Why listed property is riding high

Alban L’Honneur, assistant fund manager on the Thames River Property team, examines why listed real estate has outperformed other sectors.

Listed real estate is often regarded as a ‘hybrid’ equity sector sitting between financials and physical real estate.

So far this year real estate has been amongst the top performing equity sectors in the UK, continental Europe and the US while at the other end of the spectrum banks have seen significant underperformance.

The fortunes of these two capital-intensive sectors have been intertwined since the Lehman collapse; the positive correlation collapsed in November 2010 and is now firmly negative.

Interestingly, the listed property sector has outperformed in both a rising and falling interest rate environment year to date. Since April, bond yields have receded on the back of the recent run of poor economic data, recessionary concerns and S&P downgrade in the US and the sovereign debt contagion throughout the eurozone.

We believe this falling interest rate environment has been supportive to the property sector given the security and relatively high level of its income stream.
Physical property offers investors an average yield of 6% to 6.5% across the UK and Europe with the likelihood of further income growth to come and in our view remains attractively priced relative to fixed income and other asset classes. Indeed, while the nominal yield surplus (property rental yield less all-in financing cost) stands currently at 2.5% in the UK, it approaches 5% in real terms.

Banks underperform

The reasons behind the underperformance of the banking sector are plentiful: elevated levels of sovereign risk, regulatory (Basel III convention) and re-capitalisation concerns.

This challenging environment may further restrict the banks’ lending capacity to the corporate sector in general and to commercial real estate (CRE) in particular.
The problem is that a high proportion of the outstanding debt appears to be lent against non-prime property of the type which is not rising in value, is seeing increased levels of vacancy and therefore losing income with which to service the outstanding loans.

In the UK, which accounts for roughly a third (£300bn) of the Pan-European CRE debt, Savills estimates that 19% of UK loan books are secured against good secondary property, 19% against ‘poor secondary’ and 38% against tertiary which are hardly financeable in current standards.

So far opportunistic investors hoping to cash in on the sale of distressed assets have been largely disappointed both by the paucity of offerings and by the lack of growth in what they have purchased to date. With overloaded loan books, the banks have little appetite for new lending. There is a supply of fresh bank debt but this capital does not want to flow to the property sub-sectors and geographies which are most in need of it.