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Hot property? The real deal in the property sector

Robert Baltzer, Head of Credit Research

Key Points

  • The property sector is being affected negatively by the economic backdrop, changing lifestyles and occupiers’ rising expectations
  • With bond markets closed to all but the strongest property companies, many will rely on secured borrowing from banks for financing
  • Industrial real estate owner, CTP has fixed its borrowing costs at low levels and benefits from strong demand and rental growth

The value of any investment can fall as well as rise and investors may not get back the amount invested.

The property sector provides an intriguing challenge right now. Is it a compelling opportunity? Or are the high bond yields on offer too good to be true?

Stubbornly high inflation and the resulting outlook for interest rates are likely to put further pressure on property valuations in North America and across Europe. In certain sectors, such as office and retail, these factors compound secular declines in demand as working and shopping patterns change. To make a landlord’s life more challenging still, occupiers are becoming much more demanding regarding asset quality, amenities, and environmental efficiency, leading to the need for expensive modernisation efforts.

Against this backdrop, property companies looking to refinance their existing debt will find lenders far less generous than in recent years, with tighter lending standards and higher costs. Bond markets are also currently shut to all but the strongest property companies.

In selecting the investments that are held within portfolios, we devote a lot of time searching for inefficiencies within sectors. Looking at the property sector today, we believe the answer lies not in a top-down view; but in unearthing hidden gems, such as the industrial property developer and manager CTP, that can outshine the sector narrative based on how they are run and likely to grow in value over time.

 

A hidden gem - CTP

CTP is the largest listed owner of industrial and logistics real estate in continental Europe. Its combination of strong tenant demand, the resulting pricing power, and financial flexibility position it well to handle today’s difficult market environment.

CTP continues to experience strong demand from local and international tenants for space at its parks. The growth of ecommerce in Central Europe, more companies outsourcing product distribution and increasing demands for supply chain resilience through ‘near-shoring’ – outsourcing work to a country located near your own – are specific tailwinds for CTP.

Strong demand allows CTP to attract high-quality tenants who pay their rent on time. Its parks operate at high occupancy levels, maximising rental income. And rental growth momentum has picked up sharply in recent years to reflect strengthening tenant demand and higher construction costs. Historically, CTP’s leases incorporated fixed annual rent increases of 1.5-2 per cent, which meant that the benefit of higher rents was captured slowly. However, with more than half of the company’s leases now linked to eurozone inflation, CTP has accelerated the pace at which this growth is reflected in cash flow.

Strong demand and good pricing power lead to a healthy rental income outlook. Property buyers look at the industrial and logistics real estate sector more favourably than challenged areas such as office and retail where demand is weakening, or residential property where rents are capped in many countries. As a result, property valuations are likely to be more resilient here than elsewhere.

The company has invested heavily in new developments. Given that the company is achieving more than a 10 per cent yield on the cost of development, this remains a significant and accretive driver of cash flow growth. However, it is important to note that this spending is discretionary and, unlike in many other property sectors, has a relatively short lead time. This means it can be reduced quickly if economic conditions sour or financing terms become unattractive. CTP has savvily fixed its borrowing costs at low levels and is having no difficulty securing incremental financing at yields well below the income yields on its portfolio, evidencing strong financial flexibility.

 

Focus on company resilience

Despite CTP’s rude health, its bonds have been caught up in the wider sector downdraft. Its senior unsecured bonds are rated BBB-, a low investment grade rating to which the company is committed. Yet it offers yields commensurate with ratings three or four notches lower as if it were clearly below investment grade in quality. We view CTP’s bonds as a highly attractive opportunity for investors with a multi-year investment horizon who can look beyond the wider property sector narrative and identify underlying company resilience.

Actual Investors
imagine ‘what if?’. 

Not ‘what is’.

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This communication was produced and approved in July 2023 and has not been updated subsequently. It represents views held at the time of writing and may not reflect current thinking.

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Author

Robert Baltzer

Head of Credit Research

Robert is head of Credit Research and co-manager of the Global Strategic Bond Fund and our high yield funds. He is a member of the Investment Grade, Crossover and High Yield Portfolio Groups. Robert joined Baillie Gifford in 2001 on the graduate scheme. He graduated MMath from Durham University in 2001 and is a CFA Charterholder.

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