With August’s 0.25% cut from the Bank of England, we have moved past peak rates for this cycle. As a leveraged asset class, real estate enjoys a tailwind from falling rates. So, what is in store from here and what should investors consider when reassessing the merits of property allocations in their portfolios?
Rates down, real estate up?
Analysis of the last four rising cycles suggests that there is scope for real estate equities to outperform relative to the wider market as borrowing costs begin to tick downwards. The chart shows this potential with real estate equities outperforming broader equities by an average of 8% in the 12 months following the last rate rise.
Performance of real estate equities vs. global equities - after the last four cyclical peaks in interest rates
Source: Columbia Threadneedle Investments
Well positioned even if rates remain elevated
We see little likelihood of interest rates returning to their post GFC lows. More likely is a return to longer run average levels against a backdrop of moderate inflation. But what if we witness a resurgence of inflationary pressure – would this place property business models under strain? Within our portfolio we are selective about the sort of businesses we invest in. We look for quality companies operating in sectors and locations characterised by supportive supply/demand dynamics. Management teams are crucial – the right expertise, approach, and alignment of interest are all vital components. Our listed real estate exposure has an average loan to valuation of around 33% and with debt costs capped/fixed to 2026, their immediate prospects are not dependent on the broader direction of rates.
Deciding how and when to start the transition from accumulating wealth into decumulation and retirement is one of the most challenging financial decisions an individual will make in their lifetime.
Marcus Phayre-Mudge, Portfolio Manager
Mind the gap – a buying opportunity!
We have seen a welcome recovery in real estate equity values from their lows of 2023 but in broad terms, there remains a dislocation between share valuations and the true value of underlying property assets. In our view, this is a timely juncture for upping weightings to real estate. But as active investors we would always argue against doing so through a broad-brush allocation – not all real estate is created equal, so selectivity is key.
Once in a decade value proposition? European listed real estate materially underperformed wider equities
Source: Columbia Threadneedle Investments
Near term, large discounts between share prices and underlying asset valuations certainly offer scope for a capital value kicker. Longer-term however, it is income streams that will be the key driver and seeking out pockets of potential rental growth is our primary focus. In key markets we see little oversupply – a function of a range of factors not least a non-existent development cycle 2008-14 post the Global Financial Crisis (GFC) and a covid-deferred cycle 2020-21. Where supply of new space is limited, and where tenant demand is stable, strong incumbent firms look well placed. We see a positive outlook for sectors including logistics, data centres, hotels, prime retail in cities with high tourist footfall and even prime office markets in key central business district (CBD) areas such as London’s West End and core central Paris.
Industry shift endorses our hybrid approach
By investing in a blend of listed and physical real estate the CT Property Growth & Income Fund can tap into the best of both worlds and adopt a more active and flexible approach.
Flexible property investing with minimal cash drag
Source: Columbia Threadneedle Investments
And being flexible is exactly what we have been doing in the last 18 months. Since January 2023 we have tactically sold seven physical assets for £53 million and reinvested proceeds into listed European real estate securities – a move that, we believe, positions the portfolio well to take advantage of pricing differentials between the two markets.
Source: Columbia Threadneedle Investments. Data as at 10.06.24
How are we targeting relative value?
We launched our hybrid strategy in 2005 – a structure and approach designed to counter the challenges faced when seeking to offer open-ended, daily dealing access to commercial property. In subsequent years we’ve seen the merits of doing this – and, during liquidity events, the pitfalls associated with more traditional daily dealing (liquid) funds that invest purely in physical property (illiquid assets). The broader industry has belatedly responded. Alongside some high-profile fund closures, a growing number of vehicles are transitioning to a blend of physical property and real estate equities. We view this evolution as an endorsement of the approach we implemented almost 20 years ago, and it will be interesting to see how successfully (and quickly) they adapt. For investors considering increasing real estate weightings against a backdrop of falling rates, we would make the case for a hybrid approach that has a long track record of success.
