Tuesday 23/07/2019

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'Money for nothing' but for how long?

Senior Equity Analyst

We argue that higher rates are not a fatality yet in Europe considering a still fragile economic and subdued inflation prospects. Actually, higher rates might even be a blessing if it is progressive and caused by economic growth & higher inflation. Should rates still rise further without immediate tangible economic factors, some US effect for example, we strive to show that listed property companies have down their howework in order to minimize the sensitivity of their earnings to higher rates. At well over 300 bp, the risk premium offered by listed property (dividend yield minus risk free rates) remains high, both in absolute and relative terms. Finally, and beyond short-term reactions, historic data shows no clear correlation between listed property and bond performances.

Eurozone listed property : do not write-off it yet

The question ‘is listed property doomed to fall as interest rates rise’ actually contains several questions such as ‘are rates going to rise ?’, ‘is listed property that interest sensitive ?’, ‘which steps did they take in order to mitigate the effects of higher rates ?’. We endeavour hereunder to address some of these questions.

In barely 2 months, the Belgian 10-years shot up from 0.1% end September to the current 0.7% with similar moves elsewhere in Europe. Considering that shorter maturities rose less (Euro swap 5-years up 0.25%) or not at all (Euribor 3 months),  rates are actually steepening (i.e. rates for longer maturities rise more than shorter ones). Still, it is long-term rates that matter as they are the most pertinent to assess the attractiveness of a long-term business as property and as property companies typically finance themselves on a long-term basis (directly  or with hedging).

The European economy does not suggest sharply higher rates are in the cards in the foreseeable future…

Save in the case of an inverted yield curve, a rather rare situation, long-term rates are usually higher than short-term ones in order to reflect the uncertainties of a longer term horizon  but still depend on short-term ones.  Long-term rates are market rates and as such more difficult to predict than short-term ones which depend on the stance of monetary authorities. Their latest rise may be the result of several factors, some of them rather fuzzy (geopolitics,  some relation with US rates…), other more rational such as inflation expectations and/or better economic prospects.  This point is crucial; a doom scenario of higher rates ‘other things equal’ is highly unlikely as higher interest rates mean, admittedly with some lag as markets anticipate, higher economic growth (good for property) and/or higher inflation (again, good for property).

Our economists expect the current monetary policy in Europe to remain accommodating i.e. to keep short-term rates close to their current low level. This is the result of the expectation that inflation will remain low for the time being and the genuine, but still modest, economic recovery as the European economy still runs below  potential (negative output gap). One can notice a strong relation between rates and economic growth. Leading indicators in Europe suggest a strong economic recovery still needs to be confirmed.

… still, companies feel they are better safe than sorry

The recent long-term rates’ hike is a healthy reminder that ultralow rates cannot be taken for granted and it can be expected from property companies that they do not make bets on future rates and hence strive to ‘freeze’ their cost of debt for at least some years ahead.  One way to reduce the sensitivity of results to rising interest rates is to keep leverage in check. When looking at the companies we cover (Benelux & French property stocks), one can notice that most of them show leverage (loan-to-value i.e. net debt on assets) well under control, in most cases at or below 40% (2016e). This is the results or capital increases (Cofinimmo, Befimmo) or assets’ disposals (Gecina). Companies combining capital increases and portfolio growth (Aedifica, Care Property, WDP, Wereldhave) show a less clear situation with but leverage here too looks reasonably safe at or slightly above 50%.

A clearer picture emerges when analyzing the interest coverage ratio (ICR) i.e. by how much interest expenses are covered by operating results (aka EBIT i.e. results before financial expenses). ICR’s expected for end 2016 are all above 3 (i.e. EBIT covers more than 3 times interest expenses), even in the case of momentarily highly indebted REITs such as Leasinvest Real Estate, and often above 4.

The favourable ICR is the result of leverage kept in check but also benign interest rates; so what about results if interest rates rise ? Here too, companies have done their homework and hedged their interest rates’ risk  directly (borrowing on a long-term basis) or by hedging (for example swapping short-term  borrowings with fixed debt). Sensitivity figures provided by companies show that a rise of market interest rates by 1% (100 bp) would have a negative effect on recurrent results of less than 5% and in several cases even less than 3%. A surprising side effect of higher rates is the higher value of hedging instruments covering against higher rates and hence, all other things remaining equal, a higher net asset value (IFRS NAV) of the share and lower headline leverage.

Last but not least, it is worth noting that the average cost of debt of companies i.e. including old/legacy debt stands well above the marginal cost of debt (i.e. for new debt). In other words, should current market rates stay flat or even rise modestly, cost of debt is likely to continue to marginally fall in 2017-18. Some companies have ‘anticipated’ these low marginal cost of debt by cancelling expensive ‘historic’ financing, restructured their financing (for example, a lower rate but for a longer duration) whereas other REITs chose to ‘bite the bullet’ and have therefore still not fully tapped the potential of lower cost of debt. Cost of debt at the companies we cover has been falling steadily in the last years and now varies from 1.7% (Unibail-Rodamco) to slightly over 3%; these figures depend on a lot of factors including the credit rating of the company, history or growth (the more the company grows, the more it can borrow at the current low marginal cost of debt). Considering current Euro Swap rates and margins of 100-120 bp, one can estimate property companies can borrow at ca. 1.2%-1.4% for 5 years and 1.9-2.0% for 10 years. Such rates might look optimistic but are in line with recent transactions in the bond market, especially by large French REITs (2.0% for a 20-years bond issued by Unibail-Rodamco, 1.0% for a 12.3-years bond issued by Gecina, 1.1% for a 9-years bond issued by Icade, latest Cofinimmo 8-years  ‘green bonds’ at 2.0%…). Recent banking borrowing favoured by Benelux companies are obviously less public but still confirm a marginal cost of debt close to 1% in the case of 5-years borrowings with bank margins in Belgium now close to 100 bp. As an example, a 5-years loan was closed last March by Wereldhave with a Belgian bank at 1.17%.

How will markets react ?

As a matter of fact, financial market have already reacted; as of end August Eurozone listed property (EPRA index) still retained a sharp return (price+dividends) outperformance of 17% vs. shares (Euro Stoxx 50 index) but this has now melted away to a mere 2% as of end November. In other words, since August, listed property has been severely punished vs. shares but still show marginally better year-to-date performances. Looking further in the past, listed property still retains very good performances with an annual average return of +14% since 2011 (5 years) vs. +9% for the Euro Stoxx 50.

As a result of this correction, the risk premium between dividend yields of listed property and risk-free rates remains above 300 bp, a historically high level and actually one of the highest since 4 years . In other words, the recent rise of bond yields is more than reflected in the price of property shares.

So in the short run, property shares look negatively correlated to bond yields (i.e. when yields rise, property shares are likely to fall). However, on the  more medium-term, this correlation is close to irrelevant as show by US data (not much long-term research available for European markets). Several studies for US REITs show a correlation close to zero between the performances of bonds and REITs. This is supported by market observations of the US market (US 10-years bond rates vs. performances of US equity REITs) with negative reactions during periods of rising rates followed by vigorous catch-up movements. In other words, temporary market corrections can be seen as opportunities to take positions in REITs. This is consistent with the two fundamental facts highlighted above  i.e. higher long-term rates mean eventually higher inflation and/or economic growth and companies do their homework in order to substantially mitigate the effects of higher rates on their P&L account.

Last but not least, history shows that markets can have a ‘double reading’ on higher rates, bad as it weighs on financial costs, valuations etc… or good as it is seen as a sign of a recovering underlying economy. In other words, keep a sharp eye on listed property and do not get carried away by a temporary gloom or urban legends.

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