September 24, 2023

A new wave of real estate pain comes after the European defeat

(Bloomberg) — Excited by rising borrowing costs and falling valuations that wiped out $148 billion in shareholder value, European landlords are bracing for another wave of pain.

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Real estate companies have about $165 billion in bonds maturing through 2026, while banks are reducing their exposure to the sector and borrowing costs are at their highest since the financial crisis. As a result, some companies risk being relegated to junk status, making it even more expensive for them to borrow.

The headwinds include a crash in office value from the City of London to Berlin, making real estate the least popular sector among fund managers for the third consecutive month, according to a survey by Bank of America Corp. Bloated with debt, many landlords will have to turn to asset sales, dividend cuts and rights issues in an effort to get the companies right-sized for a more turbulent future.

“The maturity wall can be a catalyst for transactions to happen because if borrowers are unable to refinance, they will have to leave,” said Jackie Bowie, head of EMEA at Chatham Financial. “You will have sold more assets into the market, I suspect, at distressed levels.”

Guilt Millstone

The poster child for the defeat is Swedish property company Samhallsbyggnadsbolaget i Norden AB, which is down more than 90% since its all-time high.

The $8 billion mountain of debt used to build a portfolio of more than 2,000 properties has turned into a millstone after the end of the cheap money era. The company’s downsizing efforts have drawn interest from the likes of Brookfield Asset Management, sending the stock price up on Friday.

The landlord has already been relegated to junk, forgoing a planned rights issue, and the market is praising in the prospect of others to follow. According to a quantitative model by Bloomberg, the majority of the real estate bonds on the euro’s high-grade bond index are issued by companies that now have a credit quality more typical of junk-rated companies.

Unless they can shrink their debt piles or borrow rates can fall again, these so-called fallen angel candidates will likely have to pay higher rates on their credit when they finally get around to refinancing.

‘Strong incentive’

“There will be a very strong incentive for many of these issuers to return to investment grade. We have already seen them trying to defend that line in the sand as their business model is not inherently high yield,” said Viktor Hjort, Global Head of Credit Strategy and Desk Analysts at BNP Paribas SA.

However, maintaining the rating may prove prohibitively expensive for some, not least as lessor hybrid bonds have tanked in the secondary market.

Some money managers lose patience and sell notes back to the real estate firms that issued them, including Aroundtown SA and Sweden’s Heimstaden Bostad AB. The appeal of liability management for landlords is clear: prices for high-quality euro banknotes have fallen by almost a fifth since the beginning of 2022.

“Large and sudden movements in nominal interest rates create uncertainty and it is important to maintain financial discipline to navigate through such periods,” said Heimstaden AB Chief Investment Officer Christian Fladeland. “We view this as reflected in our strong balance sheet, hedging policy and balanced debt maturity profile.” Aroundtown and SBB did not respond to requests for comment.

Other companies will turn to rights issues or expensive alternative forms of debt to reduce their burdens, eroding profits over time.

Those are left corners of the stock market flashing red flags not seen since the financial crisis. Forward price-to-book multiples suggest these stocks are trading at their cheapest levels since 2008. The measure measures the value of a company’s stock relative to the value of its assets.

The peak-to-trough sell-off since August 2021 is approaching 50%, or $148 billion, putting the Stoxx 600 Real Estate Index at a record low against the European benchmark stock index.

The wider unrest cost British Land Plc its place in the FTSE 100 after more than two decades, while the owner of London’s Canary Wharf financial district was further downgraded to junk. A British Land spokesperson declined to comment. Canary Wharf Group did not respond to a call for comment.

British Land loses place on FTSE 100 after two decades in index (1)

It has also nearly frozen property markets, with buyers demanding higher yields to offset the risk of rising interest rates and departing tenants. According to broker Savills Plc, the price of prime office buildings in Paris, Berlin and Amsterdam has fallen by more than 30% in 12 months.

“Sentiment is still pretty bad and it’s reflected in these market prices,” said Chatham Financial’s Bowie.

It’s part of a global trend where the number of real estate bonds and loans trading at distressed prices has surpassed $190 billion. That is in contrast to other industries, where it has shrunk in recent months.

Further waterfalls

There may be even worse to come. Commercial real estate values ​​in Europe could fall as much as 40% due to the extent to which debt markets are turned upside down, Citigroup Inc. analyst Aaron Guy wrote in a note earlier this month.

In addition, he wrote, landlords may need to provide about 50% additional equity when refinancing an asset to meet the benchmarks against which banks and private credit funds borrow. That is based on a refinancing rate of 6%.

We assume that valuations still need to be revised downwards. This means more pain to come,” says Max Berger, loan portfolio manager at DWS Investment GmbH. “Some of these business models are no longer viable. Bond markets are well aware of this.”

The uncertainty has made money managers wary.

“We’re staying out of the industry,” said Lucas Maruri, a fund manager at MAPFRE Asset Management, which manages about $40 billion. “We estimate that there are still risks to the good performance of the shares of real estate companies, REITs and European developers in the coming months.”

–With help from Macarena Muñoz.

(Updates with scale of real estate distress in paragraph above subheading Further declines)

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