In this note I will try to answer the following questions:

  • Have Private Real Estate markets reached a bottom?
  • Are Public Real Estate markets still more attractive than Private Markets?
  • Is it possible to offset withholding taxes and boost the yield of REITs?
  • Is there a turn of fortunes in Logistics?

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Have Private Real Estate markets reached a bottom?

During the first quarter of this year the Green Street US and Pan European Commercial Property Price Indexes (CPPI) were relatively unchanged relative to the year end mark, prompting many analyst to declare that the bottom of the cycle in Commercial Real Estate is here.

There seems to be a consensus that interest rates have picked, and that Commercial Real Estate has repriced enough to be attractive relative to fixed income. Even the Retail sector has returned in the radar of strategists (and brokers), who have noted that capital values have stopped falling and the yields are extremely attractive.

US CPPI

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Pan European CPPI

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The reality from the ground is a bit different.

As owners of Commercial Real Estate, we continue to see a wide disparity between the theoretical value of our assets calculated using a Discounted Cash Flow model and the value based on market comparables which prevent us from putting properties in the market for fear that bids will come substantially lower than our expectations.

Like us, many owners of Commercial Real Estate are refraining from selling assets leading to a substantial drop of secondary market liquidity.

The above-mentioned Green Street CPPI represents the theoretical price at which a buyer would be willing to acquire an asset, based on a multitude of market variables (including liquidity). However, if there are no willing sellers, there will not be a transaction at those levels, so essentially the index just tells us that buyers have probably stopped lowering their bids.

The following chart provided by Aberdeen Standard using data from Green Street illustrates the point:

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The black line (INREV CV) represents the price at which Commercial Real Estate properties in Europe have transacted. The blue line (CPPI) is the above-mentioned Pan European CPPI Index.

As you can see, there is quite a big gap between the level at which most of the liquidity is found (CPPI) and the level at which transactions are occurring (INREV) leading us to believe that at present, only a small fraction of properties is transacting between motivated sellers and buyers with extremely long investment horizons able to see through the current inflection point of the market.

The dotted line provided by Aberdeen Standard shows their expectation that over the course of this year buyers and sellers will eventually agree on the value of real estate and liquidity will return to market. In a way both parties will reach a compromise, with sellers increasing the price at which they are prepared to buy and buyers increasing the price at which they want to sell.

If this expectation is correct, 4Q24 will probably be the real bottom of the cycle from which we could see capital values increasing again.

What could go wrong? Interest rates could remain elevated, further delaying the meeting point between buyers and sellers. We have seen this happening in 2023 (remember 4Q23 was expected to be the bottom of the market), and we should not be surprised if it happens again.

Stress could also appear in the market as banks work through refinancing of existing loans. The longer interest rates stay high, the greater the number of transactions that will become under pressure requiring a forced liquidation.

Are Public Real Estate markets still more attractive than Private Markets?

At the end of 2022 and again at the end of 2023 we noticed the stark divergence between public and private real estate markets, with public markets relatively more attractive than private markets.

This is exemplified well by the chart below comparing the NCREIF Index (private markets) with the FTSE NAREIF US REITs index (public markets).

Our call to go all in on REITs and Housebuilders worked out well in both 2022 and 2023, especially in the UK where in addition to equity gains we benefited from currency revaluation gains.

As you can see below, the value of listed real estate (at least in the US) has moved above private real estate leading us to change our positive stance for REITs.

Nevertheless, we see some specific opportunities in the REITs space which could deliver returns superior to private markets. Feel free to reach out if you wish to discuss.

Image_2024-05-21_08-07-11

Is it possible to offset withholding taxes and boost the yield of REITs?

With the undervaluation of REITs broadly corrected, we are now focusing on boosting the yield of our portfolio.

REITs are a tax efficient vehicle for domestic investors who can receive their dividends gross. International investors are usually subject to withholding taxes ranging from 20-30% which greatly reduce the merit of a permanent allocation to the asset class.

Within our portfolios we implement strategies to boost the yield of REITs generating additional income which compensate the tax leakage.

The strategies make use of our Shariah structure which enables us to monetize the volatility of securities boosting their return. In return for boosting yield, we need to sacrifice some of the upside from further property appreciation.

But given our view that most of the upward revaluation of REITs market has already occurred, we are happy to give up some of the upside if we can boost the yield from 4% (net) to 8-10% (net).

Feel free to reach out if you wish to discuss further this topic.

Is there a turn of fortunes in Logistics?

Market participants were caught off guard recently when Prologis announced that they had observed declining rents in the US Logistics sector. The repricing of Logistics assets from yields of 7-8% (2010) to around 5% was predicated on the ongoing technological transformation underpinning Logistics demand and perpetual rental growth. What about if that growth is negative or flattens out? Should Logistics be repriced again to 7-8% like Offices and Retail?

Below is one of the slides that worried the Market. A rise of vacancy rates is a big worry in real estate because it gives more bargaining power to tenant and caps rental growth.

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Markets promptly derated Prologis shares which fell 25% to just above $100 taking the pick to through drawdown to 45% from the pick of March 2022 when the shares were trading at just above $170.

Interestingly we saw this coming 2 years ago (link here https://tinyurl.com/yc2mzfs5) and recommended selling Prologis. But now we see an interesting case in both owning Prologis and investing in logistics.

In doing this, we adopt the thesis of CBRE which recently went on a charming offensive separating what they call “Legacy Logistics” from “Modern Logistics”.

CBRE accepts the headwinds to the Logistics sector caused by factors like unaffordable rents, increase cost of labour, obsolescence etc. However, they point out that Modern Logistics displays certain characteristics which make the assets essential, e.g.:

  • Robotic retrieval
  • Automatic sorting and stacking
  • Interconnectivity with Electric Vehicles
  • High flow through.

Here is the link to the replay of CBRE webinar “The Future of Logistics”: https://tinyurl.com/37kthu2z

We are currently developing a modern logistics facility in the Netherlands which has been pre-leased by the tenant for 15 years, under a contract which entitles us to annual inflation linked reviews of up to 5%. Furthermore, the tenant is installing within our premises a fully automated sorting and stacking system costing more than the value of our property, giving us confidence that they will stay on these premises for a very long period of time. Irrespective of the fluctuations of Logistics rents, we should be able to earn a secure income.

This is how a modern logistics facility looks like. As you can see no more human-operated forklifts moving around pallets.

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Fun fact: we have heard about robotic companies having developed humanoids powered by Artificial Intelligence working alongside humans in warehouses to learn and replace them. It feels like we are getting closer to the Singularity, with AI supplanting human intelligence…

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Best regards

Ruggiero Lomonaco
Head of Real Estate Funds

Chancery Lane

Westminster, London

A boutique development of 14 residential apartments located in the prestigious legal district in Central London.

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