Having completed another satisfying, successful year as a U.S.-based REIT analyst, I found myself again curious and wanting a closer look at REITs in the European continent – which is geographically slightly larger than the U.S., but sports a population over 2.25x the U.S. – around 743 million people.
2018 was a rollercoaster for U.S. stocks and REIT investors. Starting in January, REITs experienced a drastic selloff with share prices dropping on average more than 10%, followed by a strong recovery and a crash again towards the end of summer. And I don’t have to revisit the late-year performance to make the point. You can see the turbulence by checking the performance of the Vanguard Real Estate ETF (VNQ), which invests in issued REIT stocks, and tracks the MSCI U.S. Investable Market Real Estate 25/50 Index.
With interest rates back on the rise, investors became increasingly worried about REITs, which are often perceived as interest rate sensitive vehicles. This perception (actually false), still caused the volatility to increase as investors ran for the exits, in anticipation of further interest rate increases coming in 2019.
It’s this very kind of irrational market behavior that reminds me of the importance of diversification. You can’t afford to put all your eggs in one basket – and with volatility expected to continue, I’m increasingly looking past our own shores, for added diversification.
In preparation of a future investment in Europe, I reached out to my friend Jussi Askola, president of Leonberg Capital, to discuss individual opportunities in the European REIT market. Jussi has real estate experience in several countries, including France, Germany, the U.K., and the Baltics. He’s a local expert in REIT investing, and we talked about why U.S. investors should consider European REITs as part of their portfolio. Here are excerpts from the five questions I asked – in our November conversation…
Brad Thomas: Why should U.S. REIT investors consider investing in European REITs, going into 2019?
Jussi Askola: The saying “location, location, location” is often quoted as the three most important virtues of real estate investing. When it comes to REITs, I find that “diversification, diversification, diversification” is a more accurate representation of what it takes to achieve investment success. Every real estate market ticks differently, and by investing in European REITs, U.S. investors can target valuable diversification benefits. Today, there is a clear trend towards higher interest rates in the U.S. This is much less certain in Europe where interest rates remain exceptionally low, and spreads are particularly attractive. This may cause U.S. REITs to perform differently from European ones, and you want to own some of both to reduce the overall volatility of your portfolio.
Moreover, in addition to the diversification benefits, many European REIT sectors are exceptionally cheap with historically high discounts to net asset value (NAV) heading into 2019.
European REITs trade today at close to an 8% discount to NAV with specific countries, such as Finland, offering up to 30% discounts to private market valuations. Some of these countries may rightfully trade at a discount (think Italy) but others appear greatly undervalued according to my market research.
Simply said, U.S. investors should consider an investment in European REITs to mitigate the risk in their portfolio, and potentially improve their future risk-adjusted returns.
Thomas: In which European country do you invest most heavily?
Askola: Presently, we’re overweight in U.K. REITs within the European region. The reason is quite simple: we believe people are overreacting to Brexit concerns, causing valuations to be deeply discounted.
Allow us to go back in time a little bit. Right up until the Brexit referendum, U.K.-listed real estate was on a strong bull run. So strong in fact, that listed real estate produced the highest average institutional investment returns in the U.K. (2010 – 2016) across eight major asset classes. Over that seven-year window, the average annual net return of U.K.-listed real estate was a staggering 10.93% for U.K. institutional investors.
This all came to an abrupt ending when the U.K. voted to leave the EU in June 2016. Investors were quick to panic, sending the broad U.K. market crashing down and even more so for anything real estate-related.
From one month to the next, the market sentiment turned south with listed real estate shares dropping by up to 25% in a matter of a few days. Fast forward two years, and the sentiment still hasn’t recovered amid continued uncertainties surrounding the potential consequences of the referendum.
Interestingly, while the share prices of U.K. REITs kept dropping, the private market values remained particularly resilient. In fact, the NAV of U.K.-listed real estate continued to rise in 2016, 2017 and 2018 as a result of steady net operating income growth.
The divergence in market opinions has grown to a rather extreme point where listed real estate sells today at just around 0.80 pence on the pound—or a 20% discount to the private market value of the underlying properties. I believe that this is an exceptionally opportunistic time to be investing in undervalued listed real estate in the U.K. I view the Brexit fears as an opportunity in disguise for the more sophisticated real estate investor who can take a contrarian and long-term approach.
Thomas: What’s your current favorite property sector?
Askola: Different property markets have different cycles. While the hotel market may be saturated in New York, it may be strongly undersupplied in Paris, as an example. Today, I believe the main opportunity is in the self-storage sector in Europe. It has been wildly successful in the U.S. over the past two-and-a-half decades: Self-storage REITs have outperformed the broader REIT sector by 50% with 42% less volatility and is on its way to replicating that story in Western Europe. While the self-storage market is now well developed in the U.S. with the low-hanging fruit already scooped up, I believe the opportunity for outsized returns in European markets remains highly favorable. While self-storage facilities are plentiful throughout most of the U.S., in Europe the supply is much scarcer. In the U.K., self-storage penetration in key urban markets remains low: as there is only 0.6 square feet per person of self-storage space, as opposed to 9.2 square feet per person in the U.S. A recent survey conducted by leading U.K. self-storage REIT Big Yellow found that 75% of its new customers were first time users of self-storage space. This indicates that the popularity and demand for this type of real estate is growing rapidly in the U.K. due to factors such as rising densification of the population, increasing awareness of the self-storage concept, and the high cost/scarce supply of office space in key cities such as London.
As a result, I believe that European self-storage companies have enormous growth runway for scaling up from their current small sizes. It remains deeply undersupplied and early players will win big here. Furthermore, I believe that it is a fairly recession-resistant business model since demand for extra storage space may actually increase when recessionary periods force consumers to choose smaller and more affordable living spaces (i.e., apartments rather than homes) and businesses to scale down office space.
Thomas: What are three of your favorite European REIT investments today?
Askola: My top three investment picks today include a British self-storage owner, a French mall REIT and a London-centric office property investor.
Big Yellow Group (BYG:LSE) is a market leader in self- storage within the U.K. It recognized the opportunity back in 1998 and has kept scaling operations at a fast pace. The market imbalance for self-storage space in the U.K. has been so extreme that it has allowed Big Yellow to generate a 15.2% return per year since 2000, representing a 1,000-basis point overperformance over the FTSE All-Share Index. The track record is reflective of the market opportunity and given that the market is still deeply undersupplied, I expect such outperformance to continue.
Klepierre SA (0F4I:LSE) is commonly known as the French version of Simon Property Group (SPG:NYQ) because it is a mall REIT that puts a great focus on investing in high-quality properties, maintains a conservative balance sheet and finally, SPG is its largest shareholder (21.2%). While Big Yellow is a high growth opportunity in self-storage, Klepierre is more of a high yield opportunity with a safely-covered 6.8% dividend yield from a diversified portfolio of European malls.
Great Portland Estates (GPOR:LSE) is my number one pick for London office real estate exposure. I view it as highly opportunistic due to the large disconnect between share price and underlying net asset value of the properties which, when combined with GPOR’s superb track record of efficient capital allocation and the significant durable competitive advantages enjoyed by both GPOR and the city of London, lay the foundation for significant outperformance over the long term. Its balance sheet has never been this strong at a mere 5.8% loan-to-value, the NAV keeps growing at a healthy pace (5% year-to- date) and yet the REIT is priced at a 19% discount to NAV.
Summary: As we move through 2019, I’ll keep an open mind for REIT opportunities in the European market. Whether I decide to make purchases will require more study and research on my end, but what I’m seeing is very encouraging. Many European REIT markets appear to be oversold, and the diversification benefits to U.S. investors could be valuable during the next down cycle. That said, I’m mindful of the risks investing in foreign country markets, including a lack of local presence, currency value fluctuation, and different macro risks. Investing in foreign markets is not suitable for everyone, but for investors willing to take the leap, I believe the European REIT market has much to offer.
Excerpts appeared in December’s Forbes Real Estate Investor. Our upcoming February issue includes “how to prepare” a REIT portfolio for a recession – whether it’s soon, or later.
