European Property Equities: Boring Can Be Rewarding

By Guy Barnard

In this article, Guy Barnard, co-head of Global Property Equities and Manager of the Pan European Property Equities strategy, discusses his expectations for European property equities in 2018. Amid an evolving market backdrop, the sector's strong fundamentals and investors' continuing search for stable income should bolster returns for property equities.

2017 proved to be a stronger year than many expected for European property stocks. The listed property sector in Europe returned 12.6%, outperforming the wider European equity market, which rose 11.2%*. It was also a year of significant stock dispersion within the sector, as those companies in high-growth markets, most notably Germany, Spain and Sweden, outperformed. Stocks focused on alternative sectors, and those offering structural growth, such as student accommodation, self-storage and logistics, also saw strong share price appreciation.

Will the Good Times Last?

Looking ahead, we entered 2018 with strong economic momentum in most parts of Europe and a still-supportive monetary backdrop. This, coupled with real estate's offer of an attractive income yield with predictable growth characteristics, has the potential to deliver attractive returns, even as bond yields begin to rise. While current equity market volatility is likely to remain a feature of 2018 as monetary stimulus is gradually unwound, we expect the long-term structural trends that are driving investors to seek secure, predictable income to continue to sustain healthy demand for real estate assets. While many investors view real estate as "dull" and not offering the cyclicality sought during periods of economic growth, the ability of landlords to benefit from growing economies through rising rents provides the potential for more attractive returns.

2017 saw an acceleration in rental growth in several European office markets such as Madrid, Berlin, Frankfurt, Dublin and Stockholm. The index-linked nature of many annual rental contracts in line with inflation also provides a clear pass through to top line revenue growth, having been absent in recent years. As a result, earnings growth estimates for European property equities in 2018 stand at approximately 8% today (Exhibit 1). Interestingly, in terms of earnings growth, although real estate sits within the "middle of the pack" versus other sectors, it is one of the few sectors to have seen upgrades in recent months. The benefit of compounding predictable earnings growth should not be underestimated - boring can be rewarding!

Exhibit 1: 2018 Estimated EPS Growth vs. 3-Month Revisions to Consensus 2018 Estimated EPS

Source: Thomson Reuters Datastream, Exane BNP Paribas estimates as of January 31, 2018. EPS = earnings per share. Estimates are not guaranteed.

Encouragingly, the market is no longer placing a premium on real estate shares. Exhibit 2 illustrates how the sector has significantly de-rated in price-to-earnings (P/E) terms. On average, the sector now trades at around a 20% discount to its long-term average multiple. As ever, averages can be misleading, and this data is skewed by the heavy de-rating in retail landlords, much of which is likely justified by the structural challenges in the sector lowering their growth outlook in the years ahead.

Exhibit 2: 12-Month Forward Market Relative P/E for European Real Estate Securities

Source: Thomson Reuters Datastream, Exane BNP Paribas estimates as of January 2018. P/E = stock price/earnings per share. Past performance is not a guide to future performance. As 2018-2019 data are estimates, they may vary and are not guaranteed.

Is the Bond Bell Tolling?

Clearly, a bigger question for the longer-term outlook is what effect a normalizaton of monetary policy will have on asset pricing. 2018 has started with accelerating global growth and rising inflation, which is putting pressure on longer-dated bond yields. While we have seen this story play out before and subsequently reverse, we do expect a gradual end of quantitative easing in Europe this year, although European interest rate hikes are unlikely until mid-2019.

In line with our fixed income colleagues' view, we continue to believe that a number of longer-term trends remain (i.e., the 3Ds: Demographics, Technology Disruption and Debt) that will keep rates lower going forward. So, regardless of whether German Bunds yield 0.5% or 2.0%, the alternative of a property asset offering, with an inflation-linked income stream, should still look attractive.

So while we see short-term pressure on property shares should rates rise suddenly, we do not expect this to have a major impact on the markets. A longer-term look at the property sector's performance over the past 20 years also reveals little obvious relationship between sovereign bond yields and shareholder returns relative to the wider market. The sector has actually outperformed in five of the seven years since 2000 when sovereign bond yields have risen. (Exhibit 3).

Exhibit 3: Total Shareholder Returns (TSR) European Real Estate Relative to MSCI Europe vs. Year-on-Year (YoY) Changes in European Sovereign Bond Yields

Source: Thomson Reuters Datastream, Exane BNP Paribas as of January 2018. Past performance is not a guide to future performance.

Opportunities Increasing

Following the global market sell-off in early February 2018, listed real estate stocks in Europe have traded at an approximately 10% discount to net asset value (NAV), meaning it remains cheaper for investors to buy property through shares than physical real estate.

The robust income streams of the European property equities sector are currently offering attractive yields. 2018 could again be "boring yet rewarding" for property equity investors.

*FTSE EPRA NAREIT Capped Net Total Return Euro Index vs. Stoxx 600 Total Return Index, 12 months to December 31, 2017, in euro terms. Past performance is not a guide to future performance.

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Basis Point (bp) equals 1/100 of a percentage point. 1 bp = 0.01%, 100 bps = 1%.

Quantitative Easing (QE) is a government monetary policy occasionally used to increase the money supply by buying government securities or other securities from the market.

MSCI Europe Index reflects the equity market performance of developed markets in Europe.

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