09/10/2012 | By Allen Kenney
Jon Cheigh, executive vice president with Cohen & Steers, is a global portfolio manager for the firm's real estate securities portfolios and oversees the global research process for real estate securities.
REIT.com checked in with Cheigh for his insights on some of the latest developments and trends in internation commercial real estate investment.
REIT.com: How has the eurozone crisis impacted the market for commercial real estate in Europe? Has that spread abroad?
Jon Cheigh: On a broad level, we believe the most significant factors for the real estate investment market are fiscal austerity and the availability of credit.
Most European governments have made significant spending cuts to shrink their budget deficits. In the future, greater emphasis may be placed on fiscal stimulus due to political pressure, but we believe sovereign deleveraging will be a large part of the picture for the foreseeable future, weighing on economic growth, and by extension, on property fundamentals. The effects of austerity are being felt most acutely in lower-quality properties and secondary markets, which tend to be more vulnerable to economic downturns.
In addition, European banks have been shoring up their capital positions by reducing the size of their balance sheets, restructuring non-performing real estate loans and refinancing large debt maturities. This means there's less capital available for financing real estate. We believe tight credit conditions will have a negative effect on cap rates for less-liquid real estate assets, widening the gap between prime and secondary properties.
On the positive side, investment demand for quality commercial real estate has been strong given the historically low yields offered by today's bond market, as well as the need for diversification into hard assets.
We believe interest rates in Europe will remain low for an extended period due to the combination of high sovereign debt, struggling economies and moderating inflation. This has prompted many institutional investors—especially pension funds—to increase their allocation to higher-yielding assets such as real estate. We expect continued growth in capital flows into real estate in both the direct-investment and listed markets.
In our view, increased investor interest in real estate has been a factor in the significant outperformance of real estate securities versus the broad equity market so far this year. This trend has not been limited to Europe, as nearly every major market for global real estate securities has outperformed local stocks through July, including in the United States.
In the direct market, institutional demand has been focused almost exclusively on the prime segment of the market. U.S. REITs have also been making new inroads into Europe, using their low cost of capital to acquire European assets at relatively low prices. Historically, U.S. companies have not been able to invest in Europe at positive spreads, so this is a notable situation with respect to pricing of global real estate. For example, Simon Property Group recently acquired a 29% stake in KlÃ©pierre, an owner of high-quality shopping centers across Europe. We believe these trends could benefit European real estate companies with prime assets, helping to narrow share price discounts relative to their NAVs due to support for investment yields.
As far as the impact of the Eurozone crisis on other parts of the global real estate markets, it has clearly had an effect on global investment sentiment and trade. Industrial property stocks have generally underperformed, as have U.S. companies with assets in Europe. It has also been a consideration in central bank policy, as the downward pull of Europe on the global economy has been explicitly stated as a contributing factor to monetary easing throughout the world. This has actually helped other property markets given the close relationship of real estate and financing costs.
REIT.com: Do you see any way that problems in the financial markets could actually benefit European REITs?
Cheigh: We believe the current crisis offers a ripe environment for a "Great Restructuring" of the European REIT market, comparable to what happened in the United States following the savings-and-loan crisis in the early 1990s. Deleveraging of the financial system in Europe will require equity, thereby presenting investment opportunities. We believe evolving the REIT structure and improving capital market access would benefit shareholders, while also helping to ease some of the stress in the European financial system. A more-flexible approach to raising equity capital could help in three ways. It could aid the process of recapitalization in the real estate and banking sectors, it would help real estate companies become more competitive, and it would likely help address the large funding gap for private real estate debt maturities.
Some European REITs have already begun to adapt to the new realities of the market, shifting their focus from "high growth" to "low cost of capital" by cutting dividends, simplifying their business models and reducing their leverage. Examples of these companies include Hammerson and Land Securities in the U.K. and Corio in the Netherlands. Some of the better European companies, such as France's Unibail-Rodamco, have had this approach from the start, and have seen exceptional returns during the current crisis. Others continue to resist reforms. In our view, companies that don't adapt will be left behind, as we believe their cost of capital will remain relatively high and their shares will continue to trade at a discount to NAV.
REIT.com: Are there any sectors or geographic regions that you're particularly bullish on?
Cheigh: Hong Kong remains one of our favorite property markets, trading at deep discounts to NAV even when the potential for slower economic growth in the region is taken into account. China homebuilders are also interesting given their current valuations and our view that policy risks have moderated and will be more neutral in the near term. Interestingly, despite Europe's current troubles, we actually like a number of segments there, including London offices and retail (stable rents, limited supply and strong investment demand), German residential (strong employment trends and a resilient economy) and Scandinavia (relatively wide discounts to NAV and a better economic outlook).
REIT.com: Are there any sectors or geographic regions that you're not as high on?
Cheigh: We're generally staying away from secondary markets and lower-quality assets. These properties are seeing meaningful declines in tenant demand, as they tend to cater to smaller, local businesses that are more vulnerable to challenging economic conditions. Eventually, they could represent a buying opportunity, but for now, we believe a challenged economic backdrop combined with modest inflation should favor dominant commercial owners with prime assets.
Also, we think a number of the traditional "safe haven" markets and sectors are overvalued. Take the health care property market in the United States. It's been one of the best performers year to date, as investors have been attracted to its defensive qualities due to its typically stable cash flows. But when we consider share prices relative to NAVs, many are trading at significant premiums, while price-to-FFO multiples are still well above their historical average. Instead, we like other sectors that have stable growth characteristics, but also offer better relative value, such as self storage and student housing.
Similarly, Switzerland has been a key beneficiary of the safe haven trade. Looking only at property fundamentals, it's not surprising. Office vacancy remains very low, while the combination of accommodative policies and a relatively stable economy have continued to put downward pressure on cap rates (already the lowest in Europe, below 5% on average). However, we think investors are being asked to pay a high premium for this safety, while the market is likely underestimating the potential downside risks, including an economic slowdown in Germany, the effects of a strengthening currency on the country's substantial export industry and the impact of new supply that's expected to come online over the next three years.
REIT.com: In the past the BRIC nations have commanded the attention of investors looking for big growth prospects. What are some of the new emerging/developing markets that are drawing interest?
Cheigh: In general, we think emerging market real estate securities are attractive right now, as policymakers are becoming increasingly comfortable with monetary easing due to recent moderation in inflation (excluding food prices). In particular, we like some of the smaller economies in Southeast Asia, such as the Philippines and Thailand, which feature positive demographics and an emerging middle class. These countries have been able to successfully manage inflation through effective central bank policies, and offer a supportive environment for commercial real estate investment.
The recent emergence of commercial property companies in Mexico has offered some very attractive opportunities in the emerging markets universe. Fibra Uno was the country's first REIT, with its IPO in March 2011. Since then, it has demonstrated strong execution in acquiring properties and has reported good operating results, enabling it to successfully carry out a secondary offering earlier this year. In July, Mexico's second income-producing company came public—Vesta, an owner of high-quality industrial properties that are a play on the growing manufacturing relationship between Mexico and the United States.
Within emerging markets, corporate governance, government stability and liquidity are especially important. Because of this, we are generally staying away from property companies in the Middle East and Russia.
REIT.com: What do you think will be the dominant theme in the international property markets in the second half of 2012 and into early 2013?
Cheigh: The most important factor, in our view, is whether or not we see a bottoming in global economic growth based on key developments in each region. In the U.S., we face the uncertainty of a presidential election and the looming fiscal cliff at the end of the year. Europe should offer greater clarity around its sovereign debt crisis. And in Asia Pacific, China's efforts to navigate a soft landing will likely continue to ripple through the global economy. In addition, we believe slowing European consumption and inventory de-stocking has and will continue to drive slowing growth within the Asian export chain. As such, clarity in Europe may have an equally meaningful impact on the growth trajectory of Asian economies and property stocks.
Another key thing we'll be watching is inflation. Moderating inflation has been a very helpful tailwind to real estate in 2012, giving central banks the flexibility to ease monetary policy to counter the effects of slowing global growth. However, food prices have climbed recently, and if this spreads to core inflation metrics, it could limit interest rate cuts.
Overall, however, we think listed real estate is in a good position relative to many other sectors considering the trend for greater allocations to real estate and the ease of investing globally through the listed market.
Cohen & Steers recently published two whitepapers on commercial real estate investment, "Introduction to Real Estate Securities" and "The Case for Real Estate Securities."