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From Teacher’s Pet to Problem Child – Developments in Commercial Real Estate
Needless to say, times are changing, and we all have to adapt again. In an era of massive decade-long money printing by central banks, where at its peak the global bond market had issued more than 15 trillion dollars (!) worth of negative interest rate bonds, commercial real estate seemed like a new safe haven for many classical bond market investors – an asset class with a relatively stable but at least a positive yield.
Today, commercial real estate is one of the most oversold asset classes in the financial markets, which worries investors, journalists, and central banks alike. As always in a downturn, shares of a particular sector are simply dumped without asking too many questions, and when the markets recover, strong companies will quickly make up for their lost value. The unpopularity of the sector today has two root causes that are independent but amplify each other – post-pandemic vacancies and the increase in interest rates. If the latter clearly affects us as well, the occupancy levels of commercial properties are much better than in the metropolises of the world.
Occupancy of commercial properties
At the moment, the international financial press regards commercial real estate as a horror story. US regional banks with balance sheets of less than $250 billion have financed 80% of all commercial real estate loans in the US. The mood on the west coast of the Atlantic is particularly gloomy. The occupancy rate of office spaces in the US is significantly lower than before the pandemic, in some cases it has dropped by up to a third. A special focus is on San Francisco and New York, where the epicenter of concerns lies in Manhattan. When San Francisco is suffering from the hangover caused by the end of the start-up funding boom and the resulting rapid layoffs and general cost savings in the technology sector, New York’s problem mainly lies in poor connections for commuters from the suburbs of the metropolis. Obviously, if it takes approx. 1.5 hours one way in overcrowded public transport to go to the office in the morning and return home in the evening, this is a situation that rather minimizes the appetite of going to the office. That is why “we work from home”, a slogan from the times of the pandemic, has gained a lot of popularity. Manhattan’s vacancy problems are being solved by converting office buildings into apartment buildings as much as possible. This is often problematic, as the inner areas of towering high rises tend to be dark, barred from the daylight that is needed for normal living.
With a certain note of sadness, we must admit that the Baltics are neither Manhattan nor San Francisco. EfTEN’s portfolio includes 19 office buildings in the Baltic countries, which offers us a relatively comprehensive overview of the office space market in the Baltic capitals and in Kaunas. In the case of Tallinn and Vilnius, “working from home” and the resulting vacancy of business premises is not an issue – the cities are simply so small and compact. The size of Tallinn is 160 sq km and the official number of inhabitants is 426,000, or 2,662 people per sq km, which makes Tallinn the most densely populated capital in the Baltics. In a city ten times smaller than London, traffic is not such a problem as in a large metropolis, although during the summer the Tallinn city government does its best to make traversing the city center impossible due to road works.
Vilnius is a city spread over twelve hills, where a large number of “city highways” or four-lane connecting roads were built during the Soviet times providing good access between the city districts. The area of Vilnius is 400 sq km, of which 70% is green space, and with its 544,000 inhabitants, the population density is only 1,350 people per sq km. In terms of traffic, the only problematic Baltic capital is Riga, which with its 307 sq km and 632,000 inhabitants is more densely populated than Vilnius, but the road network does not support daily traffic. At the same time, Riga’s population has decreased every year for 30 consecutive years, while Tallinn and Vilnius have grown.
Riga has its own “Hudson River problem” like New York. Namely, the Daugava is a fairly wide river, and crossing it using the existing bridges is a problem throughout the day not only during peak hours. The Daugava essentially cuts the Latvian capital in half. In addition, the historic and beautiful heart of Riga with its Art Nouveau facades is an endless traffic jam from the point of view of daily traffic, and business life is gradually leaving the city center. If in Tallinn there is reasonable concern about the ghettoization of the Old Town, in Riga the entire heart of the city is concerned, especially the Old Town. The center of Riga is changing into a donut shape, with a lethargic hole in the center and life swirling along the highways around the city center. Riga is the only Baltic capital where we can see for a fact that some companies, especially in the technology sector, prefer working from home instead of going to the office precisely because of the daily traffic problems. In conclusion – what are big problems in large cities may not mean the same in smaller towns such as the Baltic capitals. Real estate is local as hell, but global trends play a role here as well, albeit not as vigorously.
Interest rates
The real estate sector has had to adjust to the fastest pace of rate hikes in 40 years. Many players in the real estate market were ill-positioned for such a rapid change of the status quo. Since vacancies are not such a big problem in the Baltic countries, it has been easier for us to adapt, as the rent can also be indexed annually. Certainly not to the extent of the entire change in the consumer price index, but I can say that in the EfTEN portfolio we have still been able to increase rent rates by 3-6% per year across various segments – offices, retail, logistics. That will partially cover the increase in interest rates, but only partially, because such a rapid increase in interest rates is too steep.
Real estate investors – companies that acquire commercial properties and lease them out – are generally assessed on the stock exchanges based on the price to book value (P/B) ratio. Since these companies reassess the total value of their real estate investments a couple of times a year, using outside appraisers as a rule of thumb, the total market value of the buildings – which makes up 90-95% of the total asset value of the balance sheet – is constantly updated with market price trends. Once we subtract the company’s liabilities from that, the remaining equity should express the fair value of the company? Everything is correct in theory, but in practice there are a thousand shades of gray.
There is a snarky saying about accounting that it is neither science nor art, but merely a state of mind. This is essentially always the case with real estate appraisals. Even in the most liquid market, where hundreds of comparable transactions take place during one observation period, real estate valuations remain theoretical. In the Baltic market, where there are few transactions even in a good year, real estate appraisals often express a view of the customer, as the comparison base for transactions is so scarce. In saying this, I draw on my personal experience of over two decades in the real estate business. Unfortunately, it is a false assumption and pure delusion, that an external real estate appraiser brings the same clarity to the balance sheet value of the property as an audit company’s opinion in the annual report.
For example, the initial net yield on assets of EfTEN Real Estate Fund AS, which is listed on the stock exchange, is currently approx. 7.5% (annual net operating income divided by the book value of the properties). If another real estate appraiser would look at the situation with overwhelming optimism and would use, for example, an average of 6.0% as the expected yield rate, EfTEN Real Estate Fund’s equity capital today would be EUR 85 million or about 40% higher on paper than it is now. Real estate values are very sensitive to changes in expected yield, which in turn makes balance sheet equity vulnerable to manipulation. Or in our example – the share of EfTEN Real Estate Fund AS trades on the stock exchange essentially at a P/B value of 1.0x, which seems expensive within our peer group, but … If we were to look for, and we would certainly find, some “appraiser with a kinder eye,” who would value our assets at a yield of 6.0%, then the equity would double, and we would be trading at 0.7x P/B at today’s share price level. It is financial magic on paper that does not have too much in common with real life. P/B is definitely the right ratio for real estate investors (please don’t confuse them with real estate developers), but before applying it, it is necessary to critically understand how the “book value”, i.e., the accounting volume of equity capital, is obtained, and what the actual net cash flow return of the assets on the balance sheet is when measured in euros. Cash flows are always a fact, but different real estate valuations are merely an opinion, or the appraiser’s state of mind.
Undoubtedly, another important factor is the company’s total debt, which is measured by the “loan to value” (LTV) indicator, i.e. the ratio of the portfolio’s total debt level to the value of real estate investments. The real estate industry loves debt like crazy. In return, every bank loves real estate just as much. The more developed the country’s economy, the more intellectual property and fewer physical goods are produced. The problem with the former is that, unlike production equipment, machinery, not to mention real estate, intangible assets are not suitable as a bank loan collateral. Therefore, banks always want to finance real estate as an asset with a tangible guarantee, especially the more developed the country’s economy is. Life has repeatedly taught me that it is endlessly nice to take out loans in good times and extremely difficult to pay back in bad times. Therefore, if you look at the LTV of different real estate companies, you must admit that in this term “L” (loan) is a financial fact and “V” (property value) is the opinion of the appraiser. The higher the LTV and the lower the net yield of assets, the more pressure a particular company will feel today. Using EfTEN as an example, the LTV of our listed fund is 41%. When we acquire new properties, as a rule, we cover 50-65% of the transaction purchase price with a bank loan.
We have always gone against the flow, i.e. in good times we have paid back loans ahead of schedule. Our monthly principal repayment (plus interest) of bank loans has been 25-33% of the rental income. We have reduced the balance of our bank liabilities to such a safe level that we can also handle the situation where the six-month Euribor would rise to 6% and beyond, which realistically will not happen. During the happy days of the market, we were urged by various parties to take out more bank loans, but since the memory of the previous crisis is so strongly in us, we preferred to pay off the loans during good times, which in the current market situation opens new opportunities for us.
Many market participants have done the opposite, and that is where today’s worries stem from. For example, in Stockholm only a few years ago real estate investments were made with a rental yield of 2-4%. At that time, as a rule, transactions could be financed with bonds, the interest rate of which was approx. 1%. The investors were the same classic bond investors such as life insurance companies and pension funds, who were satisfied with any yield greater than zero. Everything seemed kosher in Excel until the Federal Reserve started raising interest rates vertically. Other central banks had to follow suit in order not to fall behind and let their national currency devalue against the world’s reserve currency, the dollar. The base interest rate of the Swedish Riksbank is currently at 3.5%, and now these same bonds, which were issued based on a mere percentage, have fallen in euros to such an extent that they offer a yield between 5-7%. Now, when the time comes for issuers to extend their bonds, they are in a new, extremely unpleasant situation called a “negative yield gap” – the assets generate less cash flow from rent than the financing cost. Therefore, it should not be surprising that the market does not believe the equity capital, P/B of such companies and they have been sold to oblivion.
As a broader recommendation, a simple rule should be followed. Namely, the cost of bank loans today is around 5.5% – 6%, including both Euribor and the added risk margin. If the company’s assets’ actual cash flow yield is higher than that, all is well. If not, forget all the theoretical balance sheet values and look for an exit.
Viljar Arakas, May 2023