Having completed another satisfying, successful year as a U.S.-based REIT analyst, I found myself again curious and wanting a closer look at REITs in the European continent – which is geographically slightly larger than the U.S., but sports a population over 2.25x the U.S. – around 743 million people.
2018 was a rollercoaster for U.S. stocks and REIT investors. Starting in January, REITs experienced a drastic selloff with share prices dropping on average more than 10%, followed by a strong recovery and a crash again towards the end of summer. And I don’t have to revisit the late-year performance to make the point. You can see the turbulence by checking the performance of the Vanguard Real Estate ETF (VNQ), which invests in issued REIT stocks, and tracks the MSCI U.S. Investable Market Real Estate 25/50 Index.
With interest rates back on the rise, investors became increasingly worried about REITs, which are often perceived as interest rate sensitive vehicles. This perception (actually false), still caused the volatility to increase as investors ran for the exits, in anticipation of further interest rate increases coming in 2019.
It’s this very kind of irrational market behavior that reminds me of the importance of diversification. You can’t afford to put all your eggs in one basket – and with volatility expected to continue, I’m increasingly looking past our own shores, for added diversification.
In preparation of a future investment in Europe, I reached out to my friend Jussi Askola, president of Leonberg Capital, to discuss individual opportunities in the European REIT market. Jussi has real estate experience in several countries, including France, Germany, the U.K., and the Baltics. He’s a local expert in REIT investing, and we talked about why U.S. investors should consider European REITs as part of their portfolio. Here are excerpts from the five questions I asked – in our November conversation…
Brad Thomas: Why should U.S. REIT investors consider investing in European REITs, going into 2019?
Jussi Askola: The saying “location, location, location” is often quoted as the three most important virtues of real estate investing. When it comes to REITs, I find that “diversification, diversification, diversification” is a more accurate representation of what it takes to achieve investment success. Every real estate market ticks differently, and by investing in European REITs, U.S. investors can target valuable diversification benefits. Today, there is a clear trend towards higher interest rates in the U.S. This is much less certain in Europe where interest rates remain exceptionally low, and spreads are particularly attractive. This may cause U.S. REITs to perform differently from European ones, and you want to own some of both to reduce the overall volatility of your portfolio.
Moreover, in addition to the diversification benefits, many European REIT sectors are exceptionally cheap with historically high discounts to net asset value (NAV) heading into 2019.
European REITs trade today at close to an 8% discount to NAV with specific countries, such as Finland, offering up to 30% discounts to private market valuations. Some of these countries may rightfully trade at a discount (think Italy) but others appear greatly undervalued according to my market research.
Simply said, U.S. investors should consider an investment in European REITs to mitigate the risk in their portfolio, and potentially improve their future risk-adjusted returns.
Thomas: In which European country do you invest most heavily?
Askola: Presently, we’re overweight in U.K. REITs within the European region. The reason is quite simple: we believe people are overreacting to Brexit concerns, causing valuations to be deeply discounted.
Allow us to go back in time a little bit. Right up until the Brexit referendum, U.K.-listed real estate was on a strong bull run. So strong in fact, that listed real estate produced the highest average institutional investment returns in the U.K. (2010 – 2016) across eight major asset classes. Over that seven-year window, the average annual net return of U.K.-listed real estate was a staggering 10.93% for U.K. institutional investors.
This all came to an abrupt ending when the U.K. voted to leave the EU in June 2016. Investors were quick to panic, sending the broad U.K. market crashing down and even more so for anything real estate-related.
From one month to the next, the market sentiment turned south with listed real estate shares dropping by up to 25% in a matter of a few days. Fast forward two years, and the sentiment still hasn’t recovered amid continued uncertainties surrounding the potential consequences of the referendum.
Interestingly, while the share prices of U.K. REITs kept dropping, the private market values remained particularly resilient. In fact, the NAV of U.K.-listed real estate continued to rise in 2016, 2017 and 2018 as a result of steady net operating income growth.
The divergence in market opinions has grown to a rather extreme point where listed real estate sells today at just around 0.80 pence on the pound—or a 20% discount to the private market value of the underlying properties. I believe that this is an exceptionally opportunistic time to be investing in undervalued listed real estate in the U.K. I view the Brexit fears as an opportunity in disguise for the more sophisticated real estate investor who can take a contrarian and long-term approach.
Thomas: What’s your current favorite property sector?