Strong but silent REITS

European real estate securities are performing well, remarkably well, says Internaxx

Over the last four years, the real estate index has consistently outperformed broader European equity indices. This is all the more impressive when we consider that the underlying conditions in the real estate market are certainly not exhibiting the same positive mood.

Some investors are therefore getting nervous and starting to wonder how long this upward trend can continue. In order to make an assessment of this, it is important to see what has driven the market so far.

One significant driver has been the introduction of Real Estate Investment Trusts (REITs). But the continued Merger and Acquisition activity, the changed risk perception of real estate, equities’ subdued performance and the continued interest in real estate as a diversifying asset class have also all been key to this strong performance.

As the underlying real estate market is forecast to recover in the coming months, and as capital flows into the sector are expected to remain enormously high, we do not expect this upward trend to peak within the next 12 months.

Strong performance From 2000 to 2003, the European real estate index returned no less then 52% while equities fell by 33% over the same period. In 2004, the strong performance has continued, with the real estate index returning 19.8% for the first 7 months of this year.

For the remainder of the year, we expect performance to continue to be positive, albeit to a lesser extent. The current upward trend has made the European real estate sector more expensive, but is has certainly not yet reached an overvalued level. For example, on average there is still a small discount to NAV. Dividend yields are also still attractive, ranging from 3% in the UK to 6 - 7% for Dutch real estate companies. Good absolute returns from Real Estate Securities September 2004

REIT-isation One of the main catalysts has been the growth of REITs. These REITs, unlike traditional real estate companies, do not pay tax as long as they pass their profits on to investors in the form of dividends.

Although these funds are not new, they have recently been adopted (or are in the process being so) in a number of the biggest markets in Europe. The advantages of these REIT structures, such as high dividends, transparency and management focus on producing real income, have added to their attractiveness.

There is evidence that this leads to higher valuations, as proven by the more mature REIT markets such as the US and Australia where REITs are generally trading at a premium to NAV. We published an Insight on this subject in March 2004.

Continued M&A activity Despite the fact that many companies are trading at or above NAV, the number of delistings continues to grow. The first 7 months of the year has been a very busy period for takeovers.

Companies such as SFL (F), Canary Wharf (UK), Rodamco Asia (NL), Benchmark Group (UK) and Chelsfield (UK) have already disappeared, while others like Fabege (S), Minerva (UK) and Bostads AB Drott (S) are in the middle of the bidding process.

As the number of IPOs so far this year has been very limited, the listed real estate sector is shrinking, with the number of listed real estate companies going down. If we can assume that investors want to at least maintain their exposure to the sector, this scarcity is likely to support share prices and liquidity for the remaining companies in the market.

A notable trend here is the increasing interest in European companies from overseas investors. The explanation is clear; European REITs are still cheaper than those in the US and Asia.

M&A activity is likely to continue as many private and public investment entities are looking to expand into the real estate sector (e.g. Westfield), and may enter the market by buying existing listed real estate companies.