Heimstaden shows rate cuts are reviving real estate

Real estate, and in particular real estate investment trusts (REITs), was one of the first sectors to come under market scrutiny as interest rates rose, but a strong return to market from Swedish real estate company Heimstaden on Tuesday was the latest sign that expected rate cuts in Europe are easing pressure on the industry.

Having generally pursued a business model of borrowing at around 1-2% and investing in properties yielding around 3-5%, the European REIT sector suffered one the biggest sell-offs across global fixed income in the bond market mauling of 2022. The most vulnerable instruments were corporate hybrids, which have call features and deferable coupons. When the European Central Bank (ECB) hiked rates by 450bp and it became clear that property rental indexation (normally linked to inflation) would not keep pace, REIT corporate hybrid spreads widened significantly.

For context, REIT issuers had taken advantage of the negative rate and low spread environment of 2020, 2021 and early 2022 to issue senior bonds with incredibly low coupons of around 0.5-2% and hybrids with coupons of around 2.5-3.5%. With the hybrids’ reset rates being significantly lower than the prevailing refinancing levels, sentiment quickly soured, and market pricing began to reflect an assumption that all REIT hybrids would not be called, with many trading at cash prices below 50. As expected, many hybrids were not called, prompting issuers to seek more creative refinancing solutions known as exchanges. In simplified terms, issuers invite investors to exchange their existing bonds for new ones with higher coupons (often with some cash returned), though still below current market rates. These exchanges enable issuers to retain the key advantage of corporate hybrids bonds – the 50% equity treatment from rating agencies – while offering some upside to investors.

The exchange process has become market standard for real estate companies. While it is a solution that can work for both parties, as hybrid investors we were mindful that issuers might continue opting for this easier or cheaper route, rather than pursuing the typical refinancing process once market conditions improved. It is also worth noting that, outside of REITs, all other corporate hybrid issuers have called their bonds as expected at the first call date, highlighting a clear distinction between REITs and the rest.

In the past three months the fortunes of the real estate sector have turned. Both hybrid and senior bonds have been buoyed by the expectation of significant rate cuts from the ECB, which are seen as a potential lifeline for the sector, helping to restore the business model to profitability. As a result, spreads have rallied significantly, the senior market has reopened, and primary market levels are now much more palatable to issuers.

On Tuesday, Heimstaden surprised the market by announcing the tender and refinancing of a corporate hybrid which would have become callable on 27 December 2024. While management had previously guided the market to expect an exchange, the significant rally in spreads provided the opportunity to pursue best practice instead. To illustrate the scale of this turnaround, the bonds being replaced (HEIBOS 3.248%) were trading below a cash price of 45 in December 2023. A tender at par represents a return of over 120% from that nadir, a staggering figure rarely seen for a company with an investment grade rating.

For the new deal, a perpetual non-call 5.25-year hybrid, initial price thoughts were in the range of 6.875%-7%. However, with an initial €3bn order book for the €500m bond that guidance was quickly revised to 6.5% before the deal was ultimately priced at 6.375%. While pinpointing fair value was challenging, most put it in the 6.50%-6.75% area and a revised order book of €2.1bn suggested a third of investors thought the final pricing was indeed too expensive. In any event, it marks a significant decline from the double-digit yields REIT hybrids have been trading at over the past 24 months. Significantly, Heimstaden’s called bond would have reset to a coupon of around 5.8%, so still below the new deal, but the difference reflects the premium management are willing to pay to preserve the equity treatment and remain bondholder-friendly.

While the turnaround is encouraging, the sector is not yet out of the woods. We remain cautious about the more cyclical segments of the real estate sector, such as offices, hotels, and retail. At the same time, we acknowledge the recovery in the outlook for high-quality residential assets and logistics. Heimstaden’s actions set a precedent for others to follow, further enhancing the credibility of the asset class. Having weathered its own "2008 moment" the corporate hybrid sector is emerging with a few bruises but no lasting scars.