Investment Trusts

Outlook 2019: Schroder Real Estate Investment Trust and Schroder European Real Estate Investment Trust

Duncan Owen, Head of Schroder Real Estate Investment Management Limited, Fund Manager of Schroder Real Estate Investment Trust and Schroder European Real Estate Investment Trust sees demand for European commercial real estate underpinned by an increase in technology and professional service jobs. European commercial real estate markets have performed strongly. Prices in Europe’s major cities have risen on average by 40-50% since 2013 (source RCA) and except in southern Europe, they are now 10-20% above their previous peak before the global financial crisis (GFC).

18 Jan 2019

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Cycles vary enormously

Intuition suggests that markets are due a correction, but it would be wrong to assume that real estate cycles are fixed like the tides. History shows that the length and strength of upswings has varied enormously across different cities and sectors over the last 50 years. For example, e-commerce is currently driving a wedge between the retail and industrial sectors and whereas industrial capital values in the UK rose by 10% over the first 10 months of 2018, shopping centre values fell by 7% (source CBRE).

European commercial real estate faces two main risks. Firstly, the growth of populist parties across Europe has increased the chance of radical shifts in economic policy. The obvious example is Brexit, which poses a threat to financial services and office rents in the City of London and the Docklands. Conversely, this has given a modest occupational boost to office demand in Frankfurt and Paris. In addition, Catalonia’s declaration of independence has raised a question mark over assets in Barcelona, while the Italian government’s budget dispute with the EU has hit foreign investor interest in Milan and Rome.

The second clear risk is higher interest rates. Schroders expects the Bank of England and the European Central Bank to raise rates to 1.75% and 1% respectively by the end of 2020. Yet, despite textbook theory that real estate yields should move in parallel with government bond yields, we think that the increase in office and logistics yields over the next 2-3 years will be limited to 0.25-0.4%. Retail could be the one sector where yields rise and capital values fall more sharply.

Generous yield gap

We do not expect a bigger increase in office and industrial yields, partly because there is still a generous gap of over 3% between average investment grade real estate and government bonds. The long-term average is only 2%. Globalisation, particularly at the prime end of the market is also a factor. Asian, North American and Middle Eastern investors, with varying costs of capital, together accounted for a quarter of European investment deals by value in the first nine months of 2018, compared with 17% a decade ago.

However, the key reason is that real estate is not a fixed income asset and office and industrial rents are rising, as occupational demand outstrips supply. Office rents are rising as the increase in technology and professional service jobs lifts demand and as new, tighter bank regulations introduced after the GFC hold down speculative development. UK industrial rents are growing by 3-4% p.a., supported by both the growth in online retail and loss of supply because a lot of estates have been converted into housing. There are also signs of an upturn in industrial rents in the more supply-constrained parts of France and Germany (e.g. Hamburg, Munich, Paris, and Stuttgart). 

The catch, however, is that yields at the prime end of the market have compressed to record low levels and all of the good news on future rental growth is in the price. In most big European cities prime office yields in the central business district (CBD) have fallen to 3.0-3.5% and prime industrial yields are between 4.0-4.5%. So where do we see value? 

In the office market we have a two-pronged strategy in big cities. We seek to add value by re-developing older buildings in the CBD. We also look at adjacent areas where yields are higher and which are being transformed either by a technology, or life sciences clusters, or by new transport links, or other regeneration and new infrastructure. Examples include the Arena in Amsterdam; Kreuzberg-Friedrichshain in Berlin; Bloomsbury and Waterloo in London; Boulogne-Billancourt, Clichy and Montreuil in Paris and Solna in Stockholm. 

We also like multi-let offices in smaller “winning” cities which have good universities and a diverse economy (e.g. Cambridge, Leeds, Leipzig, Lyon, Manchester, Malmo, Mannheim and Utrecht). In the industrial market we favour multi-let estates and smaller distribution warehouses, where it is still possible (except in London and the South East) to buy good quality assets on yields of 5.25%, or higher.

Looking further afield, we also see value in other sectors such as self-storage and hotels, specifically hotels with management agreements. Both segments are benefiting from structural change – urbanisation and people spending more on experiences, respectively – and while they each involve operational risk, this can be controlled by skilled asset management and yields are relatively high.

Potential retail opportunities

Is now time to go back into the retail sector given that the transition to omni-channel retailing still has a long way to go? Projections suggest that the internet’s share of UK retail sales, for example, will almost double from 17% to 30% over the next 10 years. Unfortunately, that suggests that the recent wave of retailer failures and store closures in northern Europe will continue and that there will be a sustained fall in rents. At present, that reality is not reflected in current valuations and retail yields.

However, looking forward, if most investors shun the sector and yields jump over the next 12 months, then there could be some interesting opportunities to buy defensive retail assets (e.g. dominant shopping centres, convenience stores). There may also be opportunities in town centre buildings which can be re-modelled into mixed-use schemes incorporating apartments, offices, medical clinics, places of worship.

In conclusion, we continue to see value in parts of the European commercial real estate market. The upswing in office and industrial rents has further to go in most winning cities and some segments such as hotels where management agreements are attractive. The big concern is the current economic and market cycle. Whilst we may not be at the peak of market pricing, no one would be surprised in a year’s time if we discovered we are in reality there now. Therefore, 2019 could be a year of price corrections which may offer some good opportunity for investors who are well capitalised. There is more than one real estate cycle in Europe.

 Schroder Real Estate Investment Trust discrete yearly performance (%)

 

Q3/2017 - Q3/2018

Q3/2016 - Q3/2017

Q3/2015 - Q3/2016

Q3/2014 - Q3/2015

Q3/2013 - Q3/2014

Share price¹

1.3

12.4

1.7

7.0

29.3

Net Asset Value Total Return²

8.9

11.8

4.4

15.4

27.7

SREIT Real Estate Total Return³

 

11.0

12.2

6.6

15.2

21.8

MSCI Quarterly Version of Balanced Monthly Index Funds³

9.5

10.0

2.9

14.5

17.9

 

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 you may not get back the amount originally invested.

¹ Source: Schroders, Datastream, bid to bid price with net income reinvested in GBP.

² Source: Schroders, NAV to NAV (per share) plus dividends paid.

³ Source: MSCI Quarterly Version of Balanced Monthly Index Funds (including indirect investments on a like-for-like basis).

Schroder European Real Estate Investment Trust Plc discrete yearly performance (%)

 

Q2/2017 – Q2/2018

Q2/2016 – Q2/2017

Q2/2015 – Q2/2016

Q2/2014 – Q2/2015

Q2/2013 – Q2/2014

Share Price Total Return (GBP)¹

-3.0

8.8

-

-

-

NAV Total Return (Euro)²

9.7

5.2

-

-

-

NAV Total Return (converted to GBP)³

 

10.7

10.5

-

-

-

Data as at 30 June 2018

 

 

 

 

 

 

 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 you may not get back the amount originally invested.

¹ Source: Schroders, Datastream, bid to bid price with net income reinvested in GBP.

² Source: Schroders, NAV to NAV (per share) plus dividends paid.

³ Source: Schroders, NAV to NAV (per share) plus dividends paid. Converted into GBP.

4 Performance data does not exist for periods before launch in December 2015.

The forecasts included 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. Forecasts and assumptions may be affected by external economic or other factors.

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What are the risks?

Schroder Real Estate Investment Trust Risk Considerations

-        The trust may be concentrated in a limited number of geographical regions, industry sectors, markets and/or individual positions. This may result in large changes in the value of the fund, both up and down, which may adversely impact the performance of the fund.

-        The Company may borrow money to invest in further investments, this is known as gearing. Gearing will increase returns in the value of the assets purchased increases in value by more than the cost of borrowing, or reduces the returns if they fail to do so.

Schroder European Real Estate Investment Trust Plc Risk Considerations

-        The trust may be concentrated in a limited number of geographical regions, industry sectors, markets and/or individual positions. This may result in large changes in the value of the fund, both up or down, which may adversely impact the performance of the fund.

-        The Company may borrow money to invest in further investments, this is known as gearing. 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 trust can be exposed to different currencies. Changes in foreign exchange rates could create losses.

-        The dividend yield is an estimate and is not guaranteed.