13 April 2023

During the last few weeks I travelled to both the UK and Continental Europe to have a better understanding of what is going on in the Real Estate sector. Now, having received most of 1Q24 valuations of the Commercial Real Estate properties in which we invest, I thought it would be useful to share some notes (and some pics) of my trip.

Before I go into the details, here are my conclusions.

  • Commercial Real Estate is going to deliver substantially higher income than investment grade fixed income (by an order of 200 or 300bps) but at a cost of substantially lower liquidity.
  • Large-cap REITs will be the preferred route for private investors to CRE. Small cap REITs will be taken over by larger REITs (or taken private by Private Equity investors).
  • Offices and traditional Retail properties are not coming back as Core assets. They will remain the preserve of sophisticated investors.
  • The spread trade (borrowing to boost income) is over. CRE has become an asset class for patient investors who are prepared to collect growing income over a long time horizon.
  • Value-add and Opportunistic Funds will have a tough time to give an exit to their clients as the pool of Core investors has shrank.  

First stop: London, Budget Hotels

My first stop was in Kingstone Upon Thames, southwest of London, where we are invested in a Travelodge Hotel (I actually checked in at this hotel for one night as part of my site-visit).

Budget hotels on long leases are currently trading at an attractive yield, having de-rated substantially during the COVID pandemic.

The high yield reflects the risk of tenant default, as in the case of Travelodge which wasn’t able to pay its rent during the pandemic and then forced many landlords to accept a restructuring of their leases.

I would also add that these high yields may also signal an increased depreciation of the asset and the need of extensive refurbishment upon expiry of the lease. To compensate for the lack of business and tourist travelers, some operators have decided to make properties available on a short term basis to the housing of refugees, something which has lowered dramatically the investment in the upkeep of the property.

Overall, these assets are trading well above 10 years UK gilts with yields ranging from 6.7% to 8%.

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Day two: Dorset, Supermarkets

Next day went to see the Asda in Gillingham, another asset in which we are invested. The journey was a bit of an Odyssey, with an Atlantic storm in full swing, and 4 lanes motorways of London eventually becoming single alternate lane in the lovely British countryside (I even passed by Stonehenge!).

Supermarkets form part of the basic infrastructure of any urban area and represent a reliable source of long term income for landlords. In the “race for space” of the ’90s, many operators entered into sales and leaseback of their assets to expand their footprint, creating a different way to invest in the Retail sector.

Following the COVID pandemic, when Supermarkets became highly sought-after properties generating secure income, the asset class has derated.

Various explanations have been given. Initially, open-ended funds and insurance companies started selling Supermarkets to raise liquidity since their Offices and Shopping centres had no buyers.

Subsequently, a number of Asda and Morrison stores were put in the market by their over-levered owners as a way of raising cash.

More recently, market commentators have started to notice that the spike in inflation has pushed contractual rents above market, impacting the residual value of the properties.

Whatever the cause may be, UK Supermarkets now offer yields well above 10 years UK gilts, and with their inflation linked leases, represent a very good source of income with yields ranging from 5.25% (prime) to 8% (secondary/overrented).

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Day three: Retail Parks

The next leg of the journey took me up North to Doncaster where we are invested in a Retail Park leased to multiple tenants like Aldi and B&M.

These assets have also proven quite solid during the pandemic as they were easily accessible and able to accommodate online sales.

Valuations have been quite stable because they were late to the party (being Retail assets) so they never traded at premium levels.

Looking at the CBRE Q1 yield guide, we can see that there is a big spread between prime and secondary yields, ranging from 5.25% to 8%, but overall the trend is stable.

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Missed stop: the Netherlands

The Dutch leg of the journey was cancelled because one of my colleagues happened to be there and went to visit our properties on my behalf. Nevertheless I managed to speak to the CBRE team in Amsterdam to get an update on the market.

In the Netherlands we have an R&D laboratory in the bio-science park of the University of Leiden and two logistics warehouse leased to Timberland Europe in Almelo (one of which is under construction).

The Dutch CRE market is extremely illiquid at the moment, with any property put on the market receiving bids at which sellers are not prepared to trade. Which explains why volumes are so low.

We have received two valuations of the R&D laboratory from JLL and CBRE, both of which confirm that the resale value of the property is in line with the purchase price paid in 2020. We also performed a theoretical valuation using a discounted cash flow model and noticed a striking difference between the present value of income (much higher) and resale value.

R&D laboratories are gradually becoming a distinct asset class from Offices, with some specialist funds deploying capital in the sector. However, with the indiscriminate search for yield having come to a halt, pricing of secondary market transactions is going to be impacted by the overall dynamics of the Office sector which is going to cap capital growth.

However, since these are operating assets for their tenants (they can’t easily move their R&D to another laboratory), the security of the income is high, warranting an allocation in a CRE portfolio.

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Modern logistics assets are in a slightly different dynamic. Having traded at a premium relative to the CRE market, they have corrected substantially until yields reasserted a positive spread relative to investment grade bonds.

However, liquidity to the asset class has not returned because lending spreads have expanded to 2-2.5% and leveraged buyers can’t afford the loans.

This state of affair is keeping a lid on capital growth, but preliminary indications are that at least capital values have stabilized.

Rental yields at these levels signal that the market expects both income and capital growth in the long term, with logistics primed to deliver superior returns even in a high interest rate environment.

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Final stop: High Tatras, Slovakia. Luxury Hotels

Finally landed in Vienna and headed to the Grand Hotel Kempinski in High Tatra, Slovakia to catch the last snow of the season.

Admittedly this was a personal trip, but it gave me an opportunity to confirm that luxury hotels remain a coveted asset class to preserve value over time. Occupancy is very high and daily rates at the top of historical ranges. Really a parallel economy.

This is not an asset class in which our Fund invests, however if you are interested I suggest you have a look at Marriott and Hilton to gain indirect exposure to the asset class.

If you wish to own luxury hotels in Europe one way is Covivio Hotels, a little known listed company affiliated to Covivio. Bear in mind, however, that Covivio intends to acquire all shares of Covivio Hotels because the sector is doing very well and they wish to own the entity in its entirety.

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