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A Quest for the Top Performing Sectors

Cedrik Lachance, Director of REIT Research, compares real estate returns in Europe and in the United States and finds Europe more attractive. Although comparing real estate valuation globally is challenging, Cedrik leans on Green Street’s unique ability to spot investment opportunities to identify three sectors that stand out as having the best risk-adjusted return expectations. He also discusses three disruptors with varying impacts on long-term expected returns.

European Real Estate Returns Outpace U.S. Returns

Real estate is often seen as a local business, which makes comparing valuations globally a challenge. But Green Street, with more than three decades of real estate analysis and a high-caliber team of more than 50 researchers focused on European and U.S. public and private real estate markets, has developed valuation frameworks that can help investors spot opportunities across sectors and geographies.

Today, real estate returns are far more attractive in Europe than they are in the United States when compared to local bond rates. Europe’s relative attractiveness is true in both the private and public markets. This is because REIT discounts to Green Street’s estimated private market value of the properties they own are roughly similar across continents. In fact, discounts are often comparable across sectors within different regions, suggesting that while real estate is a local game, broad trends can transcend borders.

Green Street's Global Property Allocator
As of August 1, 2018

 

Green Street’s Top Three Sector Picks

In the public market, Green Street covers nearly 125 real estate companies divided across almost two dozen sectors in the United States and Europe. Three sectors stand out as having the best risk-adjusted return expectations, all in Europe. Green Street’s favorite sector in Europe is self-storage because the business is still institutionalizing and therefore offers a very attractive rate of return. Self-storage has one of the lowest capital expenditure (cap-ex) burdens of any real estate asset class. Owners need to invest less in their properties over time to keep them competitive, providing a huge advantage that is often not fully appreciated by the market. In addition, self-storage offers a strong net operating income (NOI) growth profile as the sector is enjoying a high pace of adoption by European consumers, which should boost occupancy and create room for excess development profits.

Observed Premium/Discount to Net Asset Value
As of August 1, 2018

 

Green Street is also positive on Swedish-listed property companies, which is largely a play on the office sector in the country. These companies boast an attractive medium-term NOI growth profile on the back of strong job creation that outpaces high development volumes. Projected NOI growth would be the envy of the rest of European and American office companies. In addition, development projects should create significant value. It’s too bad the balance sheets are so levered. Nevertheless, the good greatly outweighs the bad, and the market is providing a great entry point.

Third, Green Street likes the London Specialist property companies, which is a mix of office owners (Derwent London and Great Portland) and retail-focused companies (Shaftesbury and Capital & Counties). The office players, in particular, are exceedingly well-managed and currently trade at discounts to NAV due to concerns around the Brexit impact on office space demand. But there has been a lot more bark than bite since the U.K.’s mid-'16 vote to leave the European Union. These discounts to NAV are especially overblown compared to the value creation the companies can produce as they continue to deliver inventive projects in some of the most in-demand submarkets of London.

Green Street's Global Property Allocator
As of August 1, 2018

 

For those investors focused on the United States, Green Street favors the residential sector in the public market, where manufactured homes and apartment assets are attractively priced. Learn more about Green Street’s view of the apartment sector in the blog post, Apartments: Bright Spots and Warning Signs.

Monster vs. Mouse: Disruptors Are Not All Equal

Green Street accounts for long-range themes in its sector analysis by evaluating the impact of near- and long-term real estate disruptors. The biggest near-term disruptor remains ecommerce, which will continue to be detrimental to brick-and-mortar retail and a boon for the industrial sector.

Ecommerce has surged over the past decade and will continue to grow with improvements in voice activation and the internet of things, which are creating an omnipresent retail world. For retail real estate owners, that means slowing demand for space and more capital expenditures to successfully adapt, which will lower real estate returns at the high end and leave the low end with dubious prospects. Conversely, Green Street sees significant runway for additional demand growth for warehouses and the industrial real estate sector, which should top all U.S. sectors in rent growth for the next five years and fare reasonably well in Europe.

Market Share of Online Purchases
(% of Total Retail Sales)

 

Another disruptor impacting real estate is co-working. The rise of co-working is influencing how worker density is evolving, and therefore the need and demand for office space. It is also creating pressure for flexibility in lease terms. For office landlords, co-working may mean more cap-ex, more flexibility provided to tenants, and potentially a bit less NOI growth over time. Of these impacts, higher cap-ex has the potential to weigh most heavily on the sector. For deeper insight, see blog post, Co-working: Good or Bad for Office?

Airbnb is described as an ecommerce-like disruptor for the hotel business, but Green Street disagrees. Airbnb has actually expanded the pie, only tweaking the growth rates for the hotel business, and not damaging underlying fundamentals in a meaningful way. Airbnb is not leading to the declines in NOI growth potential the way disruptors have in other sectors.

The bottom line is that disruptors are very important, but the range of impact can vary dramatically, and it requires deep analysis to understand these dynamics.

Chief investment officers across the globe are challenged with seeking relative returns in a still-low-yield environment. Europe offers some attractive investment opportunities, but there are risk/return tradeoffs to consider and disruptors to watch for. Green Street’s cross-border, risk-adjusted return analysis helps investors navigate across geographies and property types as they seek successful execution in international real estate investments.

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