Ever since the financial crisis we have seen rising transaction volumes in the property market thanks to the strong growth in value that has taken place. We have also seen this being reflected in the public property companies share prices over a long period of time, not the least during last year with increases of approximately 60-70 percent on average. A lot has changed as a consequence of the Covid-19 pandemic both structurally in terms of behavioural patterns as well as the development of public property companies share prices. In a pod, together with Arvid Lindqvist Head of research at Catella Corporate Finance, we look into the development of the property market.
The world around us
We are in the midst of a global recession, the most powerful in modern time. Sweden has not shut down as forcefully as the rest of the world. Initially the services sector has been able to cope better than the manufacturing sector, but around 50 percent of GDP comes from exports, hence we are being impacted by what is going on in the rest of the world. Investments are dropping around the world and we are impacted consequently.
What is the impact on the property market?
The hotel and restaurant segments have been directly impacted, however they constitute a small part of the overall property market. Initially it heavily affects property companies like Pandox, as they are entirely focused on properties that are adapted for hotel business. Pandox's revenues are also partially based on the hotels' revenues. Premises rented to hotel businesses are impacted a lot and we can now see that office space has been affected to a larger extent as well. Office space is a big segment in the property market and a volatile one, says Arvid.
When we look at the property market, we divide it into around 30 sub-segments, based on how they are affected by macro economic variables, Arvid continues. A simplified way of describing the market is to divide it into three main categories where you see impact on rental income depending on 100 bp stronger or weaker GDP-growth or CPI-inflation. Rent levels correlate with real GDP, nominal GDP or with CPI-inflation.
- Category 1 – Property with office space in Stockholm. This correlates with real GDP-growth.
- Category 2 – Shopping malls and office space in regional cities, these correlate with nominal GDP (real + inflation).
- Category 3 – Other segments, these are tied to CPI. Examples include residential rental property, mixed real estate holdings and logistics. All correlate with rolling 2 year inflation.
The only segment which has a strong volatile rental development is office property in Stockholm. It has a strong correlation to real GDP-growth, if rolling four year GDP-growth increases by 100 bp rental income growth increases by 500-600 bp in the best locations. Stockholm is the growth engine in Sweden and there is big focus on the best locations.
The other property segments are stable and when the economic cycle weakens, as now during Covid-19, it mainly hits property in Stockholm. The other rental segments are relatively less impacted part from the hotel and restaurant segments.
We have modelled different scenarios with 3, 6 and 12 percent fall in GDP-growth. The feeling right now is that we are leaning towards the 12 percent scenario. Vacancies increase in the Stockholm office space market and we estimate a two- or threefold increase in vacancy levels. This leads to a sharp fall in the rental levels for offices space in Stockholm, which is closely connected to real GDP growth. If you add a weak economic recovery thereafter, it becomes a hard hit.
Residential rental properties are not really affected in the same negative scenario. The development in residential rental properties is tied to inflation and if there is a slowdown, not a lot happens to rental levels. If you look at the yield levels in the property market they vary a lot depending on the segment. In general, major city properties tend to correlate with interest rate development based on the financing costs for property companies. The financing cost is a rolling market rate with 3,5 - 4 year fixed duration on average for the publicly listed companies and an average credit spread. Changes in financing costs move slowly. Now it has become more expensive to borrow, but as it takes time before you renegotiate loans, we will see this impact first during the course of next year and as a consequence higher yield demands from investors.
What is the optimal location for office space?
The volatile objects in the market are mainly in the best locations in Stockholm. After years of strong increase in rental levels we now see around 8 000 – 10 000 SEK/sqm, which has primarily been driven by Tech and Coworking space companies. We expect that the Coworking companies, which is the fourth biggest property category in Stockholm, will have a much tougher time in the future. They have around 100 000 sqm space of 1 500 000 sqm of CBD (Central Business District) space in Stockholm, which is around 7 percent and we believe they will take a big hit. "It wouldn't surprise me if half of these companies don't survive and that this space will be out on the market", says Arvid.
On the other hand, Stockholm CBD is a property segment with low risk, as over time vacancy levels are low with low residual value risk. This is due to the fact that they own the most attractive piece of land in Sweden. This attracts institutional investors which is the most common owner of these properties, so you won't find weak and highly leveraged players in this segment. This means that there will be no panic selling of properties, as this is a slow moving segment.
In the transaction market there are still deals happening, but at a lower rate. Normally there are around 300-400 deals per year on average, the average over the last 15 years is 370 transactions. Now it is probably under the 300 level, maybe down to 250 deals annualised level. Measured as volume it has increased thanks to the value increase in property,
A survey was recently sent out by Catella to the biggest institutional and private investors on macro economic outcomes, the result was an expectation of a deflationary scenario. This was the same outcome as in a survey that was sent in September of 2019, Arvid points out. There is a strongly anchored expecation of low interest rates and low inflation for an extended period of time. There is an expectation that so called "samhällsfastigheter", ie properties that are linked to functions in the society such as schools, police stations, court houses, etc and residential rental properties will have the best development and that this segment is best suited for a deflationary scenario with stable cash flows. Property in this segment are attractive among investors,
Retail properties already had a tough period a couple of years back due to structural changes in the consumption patterns, for example due to e-commerce. Some companies are now thinking whether if there is a structural change in office space as well. Coworking companies argue that there will be a need for more flexible offices and that you will need more space to keep distance in the offices. We can also note that video conferencing definitely has had a breakthrough and the fact that you can work from home to a larger extent than previously is sufficient for investors to start speculating around this to create uncertainty. Furthermore, this segment is believed to be cyclical, hence there is a more positive view on the stable segments such as residential rental properties and "samhällsfastigheter". There is not a lot of samhällsfastigheter, accordingly it is relatively safe to be invested in this segment. In these segments we therefore don't see any material impact on prices.
Impact of share prices
Rising share prices drive transactions. During a year like 2019 when property shares were up 70 percent leads to more investments and as a consequence more transactions. We come from high levels and transactions are now being closed at a certain discount. Property companies with more restaurants and retail are impacted more. Property companies with a mix of industry even trade at a premium if you look at the shares. If you assume with the worse economic scenario with 12% lower GDP, it will lead to selling pressure for the listed companies. Property companies within the volatile segments such as offices space in Stockholm's suburbs, offices in regional cities and shopping mall properties are impacted the most.
If you look at leverage, and the companies that need refinancing in the coming 18 months, this is even more troubling for valuations. The problems of refinancing are mostly represented in the same segments.
We rather see buying pressure in logistics and industry properties such as Catena, Corem and Sagax, as well as within residential properties. They have predominantly institutional ownership as owners, they reweight their portfolios and rather invest more, says Arvid.
During the summer of 2019 the market had the view that inflation was gone and that rates would remain low for an extended period of time. As a consequence, properties and property shares repriced massively during that fall. There is still a consensus belief that rates will remain low for long, but there will be a big difference in how the different property segments are impacted. A consequence of the market action during the fall of 2019 was that yields came down massively in the equity market, but this was not fully reflected in the direct property market.
Valuation wise there is a now discount to NAV in many listed companies, compared to previously when they traded at a premium. It is mainly property companies that are focused on office space and those who have a mix of retail properties, that trade with a discount. Companies with a mixed portfolio and companies with other segments often do not trade at discount and quite a few still trade a premium.
The yield on properties in prime locations went down below 3 percent, but is on its way up now. This can be explained by expectations of rental developments are not as positive as previously and that financing costs are on their way up. The yield levels have a high correlation to financing costs. The financing cost consists of average market rates in the companies and average credit spreads, based on the duration. We now see pressure of market rates down and pressure up on credit spreads, in total an increased cost of financing.
Will property companies have problems with their financing?
"Yes, depending on what risk the company has in its business model", explains Arvid. Both the equity market and the bond market are priced based on the risk in the companies, the risk in the companies is based on the risk in the underlying risk property portfolio.
If you look at the real estate and property as an asset class and look at the standard deviation, as well as the total return as a measure of risk, then all property companies look stable part from offices in Stockholm. When you analyse property companies you need to use a broader measure of risk. You need to weigh in vacancy risk, liquidity risk, residual value risk, standard deviation in the total return and the market yield. Using all measures of risk you get a clearer picture of the different property segments, that is how the equity and bond market price the property market, he continues.
The low risk companies are the ones that invest in the best locations in Stockholm such as Hufvudstaden and Atrium Ljungberg, despite them having discounts and a mix of retail in their property portfolios. They have volatility in their earnings, but they have value in the land and liquid assets. These companies have stable credit spreads over time, in the range of 60-150bps in credit spread on the corporate bond market. The credit spread in the high risk companies varies a lot more. They can borrow at approximately the same levels as the low risk companies during good times, but in a "risk off" environment they reach 150-300 bp in average credit spread and the spot spread can be much higher for some.
The impact from rising financing costs is greater in the low risk companies. Properties in worse locations are affected less by a rising cost of financing. The correlation is as strong, but the impact less, less attractive objects have so many other risks to take into consideration such as rising vacancies. This means that we see yields rising and they will rise more in the bigger cities as a consequence of the rising costs of financing.
Will vacancies increase?
If we get the negative scenario of 12 percent fall in GDP and a weak recovery, vacancies can increase dramatically. Within offices and commercial space it possible to see vacancies to rise by 3 times. If we then get a slow recovery in the total economy, we will get difficulties in the companies that are closely tied to real GDP-growth, while the companies that are more closely linked to inflation won't be affected in the same manner.
How will the leverage ratios be affected?
The property companies have fought to keep their LTV (Loan to value) ratios, as the value of property has risen and they have acquired more properties to ensure the level does not decrease too much. Now we are in the opposite situation, they need to work with making sure the leverage ratio does not get too high which leads to sales of properties. It won't be called a "fire sale" but rather strategic divestments. Property companies won't want to have unnecessary financing in place. To a certain extent this will affect the borrowings in the corporate bond market, which constitutes approximately 35 per cent on average for the listed property companies for refinancing. "You have a relationship with a bank, the corporate bond investors can be much tougher at a refinancing", Arvid explains.
Could you have inflation in the worse economic scenario that was believed to happen in your survey?
Arvid himself does not believe in the consensus stagnation scenario as the market sees. He rather thinks this will turn into inflation. "We have so much debt right now, an ageing population. An ageing population tends to push down inflation and real rates, an old population pushes up real rates and decreases savings. A decreased level of globalisation and supply chains being taken home, especially food and medicine, can be inflationary. Add to this an increased amount of debt, where central banks print money which undermines currencies, is inflationary".
There will be a need to inflate away debts and properties will be an attractive asset class, in particular the segments that cope well with inflation. Properties are attractive as an asset class even in a deflationary scenario, Arvid sums up.