The chart
After ballooning during the rate-hiking induced shock, credit spreads in the investment-grade (IG) REIT market have fallen back to align more closely with corporate bond market spreads.
Source: BofA, Bloomberg, 15 July 2024. Spreads are option-adjusted spreads (OAS). European IG = BofA European Investment Grade Index. European IG REITS = Bloomberg Pan-Euro Corp: REITS.
The context
Low borrowing costs and investors’ hunt for yield from 2016 to the end of 2021 prompted a period of aggressive dealmaking across European real-estate markets. European REIT bond issuance surged as a result, with the sector’s share of the European investment-grade debt market jumping from 2.5% in 2016 to 6.3% in 2021.
However, the rapid rise in interest rates over 2022 quickly revealed how unprepared the now heavily indebted sector was for a shift in financing conditions. Equity and debt capital dried up and real-estate transactions collapsed – closing traditional deleveraging routes for over-levered companies. Some high-profile bankruptcies ensued, with company-specific governance issues adding to the negative headlines. The result was a ballooning of spreads in real-estate credit markets, with dispersion across the sector rising dramatically; spreads on real-estate credits that were considered at risk of being “junked” widened substantially more than those in the rest of the sector, regardless of underlying fundamentals. This created some attractive mispriced investment opportunities.
Conditions and sentiment began to turn towards the end of 2023, with improving inflation dynamics and an end to rate hiking in sight, leading to a return of debt-capital market access for real-estate firms. Excessively wide spreads, combined with an improving outlook for real-estate credit, made for an attractive entry point into the sector, which began to outperform. Today, spreads are trading at similar levels to where they were before abrupt rate-hiking commenced, as the chart shows. Notably, dispersion among issuers has fallen from the elevated levels seen previously, both on a credit-quality and cross-asset-class basis.
The conclusion
Investors can still find interesting opportunities in the real-estate credit market, but the tightening of spreads means valuations are no longer cheap across the board. This, combined with a lower level of dispersion in spreads, makes selectivity increasingly important. Specifically, low dispersion means there is little to gain by considering higher-risk real-estate credits.
With a liquidity crisis having been avoided, the focus will return to real-estate fundamentals over the next couple of years; real-estate companies with reasonable balance sheets and exposed to sectors with growth prospects – such as logistics and residential property – will be best placed to win in the new rates environment, in our view. In contrast, companies with over-levered balance sheets and operating in structurally uncertain sectors – such as offices or retail – will find it hard to continue to exist in their current form, given the post-COVID changes to those sectors. The ‘new normal’ in the sector is likely to result in winners and losers, i.e., increasingly diverse fundamentals across real-estate sectors, creating a conducive environment for active bottom-up bond selection.
