George Bernard Shaw said “beware of false knowledge; it is more dangerous than ignorance”, and the real estate industry is having to gen up on climate change fast.
At Jefferies, we don’t think the post-Covid economic recovery is going to be as short-lived as equities have been factoring in, and central banks’ ability to tighten policy is straitjacketed by the overwhelming accumulation of debt since the global financial crisis.
The UK is experiencing high Covid infection rates with immunity fatigue and the winter ahead, but we aren’t pricing in another lockdown. The World Health Organization has designated Covid Mu as a ‘variant of interest’ but not ‘concern’ – yet. Meanwhile, office reoccupation has been slow and weighted to financial services, with a degree of behavioural change creating greater uncertainty.
An upward sloping yield curve is supportive of real estate, but only if tenants can absorb rising costs – including new decarbonising costs – to limit default risk. Ten-year gilts at 1.1% and near-zero base rates are consistent with real estate performing well and any flattening of the yield curve is likely to be short term.
True, inflation is stickier than expected, but we think it will be relatively benign and the reaction is likely to be a 50bps to 75bps ‘short sharp shock’ interest rate rise. The Bank of England estimates that inflation could peak at 5% and although the relationship between real estate returns, inflation and interest rates is complex, there is a positive correlation overall.
The biggest challenge for real estate is climate change. Unlike the pandemic, which is likely to burn itself out, climate change won’t. Zero carbon ambitions may be just broad targets for now, ahead of cash being spent on the greening of portfolios, but these are next year’s hard costs and will dilute earnings.
REITs’ ESG strategies seem underdeveloped. This isn’t surprising, given the culture for compensating executives that beat the IPD – but that might get trickier following RICS’ ‘Independent Review into the Valuation of Property Assets for Investment Purposes’. We looked for examples of compensation for REIT executives being linked to ESG criteria, but couldn’t find many, with the notable exception of Landsec and British Land.
Buildings tend to be ‘dirty’ and our hypothetical pricing in a year ago of a ‘green premium’ and ‘brown discounts’ is becoming valuation reality, with the UK ahead of most of the rest of Europe in climate control, despite Brexit. Ageing offices and regional shopping centres top the list of assets requiring cap-ex, but hotels are also high up on the list.
REITs tend to be overly optimistic about the quality of their portfolios. We think it is better to take a low yield on grade-A buildings rather than increasing income returns by holding inferior credit, older, less well-configured grade-B buildings, with ESG risk looming. For over- costed REITs that means earnings dilution, as it is unlikely that they can pass on retrofitting costs to tenants, which have their own explicit carbon zero deadlines.
New scrutiny of environmental impact is driving demand for greener offices, as the supply of green buildings falls well short of growing requirements for environmentally acceptable buildings. Lenders are now shying away from underwriting loans to ‘brown’ assets and there is the risk of a looming credit drought.
Our conclusion is that green buildings are not necessarily undervalued, but more that brown buildings are overvalued. In every bull market, secondary asset pricing ends up getting too closely aligned with prime, and the yield premium between prime and average quality UK commercial property is currently 30 basis points – the narrowest it has been since 2007.
For the coming year, we see strong logistics rental growth supporting capital values and still anticipate widespread declines in prime and secondary retail values, but older and smaller shopping centres in metropolitan areas should be repriced for alternative uses. Office prime values are holding steady but the outlook for secondary values is increasingly negative.
The rise of Amazon has debased diversified REITs that have retail in their portfolio mix to balance out offices’ boom-bust cycles. We have downgraded Landsec and British Land price targets, as we believe these are stocks to hold as macro trades, rather than to buy, as they have a surprisingly high proportion of sub-B-rated (EPC) buildings, at 70% by area. But London office ‘upcyclers’ Derwent London and Great Portland Estates remain stocks to buy on valuation grounds.
We want to own REITs that benefit from structural demand, high barriers to entry and simple structures that are cheap to operate, and we see high income-to-earnings conversion rates in our ‘beds, meds n’ sheds’ cohort.
We are seeing ‘REIT Darwinism’, as capital migrates from formerly prime legacy assets to the new growth sectors. Best-in-class specialists such as Tritax Big Box in mega shed logistics and Unite Group’s student housing are now both capitalised at over £4bn and closing in on the traditional but shrinking Landsec and British Land conglomerates.
Mike Prew is managing director at Jefferies