With an era of cheap debt over, here’s why Premier Miton’s real estate team favours internal management over corporate external management structures. Alex Ross, fund manager of the Premier Miton Pan European Property Share Fund, covers real estate investing in a higher rate environment, M&A, shareholder alignment and what’s ahead.
Investing in property in the era of cheap debt
The last property cycle presented a lucrative environment for owning long leased property financed off cheap debt. Many property investment companies launched to offer investors a highly tangible income from this strategy. Given the perception these investment companies offered lower volatility relative to more traditional property companies, which are typically more tactically used by generalist fund managers, they became the property vehicle of choice for many wealth managers to replace the structurally impaired bricks and mortar funds.
However, with the onset of higher interest rates since 2022, many of these externally managed property investment companies, which hire third-party managers to make investment decisions, have seen their fee-based business model become less effective. With an era of cheap debt over, continuously raising more equity to grow assets by buying long income (i.e. targeting income payments over the long-term) using low-cost financing doesn’t work anymore.
Despite property yields for long income increasing in this property downturn, for most of these companies the yield is still not high enough to make earnings accretive acquisitions, i.e. increasing the acquiring company’s earnings per share, with the high debt costs.
Indeed, it would take a substantial fall in rates to make the numbers work again for many of these businesses, and we don’t envision such ultra-low rates returning.
Bullish investors would point to the high dividend yields of many of these companies, and their key attraction should be income rather than Net Asset Value, but we believe there’s a potential value trap ahead for some.
The lack of revenue growth limits the ability to offset the inevitable medium term cost impact ahead of refinancing their existing low-cost debt at materially higher interest rates. We believe this could lead to a decline in earnings (and hence dividends) in some cases.
Real estate investing in a higher interest rate environment
In an environment of higher interest rates, real estate can perform very well, but this requires cashflow growth. It needs a different type of real estate than the long income type of property owned by many of these externally managed property companies designed to benefit from the ultra-low interest rate cycle.
Attractive cashflow growth requires active management teams with strong operational platforms via property companies with the ability to manage shorter leases where there is pricing power to regularly increase the rents.
Or from real estate companies with the expertise to regenerate property through creating structurally in-demand property (such as warehouses or modern, amenity-rich green offices).
Or through acquiring mis-managed assets with opportunities to grow the income from reducing vacancy.
To generate this cashflow growth requires intensive real estate management skills from established property companies with operational platforms, rather than a small external management team more passively managing a long income portfolio with limited asset management requirements.
The final reason we favour in-house property management is about shareholder alignment. One of our long-term concerns on many externally managed property investment companies has been a lack of alignment with shareholders, where the main financial incentive has been towards the management fee, and hence increasing the assets.
With the business model of many of these investment companies now impaired as many are sub-scale and unable to grow off a poor share rating, we are seeing increasing M&A activity within the sector, principally towards mergers amongst these vehicles.
Whilst this in principle should be a good thing, our view is that in certain cases this is being aimed more towards the interests of external managers, incentivised to grow their fee income off a larger asset base, rather than the shareholders.
M&A, shareholder alignment and what’s ahead
We believe the model example of M&A in this space was demonstrated by the internally managed LondonMetric Property when it acquired the externally managed LXI. A strong earnings accretion to LondonMetric meant LXI shareholders taking LondonMetric shares in the takeover and the removal of the external management fee of LXI on taking control of the assets.
We would have liked to have seen more of these examples of high quality corporate companies with good internal management structures acquiring the assets of externally managed companies to the benefit of shareholders in both companies. However there appear to be governance and alignment issues preventing it and it is a dangerous game investing in a poorer quality company hoping for a beneficial takeover, particularly when there is a tail of poor-quality assets.
Whilst many of these externally managed companies are structurally impaired, we are now seeing pleasing evidence of the leading internal management teams in the sector getting on the front foot and taking advantage of opportunities that are arising from this downturn, particularly in Europe, where we have seen several opportunist equity raises to acquire opportunistically and accretively grow the earnings for shareholders.
We participated in a number of these, where we see healthy earnings accretion with the companies demonstrating highly attractive value creation opportunities ahead from various asset management initiatives – a very different outlook for these shareholder-aligned internally management companies vs a number of the structurally impaired externally managed investment companies.
We are now entering a more traditional real estate cycle ahead without the luxury of cheap finance. We see the clear winners as these established and proven internal property management teams, whose shareholder-friendly business model is to create value from improving real estate, be it through the hard and intensive management of growing rental revenue streams or regenerating real estate for tomorrow’s tenant requirements.
