Cromwell European Reit focuses on portfolio resilience amid sector headwinds

REAL estate investment trusts (Reits) have not been a favourite asset class for investors over the past 18 months amid headwinds from high inflation and rising interest rates.

But Cromwell European Reit (Cromwell E-Reit) believes its portfolio of logistics and office assets will stay resilient and continue delivering returns to investors.

“We understand that Reits are not the flavour of the month,” Simon Garing, chief executive of Cromwell E-Reit’s manager, told The Business Times in an interview.

“Our job is to make sure that during this period where Reits are slightly out of favour, that on a relative basis, we’re doing better than our peer group.”

To deliver performance, the manager has been working on various initiatives. These include pivoting the portfolio towards logistics, as well as actively managing its capital structure.

Logistics pivot

The manager has been working to increase the weightage of logistics assets in Cromwell E-Reit’s portfolio since 2020.

Prior to the Covid-19 pandemic, the manager identified trends such as the rise of e-commerce that pointed to the growing importance of the logistics sector in Europe.

Garing noted that e-commerce accounted for around 6 per cent to 7 per cent of total retail in Europe then. While it has risen post-Covid, it still hovers around 12 to 15 per cent.

Meanwhile, onshoring has also been a growing trend, and more companies are moving their supply chains from just-in-time to just-in-case.

Garing said: “What Covid has done is it’s accelerated the trends that we had identified.”

Cromwell E-Reit’s weightage in logistics has grown from around 30 per cent in end-2019 to 51 per cent as at June 2023.

The manager is aiming for the proportion to increase further to at least 60 per cent, which could come through the selling of office and other assets.

Office buildings make up the other key component of Cromwell E-Reit’s portfolio. The sector has faced more challenges globally, amid changing work patterns.

Garing noted that big tenants generally take on less space when their leases expire, but Cromwell E-Reit is still able to attract new tenants with positive rental reversion.

Demand is partly coming from tenants who are looking for buildings that are more energy efficient.

Garing noted that only a fifth of European office buildings are Breeam (Building Research Establishment Environmental Assessment Method) certified. However, around half of new leases being signed are for such buildings.

Around three-quarters of Cromwell E-Reit’s office portfolio is Breeam certified, which has helped attract and retain tenants.

Garing also observed that the office market is bifurcated: higher-end Grade A offices are still seeing demand, but Grade B and C buildings face more challenges.

An example would be Milan, where the average vacancy stands at around 8.5 per cent, but the vacancy in Grade A buildings is around 3 per cent.

“In the post-Covid era, tenants are more interested in moving to retrofitted or refurbished premium assets in good locations,” Garing said.

“I can see us refurbishing some of the older ones, particularly in Italy, in the Netherlands,” he said. “We could invest more capital into the refurbishment without necessarily going and buying more office assets.”

Meanwhile, Cromwell E-Reit is also reducing exposure to office assets in Poland and Helsinki, which are closer to the Russian border.

Cromwell E-Reit has previously said it intends to divest some 400 million euros (S$580.5 million) of assets across its portfolio over the next two to three years. Garing noted that the Reit is currently on track, and has sold around 220 million euros worth of assets at roughly a 10 per cent premium to valuation.

Buyers of its assets include developers who want to convert old office buildings for other purposes, such as student accommodation or apartments.

The 400 million euros in divestments would give the Reit a buffer for its gearing, with its board policy to keep loan-to-valuations in the 35 per cent to 40 per cent range. Divestment proceeds would also provide liquidity and capital to reinvest.

Garing said this could be used to buy more logistics assets or to redevelop its portfolio.

“We don’t think asset values have fallen enough to say to investors, this is a once in a lifetime opportunity to really go in and buy assets,” he said. “Where we sit today, if we had some extra capital, investing in our own properties looks more attractive than going and buying new assets.”

Financials

In the first half of 2023, Cromwell E-Reit’s net property income rose 1.8 per cent to 68.5 million euros. Distribution per unit fell to 0.0779 euro, down 4.5 per cent on an adjusted basis for absence of income from assets under redevelopment.

Garing believes that the rents are unlikely to be materially impacted even if the economy slows, as Cromwell E-Reit’s occupancy remains high at 95.4 per cent.

“Our leases (are indexed to) inflation, and there’s still these tailwinds for more demand,” he said. “I can still see us delivering a good 3 to 5 per cent rental reversion.”

He noted that the portfolio has demonstrated resilience even during the Covid-19 period, where they lost just half a million euros of rent, out of 150 million euros.

“You could throw the kitchen sink at this portfolio, and it hardly bends,” he said.

But valuations could still have some impact on the Reit.

“With higher interest rates and tighter bank lending, there may be more valuation declines (but) not as much as we’ve seen in the last 18 months,” Garing said. Cromwell E-Reit’s net asset value has fallen around 10 per cent since rates began rising.

“Most of the valuation decline from rising interest rates and cap rates is behind us, but there may be a little bit more to go,” he added.

As at Friday (Nov 3), Cromwell E-Reit’s closing price of 1.21 euros was around half its book value of 2.30 euros, and the counter traded at a trailing dividend yield of 12.8 per cent.

Garing noted that the market is implying in part that interest expenses would move higher and have an impact on distributions. But he said the hedging employed by the Reit would mean that the impact is unlikely to be material for the next two years.

“We are the highest hedged Reit in Singapore… so even if interest rates go higher, on our current debt, we’re 94 per cent locked in,” he said.

Cromwell E-Reit’s current muted valuations may also be due to concerns that foreign Reits are at greater risk of valuation declines, which may cause breaches to loan covenants.

Garing, however, emphasised that there was a difference between Reits that have worked to minimise the impact, as opposed to those that are in markets where not as much can be done.

“Last year, we started selling assets on this expectation that valuations would fall and therefore gearing would go up,” he said. The Reit’s leverage ratio stood at 38.2 per cent as at Jun 30.

“In the last 18 months, yes, valuations have fallen, but our gearing is still sub 40 per cent,” he added. “You shouldn’t necessarily price the risk with us in the same way you are pricing the risk with others.”