Positive factors persist

Office supply

The office sector has felt the pain of the deteriorating economy during the last few years. Vacancies have been rising but contrary to the property crash in the early 1990s, property companies have quickly reacted to circumstances and new office supply in Europe is fairly empty, which is very positive.

A popular way of assessing the valuation of property companies is to look at the discount (or premium) of the share price compared to the net asset value (NAV). As the chart shows, most property companies are still trading at a discount to NAV. With the European economy expected to recover in the near future, take-up of office supply will also increase and hence the discounts to NAV are expected to narrow. We prefer those office markets where supply is constrained, such as central Paris.

Other encouraging factors are low interest rates across Europe. Property shares use leverage to increase their returns and with the current low interest rates, the property manager earns a higher spread (i.e. property yield minus interest rate on leverage).

Retail sector

The retail market has been surprisingly resilient to the economic downturn. Consumer spending has been very stable in the last few years with consistent year on year growth. Property companies that invest in retail as a result have shown increasing profits and higher NAVs. We prefer countries where the square footage of retail space is relatively small compared to the European average. This is mainly the case in southern European countries such as Italy and Spain.

Changes at hand

In the next few years the European quoted property market will see some major changes. Tax legislation is expected to change dramatically. In the Netherlands and Belgium property companies have the same status as Real Estate Investment Trusts (REITs) have in the US. This means that as long as the company pays out most or all of its earnings in dividends to its shareholders, the company is excluded from paying tax on a company level. The rationale behind this is the prevention of double taxation, because shareholders pay tax on their dividend income.

The French government has already decided to replicate this system for French quoted property companies. In the UK, Italy and Germany politicians are discussing setting up the same structure and other European countries are expected to follow suit in the next few years.

This has several major advantages for investors. The first is that the total tax paid for holding property will decrease. Also, as the chart shows, countries with this tax-exempt status have on average a lower discount to NAV. The discounts in other countries are expected to decrease or disappear following this change. Thirdly, as companies have to pay out most of their earnings, dividend yields will increase. Yields are higher in those countries that already have a REIT-like structure than those that do not.

Finally, this new legislation will make it more attractive for property companies to go public. The universe is therefore likely to increase. This will in turn affect real estate buyers. Large institutional investors with a history of investing in direct property are expected to turn increasingly to indirect property because of the liquidity it offers.

All in all we expect the European property market to show stable returns in the next few years. The recovering economy will eventually result in decreasing vacancies, higher rents and capital appreciation in both office and retail property. The introduction of new tax legislation will be a positive factor. Dividend yields should increase, discounts to net asset value are expected to decrease and the quoted property market will become larger and more liquid.

Raymond Lahaut works for Aviva’s asset management company Ohra in the Netherlands. He is the manager of Aviva Funds – European Property Fund

Lahaut: Europe stays stable