Global real estate has undergone a significant correction since the start of 2022 when interest rates began rising around the world, falling 25% in EUR terms compared to a drop of only 3% for broader equity markets. This means that the average property company’s share price is now 20% below its net asset value (NAV) – double the 30-year average discount of 10%.
As always there are big differences between countries and sectors, which is good news for stock pickers like us looking for mis-priced bargains. In Europe, for example, the war in Ukraine and rising borrowing costs mean than listed real estate companies currently trade at about 35% discount to NAV. This is comparable to pricing levels during the Global Financial Crisis and COVID pandemic – low points which were followed by strong returns:
Reasons for optimism
The current outlook is incomparable to 2008 or 2020 when real estate faced a highly uncertain future. Indeed, economic growth and interest rates – the two factors most likely to drive performance in the short-term – are both improving. In its latest World Economic Outlook, the IMF upgraded predictions for Eurozone GDP growth to 0.9% this year and 1.5% in 2024. More importantly, inflation and interest rates are starting to slow with Eurozone CPI falling to 4.3% in September, a 2-year low.
In the US, where inflation has fallen below 4%, the Federal Reserve last month kept interest rates on hold, raising the prospect that borrowing costs on both sides of the Atlantic may be peaking. The periods following an end to previous tightening cycles have historically been the most lucrative for US real estate investors with annualised returns of 34.8% (see below). With around 80% of our portfolio broadly split between the US and Europe, this bodes well for SKAGEN m2's unitholders.
Against this challenging market backdrop SKAGEN m2 is performing relatively strongly, beating the benchmark by 4.5% so far in 2023 and outperforming the index over 1, 5 and 10-year time periods. This has largely been driven by good stock picking across a range of countries, particularly in Scandinavia this year where the fund has generated positive returns despite weak market performance in Sweden and Norway. Our top contributor is Norwegian Self Storage Group which has received a bid from US pension fund TIAA and contributed almost 3% to absolute returns.
The same is true over three and five years where company selection has contributed over 10% and 20%, respectively, to relative returns. Performance has also benefited from a careful barbell approach to portfolio construction which means two thirds of the fund is currently invested in segments geared towards economic recovery (e.g. office, retail, hospitality) and the remaining third in more defensive sub-sectors (e.g. data centres, logistics, self-storage, housing and health care).
Despite strong relative performance, SKAGEN m2 continues to be cheaper than the benchmark, trading at P/B, P/E and EV/EBITDA discounts of 8%, 17% and 40%, respectively. In addition to valuation support, further downside protection is provided by the portfolio holdings’ strong balance sheets with conservative loan-to-values (averaging 35%) and the majority of debt (69%) in fixed rate loans.
Attractive Scandinavian exposure
Nowhere is investor sentiment towards real estate more negative than in Scandinavia where the real estate market is down 9% year-to-date and has lost half its value since the start of 2022. Concerns over the impact of rising interest rates on highly leveraged companies have seen international investors flee the region and in Sweden, where stocks trade at around a 35% discount to NAV, valuations imply a further 15% drop in prices.
Our price-driven and contrarian approach means that we become curious when others are fearful, and we recently added Diös to the portfolio. The company trades at a 38% discount to NAV despite having a diversified portfolio of properties located in the fastest growing cities of northern Sweden which are driving the green transition. Its high yielding asset base combined with stable rent and occupancy rates mean that when borrowing costs come down Diös should be one of the first to benefit and grow earnings – we expect 60% upside from its current share price.
Continued economic uncertainty means that investor caution over company balance sheets and cash flow generation will be rewarded. Although real estate fundamentals may get worse before they get better, they are unlikely to deteriorate as much as current pricing suggests. Once macro conditions stabilise, valuations tend to recover quickly – the opportunities for active value managers like SKAGEN m2 to generate positive returns for clients have rarely looked so good.
 Source: SKAGEN. MSCI ACWI Real Estate vs. MSCI ACWI in EUR. 31/12/2021 – 30/09/2023.
 Source: IMF World Economic Outlook, July 2023. Previous April 2023 estimates of 0.8% in 2023 and 1.4% in 2024.
 As at 30/09/2023 in EUR, net of fees.
 As at 26/09/2023 in NOK.
 As at 26/09/2023. Source SKAGEN / Bloomberg. Carnegie Real Estate in SEK.