroder Real Estate Investment Management Limited and may not necessarily represent views expressed or reflected in other Schroders communications, strategies or funds. This document is intended to be for information purposes only and it is not intended as promotional material in any respect. The material is not intended as an offer or solicitation for the purchase or sale of any financial instrument. The material is not intended to provide, and should not be relied on for, accounting, legal or tax advice, or investment recommendations. Information herein is believed to be reliable but Schroder Real Estate Investment Management Limited (Schroders) does not warrant its completeness or accuracy. No responsibility can be accepted for errors of fact or opinion. This does not exclude or restrict any duty or liability that Schroders has to its customers under the Financial Services and Markets Act 2 (as amended from time to time) or any other regulatory system. Reliance should not be placed on the views and information in the document when taking individual investment and/or strategic decisions. Any forecasts in this document should not be relied upon, are not guaranteed and are provided only as at the date of issue. Our forecasts are based on our own assumptions which may change. We accept no responsibility for any errors of fact or opinion and assume no obligation to provide you with any changes to our assumptions or forecasts. Forecasts and assumptions may be affected by external economic or other factors. Past performance is not a guide to future performance and may not be repeated. The value of investments and the income from them can go down as well as up and investors may not get back the amount originally invested. Investments in real estate are relatively illiquid and more difficult to realise than equities or bonds. Yields may vary and are not guaranteed. Gearing will increase returns if the value of the assets purchased increase in value by more than the cost of borrowing, or reduce returns if they fail to do so. The value of real estate is a matter of a valuer s opinion rather than fact. Issued in October 216 by Schroder Real Estate Investment Management Limited, 31 Gresham Street, London EC2V 7QA. Registration No England. Authorised and regulated by the Financial Conduct Authority. For your security, communications may be taped or monitored. INS549. RC6373