By Hamlin Lovell, NordicInvestor

DWS open-ended property fund launched in 2018, Europe II SICAV SIF, has outperformed its target of beating European inflation by 4-5%, and the Inrev ODCE composite, which is made up of open ended pan European core property funds, thanks to a mix of country, sector and asset selection. 

“The largest driver of outperformance has been sector selection, considering structural features, fundamentals, regulation and pricing,” says Nicoletta De Bona Bottegal, Lead Portfolio Manager & Team Lead Real Estate, at DWS in London.

Affordable residential

Roughly two thirds of assets of the Fund have been allocated to the residential and logistics sectors, based on DWS research that identified them as some of the most attractive sub-sectors. “Five years ago, we did a research study and found that affordable residential property is very defensive, given strong demand, high occupancy, rental growth and rent collection. We selected countries such as the Netherlands and Ireland, with structural undersupply and favourable regulations,” says Bottegal. DWS is focused on affordable residential housing, which offers higher yields and more stable valuations than luxury property. Out of town commuter locations are sought after for more living space and a more pleasant environment. Working from home could also increase demand for larger properties outside central areas, but DWS does not have a strong view on how permanent this trend may be and expects that hybrid models, combining office and home working, are most likely to become the norm.

Finding value in logistics amid yield compression

Logistics has clearly benefitted from the growth of e-commerce, before, during and after the Covid pandemic. DWS has also drilled down into sub-sectors to find higher yields. “The Fund has invested in cold storage in Italy and France, a sector that has seen strong growth from grocery and pharmaceutical customers, and also provides additional yield versus dry storage but requires specialist knowledge. Total returns have been as high as 10% per year. This is important because logistics pricing in core Europe can be very tight,” points out Bottegal.

A highly selective approach to retail assets

Though most of the fund’s exposure to retail is indirectly via logistics, it had about 4% in retail as of 3Q 2021. DWS has very selectively pinpointed traditional high street retail assets that can provide a substantial yield pickup and also prove resilient to the pressures and challenges facing the sector. A case in point is a Next clothing outlet in one of Dublin’s leading shopping streets. “Next is an attractive tenant because it already generates 50-60% of its sales from e-commerce and even boosted sales during the pandemic,” says Bottegal.

This is exceptional, when many retail landlords did see rent arrears, and were sometimes forced to renegotiate rents at lower rates and/or as percentages of tenants’ revenues. “DWS has avoided broad based exposure to the retail sector, which has delivered negative returns. It has avoided entire shopping centres, and out of town retail parks, some of which have gone through restructurings,” says Bottegal.

Championing the outlook for the Nordics

DWS Research produces its own return forecasts.  A breakdown by countries reveals that the Nordics are some of the most attractive markets. DWS forecasts the Nordics to remain attractive with a total return average over the next 5 years (2022-26) of 8.1% for Nordics versus 7.0% for Core Europe (forecasts are gross, before fees, taxes and leverage). The majority of the additional return is due to higher yields: prime yields are at 3.05% in Nordics at the end of 2021 versus core Europe at 2.38%.

Independent of yields, DWS is also forecasting slightly higher capital growth thanks to strong population growth and urbanization trends in the Nordics. The population growth comes partly from relatively high levels of immigration in Norway and Sweden.

In logistics, the Nordics are also an attractive region: total return forecast for the Nordics region is at 6.9% versus Core Europe at 6.6%, and this is entirely explained by higher yields. Prime yields at the end of 2021 were just under 4% in the Nordics region versus core Europe 3.34% offering an attractive spread

Central and Eastern Europe can also offer some yield pickup. “The Europe II fund targets an exposure to CEE of up to 10%, our focus is mostly on the larger Polish market as it is a market where DWS has been active for more than 10 years, and where we have a local office in Warsaw taking care of transactions and asset management of DWS portfolio,” says Bottegal.

The yield pickup could also translate into stronger capital growth if yield compression and convergence towards European averages increases valuations.

Yields in local currency in the UK, Sweden, Norway and Poland could be higher at least partly because local risk-free interest rates are higher, but the fund hedges non-Euro exposures back to Euros on a quarterly basis. There is still some yield pickup after factoring in the hedging costs.  [

Rental growth forecasts are in real terms, after inflation, so faster recent inflation in Europe does not really make a difference.

Most exposure remains in core Europe

The Nordics – and some other peripheral markets in Eastern and Southern Europe – can provide additional yield, but the bulk of the fund is in larger markets of core Europe – UK , France and Germany – partly because they are more liquid, which is important for an open ended fund offering quarterly dealing. The UK is a core market where office yields have in 2021 seen yield compression for the first time since the Brexit vote in 2016. London continues to offer some yield premium over continental Europe. 

Conservative asset level leverage heeds lessons from the GFC

The strategy of the Fund employs leverage of around 30-35%, which Bottegal believes is conservative in current market conditions. Leverage costs are around 179 basis points all inclusive, and are expected to enhance strategy returns by 150-250 basis points.

The leverage is also conservative in terms of structuring. It is asset level and non-recourse, with no comingling of assets. The average duration of the borrowing is around six years (calculated on a weighted basis), with individual financing taken for periods of 7 to 10 years in line with the business plan to mitigate refinancing risks.

The Fund has a cap of 40% on leverage. If a decline in valuations pushed the portfolio over this ceiling, then some assets would need to be divested at some stage, but not immediately. “We would generally sell the weaker assets to maintain the quality of the portfolio. The risk department carry out stress tests for valuation declines,” says Bottegal. “Leverage multiples today are generally much lower than during the GFC, when they sometimes went as high as 70-75%, and some funds failed,” she recalls.

Yield and development

Roughly half of the long term return forecast is yield. A yield of around 4% pa is paid out quarterly to investors, who are responsible for any taxes, or tax reclaims, on the income. DWS in general seeks out longer leases for more predictable income, but a small allocation to development projects is intended to slightly boost returns. Up to 20% of the fund can be devoted to development, though the target is 5% of gross asset value because the priority is stable, income generating assets.

For instance, a two year development in a logistics platform in Eskilstuna Sweden, 1.5 hours from Stockholm, is expected to complete in 2022. The tenant is the Coop supermarket, which is one of Sweden’s largest supermarket chains.

There is another development project in France and one in Germany, others could also be pursued.

“We expect to earn some return premium, but will not take development risk; it only invests in projects where development risk remains with the seller,” says Bottegal.

ESG aiming for a higher GRESB score

Investments made by the Fund will align with the DWS ESG Integration Policy for Active Management, which currently commits to (a) climate change mitigation and (b) climate change adaptation, and with the other ESG aims (which Nordic Investor has discussed in an interview with Roelfien Kuipjers Fund currently has 3 stars in the GRESB reporting framework, and is aiming to increase its rating to 4 or 5 stars over time. “Data collection is one way to improve the GRESB rating, and this does pose challenges for residential assets where tenants must agree to provide the data, and older properties may lack some certifications. DWS is working with the Measurabl platform alongside property managers to help gather asset and portfolio level data that feeds into GRESB,” says Bottegal. Measurable is an ESG platform dedicated to real estate.

On the environmental side, carbon footprints, utilities, water usage and physical climate risks can all be monitored. “The data is not perfect but it is improving. There are also initiatives to improve energy efficiency through investing in insulation and renewable energy, and longer term plans to reduce carbon footprints,” says Bottegal.

On the social side, some of the affordable residential assets could be classified as “social housing” in some countries. “The criteria for defining “social housing” do vary between countries, and could include valuations, absolute levels of rents, or rents relative to disposable incomes,” she points out.

In terms of governance, DWS generally prefers to own 100% of properties, but occasionally enters into joint ventures with other funds run by DWS or third party funds. These can involve some legal advice to structure the joint venture and agree on business plans. Other investors generally share common and well aligned objectives. In theory, the Fund could invest alongside institutional investors such as pension funds or insurers, but has not done this so far. Bottegal is wary of any joint venture that does not align interests amongst the parties, having seen misalignments of interest during the GFC.

All women team

Another differentiating feature of the Fund includes diversity of staff. The DWS property team of the Fund is distinguished in that the portfolio managers are all women in addition to Nicoletta De Bona Bottegal: head of European portfolio management, Jessica Hardman; portfolio managers Astrid Galy and recently hired Olga Krychkovska. “We always seek diverse pools of candidates for dynamic thinking and to create more ideas. We work closely with the HR team to ensure that talent is diverse. It is always tempting to find people who are very similar, but this can lead to stagnant thinking. Having said that, while all of the successful candidates were women, we simply hired the best qualified for the roles” says Bottegal.