Real Estate - Sweden: Buoyant Property Market To Support Credit Quality In Next 12-18 Months, But Risks Loom in Longer Term

/nwsys/www/images/PBC_1060315 CORPORATES SECTOR IN-DEPTH 29 March 2017 TABLE OF CONTENTS Summary 1 Strong macro performance, low vacancies and limited new supply will keep Stockholm prime office rental growth strongest 2 Regulation limits residental rental growth, but risk is very low 4 Property values underpinned by stable prime yields, low interest rates and wide spreads 5 Despite solid fundamentals significant challenges loom in longer term 6 Moody's Related Research 8 Contacts Roberto Pozzi 4420-7772-1030 VP-Sr Credit Officer roberto.pozzi@moodys.com Mario Santangelo 44-20-7772-8623 Associate Managing Director mario.santangelo@moodys.com Real Estate - Sweden Buoyant Property Market To Support Credit Quality In Next 12-18 Months, But Risks Loom in Longer Term Summary Strong macro performance, low vacancies and limited new supply will support Stockholm real estate companies' credit quality in the next 12-18 months.Companies with a strong presence in Stockholm’s prime office locations including Vasakronan AB and Hufvudstaden AB (both unrated), will benefit from significant rental income growth, supporting credit quality. Demand for prime retail space will remain strong. In the industrial/ warehousing segment, rents should remain stable in most locations, with moderate rental growth in prime warehouses. Warehouse/industrial properties in Stockholm will benefit from the knock-on effect of increased demand for land for residential development. Residential sector rental growth is limited by regulation, but risk is very low.We view the Swedish rental housing sector as one of the safest asset classes in Europe, with modest rent increases and more stable valuations than other asset classes. However, while regulation limits rental growth, risk is also limited because of the large gap between market rents for newly built dwellings and regulated rents of older properties, which are benchmarked to lower social housing rents. As a result we expect Swedish residential companies to continue to benefit from steady, though gradual rental income growth. Property values underpinned by stable prime yields, low interest rates and wide spreads.While we expect stable or increasing rents for most property types in the next 12-18 months, the other main driver of property valuations - yields or capitalisation rates - should also remain broadly stable. This is based on solid investor demand, the general expectation interest rates will remain low and the substantial gap between property yields and benchmark rates. As a result property valuations and companies' loan to value ratios will remain broadly stable. Companies with higher exposure to Stockholm’s inner city but also good peripheral areas stand to benefit most, including Atrium Ljungberg AB (Baa2 stable), Fabege AB and AFA Fastigheter (both unrated). Despite solid fundamentals significant challenges loom. These include the risk of an unexpected rise in interest and capitalisation rates, a potential decline in bank appetite for real estate lending and likely tax changes which could reduce cash flows and valuations. Construction activity could also accelerate, easing currently tight supply in the capital in particular, and slowing rental income growth. MOODY'S INVESTORS SERVICE CORPORATES Strong macro performance, low vacancies and limited new supply will keep Stockholm prime office rental growth strongest We expect rental growth to be strongest in Stockholm's prime office segment in the next 12-18 months, thanks to record-high investment demand, low vacancies and limited new supply, as well as stronger GDP growth than the national average. We forecast Swedish GDP growth of 2.4% in 2017 and 2.2% in 2018 and for unemployment to fall to 6.4% in 2017 and 6.0% in 2018, from 6.8% in 2016. However in the capital Stockholm we expect even stronger GDP growth, fueled by its growing service sector. The sector now employs around 29% of Greater Stockholm's working population, compared with the national average of 19%, and is a major driver of office space demand in the capital. As Exhibit 1 shows, prime office vacancies are lower and rents are increasing faster in Stockholm than in its second and third largest cities, Gothenburg and Malmö. Exhibit 1 Stockholm Prime Office Rents Are Rising Faster & Vacancies Are Lower Than In Other Large Cities CBD office rents (SEK/sqm) and vacancy rates (percentage) 0% 2% 4% 6% 8% 10% 12% 0 1,000 2,000 3,000 4,000 5,000 6,000 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 V acan cy r ates CB D (l ines) Ren ta l le ve l CB D, SE K /sq .m . (b a rs) Gothenburg Malmö Stockholm Gothenburg Malmö Stockholm Sources: Newsec, Castellum Demand and rents will be further boosted by limited new supply. Despite the strength of the occupational market and record low vacancies in central areas, there is only a modest development pipeline in Stockholm, which bodes well for further rental growth. The CBRE, a real estate services company, forecasts just 600,000 square metres of new office space will be completed in the next three years. This is just 5.0% of the city's total stock of around a 12.3 million sqm and most of it is already let. The bulk of the new supply is concentrated in the northern suburbs of Solna and Kista. As Exhibit 2 shows, supply is increasing more rapidly in Gothenburg and remains at fairly high levels in Malmö despite high vacancies. New construction in Stockholm is limited and vacancy rates remain low. This publication does not announce a credit rating action. For any credit ratings referenced in this publication, please see the ratings tab on the issuer/entity page on www.moodys.com for the most updated credit rating action information and rating history. 2 29 March 2017 Real Estate - Sweden: Buoyant Property Market To Support Credit Quality In Next 12-18 Months, But Risks Loom in Longer Term MOODY'S INVESTORS SERVICE CORPORATES Exhibit 2 Limited New Construction in Stockholm Office Market Despite Very Low Vacancies Total new construction (sqm) and new construction in percentage of office stock 0.0% 0.5% 1.0% 1.5% 2.0% 2.5% 3.0% 3.5% 4.0% 4.5% 0 20,000 40,000 60,000 80,000 100,000 120,000 140,000 160,000 180,000 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017p 2018p 2019p N ew con str ucti on as a sha re of offi ce stock (l ine s) T o ta l n e w co n st ru ct io n , sq . m . (b a rs) Gothenburg Malmö Stockholm Gothenburg Malmö Stockholm Sources: Newsec, Castellum Higher rents will directly feed through to higher revenues, EBITDA and improved fixed charge cover for the companies with the largest portfolios of prime office space in Stockholm, which will support credit quality. We expect companies including Vasakronan AB and Hufvudstaden AB (all unrated) to benefit from strong rental growth during the next 12-18 months (see Exhibit 3). Exhibit 3 Companies With Concentration In Stockholm To Benefit Most From Market Growth Percentage of rental income generated in the Greater Stockholm area for a sample of property companies with operations in Stockholm, 2015 0% 20% 40% 60% 80% 100% Fabege Hufvudstaden Atrium Ljungberg D. Carnegie Vasakronan Corem Sagax Klövern Kungsleden Wallenstam Balder Catena Castellum Hemfosa Sources: Company data, Atrium Ljungberg Fabege AB is also well positioned to benefit, given its exclusive focus on the capital city and its large presence in the inner city and in Solna (Exhibit 4). 3 29 March 2017 Real Estate - Sweden: Buoyant Property Market To Support Credit Quality In Next 12-18 Months, But Risks Loom in Longer Term MOODY'S INVESTORS SERVICE CORPORATES Exhibit 4 Focus On CBD, Inner City And Well Connected Areas Also An Advantage Split of letting area for office space in Stockholm, percentage of Stockholm total 0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100% Hufvudstaden Alecta Skandia Fastigheter AMF Fastigheter NIAM SEB Trygg Liv AFA Fastigheter Vasakronan Humlegården Fabege Balder Atrium Ljungberg Klövern Kungsleden Starwood CBD City centre, excl. CBD Kista Suburb, south Suburb, north Sources: Atrium Ljungberg, companies' data We expect more mixed rental growth for other commercial property types and locations. Demand for prime retail space will remain strong, but there is less room for rent increases. Despite buoyant retail sales, which rose 3.2% on the year to November 2016, property companies reported only slightly higher or flat rents in the last quarter. This is because e-commerce sales made up the bulk of the sales growth, with sales from traditional brick and mortar stores also up, but only by low single-digits. In the industrial/warehousing segment, rents should remain stable in most locations, with moderate rental growth in prime warehouses. In Stockholm and Gothenburg, strong demand for development land for residential conversions has increased pressure on industrial rents, while demand for storage space in Stockholm has also increased. Overall, we expect occupier demand to rise because the manufacturing outlook improved in the last quarter of 2016. Regulation limits residental rental growth, but risk is very low We view the Swedish rental housing sector as one of the safest asset classes in Europe, with modest rent increases and more stable valuations than other asset classes. The upside in terms of rental income is limited by regulations: private residental rents must be negotiated with tenant organisations and are benchmarked to social housing rents. This has kept rents very low, discouraged building activity and encouraged private landlords to sell to their tenants. In turn this has reduced the stock of dwellings available to rent. However, rents have increased in line with GDP growth for the past 30 years, with minimal year-on-year volatility and at a much faster rate than even Stockholm office rents (Exhibit 5).1 Exhibit 5 Rental Housing Rents Have Historically Grown In Line with GDP Historic trends in rental income and GDP per capita, rebased since 1985 0 50 100 150 200 250 300 350 400 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 Housing Sweden Office Stockholm Nominal GDP per capita Sources: Cushman & Wakefield, Statistics Sweden 4 29 March 2017 Real Estate - Sweden: Buoyant Property Market To Support Credit Quality In Next 12-18 Months, But Risks Loom in Longer Term MOODY'S INVESTORS SERVICE CORPORATES However, the downside is also limited, given the wide gap between market rents for newly built dwellings and regulated rents of older properties, which are benchmarked to lower social housing rents. Of the largest private companies, D.Carnegie & Co, Wallenstam AB and Akelius Residential Property AB (all unrated) and Fastighets AB Balder (Baa3 stable) have 100%, 45%, 36% and 20% of the fair value of their portfolios invested in rental homes in Sweden, respectively. As a result we expect these companies to continue to benefit from steady, though gradual rental income growth. Property values underpinned by stable prime yields, low interest rates and wide spreads While we expect stable or increasing rents for most property types in the next 12-18 months, the other main driver of property valuations - yields or capitalisation rates - should also remain broadly stable. As a result loan to value ratios, which are one of the main ways we assess credit quality, should also remain broadly stable. Our view is based on solid investor demand for Swedish property, the general expectation that low interest rates will remain low and the substantial gap between property yields and benchmark rates. As Exhibit 6 shows, the gap between property yields and benchmark interest rates has widened in the past decade as benchmark rates have fallen to all-time lows. Exhibit 6 Gap Between Property Yields And Benchmark Interest Rates Has Widened In Past Decade Q4 2006 – Q4 20161 0.00 2.00 4.00 6.00 8.00 10.00 2006 Q4 2007 Q4 2008 Q4 2009 Q4 2010 Q4 2011Q4 2012 Q4 2013 Q4 2014 Q4 2015 Q4 2016 Q4 Office yield Gap Industrial/logistics yield gap 10y bond Office yield Industrial / logistics yield Sources: CBRE Research, Sveriges Riksbank. [1] – These statistics are based on Moody’s Investors Service estimates and should be taken as such At the end of 2016 prime Stockholm office yields were at all-time lows of between 3.5%-4.0%, and prime Stockholm residential yields were even lower, at between 1.5%-2%. Although we expect Swedish GDP growth to slow, we expect solid employment and economic growth in the country's largest cities. Given the low prime yields and the scarcity of prime assets, investors are increasingly looking to buy in the best suburban locations, generally in Stockholm, Sweden’s largest and most liquid market. Atrium Ljungberg AB (Baa2 stable) and Fabege AB are well positioned to take advantage of this trend, given a substantial portion of their property portfolios are located in these areas. Similar to other European markets, demand for Swedish property was at all-time high last year. A record SEK165.3 billion worth of Swedish properties changed hands last year, up 21% from the previous peak in 2014, with office and residential the two most popular asset classes.2 Even excluding one large transaction, investment volumes increased by around 9% in 2016 versus a year earlier. Office and residential remain the two most liquid asset classes, accounting for 33% and 24% of the total investment volumes last year. Sweden’s property transaction market remained dominated by domestic investors: we view this as positive because domestic investment volumes tend to be less volatile than foreign ones. Property companies with larger exposures to Stockholm’s inner city and good peripheral areas including Atrium Ljungberg and Fabege AB and AFA Fastighter are most likely to benefit from lower yields in these areas. 5 29 March 2017 Real Estate - Sweden: Buoyant Property Market To Support Credit Quality In Next 12-18 Months, But Risks Loom in Longer Term MOODY'S INVESTORS SERVICE CORPORATES Despite solid fundamentals significant challenges loom in longer term With the Stockholm interbank offered rate at negative 0.50% at the time of writing and inflation below the central bank target of 2.0%, at 1.7%, we expect interest rates in Sweden to remain low for the foreseeable future. However given the relatively short–dated debt maturities of most Swedish real estate companies, an unexpected increase in interest rates would rapidly increase their interest expenses and lower their fixed charge coverage ratios, an important rating factor (Exhibit 7). Exhibit 7 Refinancing Looms For Large Percentage of Swedish Real Estate Companies' Debt Percentage of debt maturing over the next three years 0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100% Wihlborgs Hemfosa Klövern Fabege Vasakronan Castellum Balder Atrium Wallenstam Hufvudstaden Sagax Akelius Source: Company data For example, Fastighets AB Balder estimates that a 1.0% increase in interest rates would lower its earnings before tax by SEK187 million. That would be equivalent to 3.2% of its 2015 pretax profit including realised and unrealised capital gains, but a whopping 9.6% of net operating income before capital gains. Although the connection between interest rates and capitalisation rates is loose, higher interest rates could also result in higher capitalisation rates assumed in property valuations. The company estimates that a 1.0% increase in capitalisation rates would lower the valuation of its property portfolio by SEK6.6 billion, or 9.0% of total assets at the end of 2015 and SEK3.9 billion (5.3%) in its residential and commercial portfolios, respectively, everything else being equal. At the end of 2015, Balder had interest hedges running for 2.9 years, with an average cost of debt of 2.2% including the effect from interest rate derivatives. A third source of risk for the sector stems from potential changes in lending standards, particularly in light of the high exposure of Sweden’s largest banks to the housing sector. According to the Swedish financial supervisory authority, almost 65% of Sweden's four largest banks' total public lending is related to residential property or commercial real estate. Around 50% of their loans to non- financial firms are for real estate-related operations. However, despite high exposure to residential mortgages, lending standards have remained stringent and banks have a clear understanding of the financial standing of their borrowers. The Riksbank has introduced several measures in recent years to curb the growth of mortgage lending to Swedish households, with only moderate success. However, lending to corporates including commercial real estate companies has grown at a far more moderate pace. We understand that lending terms to commercial real estate companies have remained broadly unchanged, with the exception of smaller and more highly leveraged borrowers, which have had their lending conditions tightened by some banks. A fourth risk is potential changes to the country’s tax legislation. At the end of March the Swedish government is expected to announce measures that will restrict the ability of companies to reduce taxes by offsetting interest against income. Although Sweden has no real estate investment trust (REIT) regime in place and the sector is therefore exposed to changes to interest expenses deductions, some companies have tax loss carry forwards, meaning that they will not pay tax even after the change. Sweden is also considering fiscal measures to increase tax revenues on capital gains from property sales. If this was introduced this could potentially affect not only real estate companies' cash flows but also the valuation of their property portfolios. These tax changes could push the government to consider introducing legislation to establish a Swedish REIT, along the lines of many other European 6 29 March 2017 Real Estate - Sweden: Buoyant Property Market To Support Credit Quality In Next 12-18 Months, But Risks Loom in Longer Term MOODY'S INVESTORS SERVICE CORPORATES countries, including neighbouring Finland. The REIT structure would enable companies to reduce their taxes but would also introduce the legal obligation to pay out most of their profits. This would reduce companies' ability to retain earnings, which we currently view as a major credit strength. Finally, the attractiveness of the Swedish property market could stimulate construction activity. If this happened it could increase supply, particularly in the capital. This would curb demand and rental income growth. Although the stock of new office space in Stockholm is forecast to increase just 1.0% a year until 2020, the expectation of further rental growth is likely to stimulate new construction activity at some stage.3 7 29 March 2017 Real Estate - Sweden: Buoyant Property Market To Support Credit Quality In Next 12-18 Months, But Risks Loom in Longer Term MOODY'S INVESTORS SERVICE CORPORATES Moody's Related Research Sector in depth: » Commercial Real Estate - Europe: Political Uncertainty Seen As Main Risk, But Property Fundamentals Remain Robust, 26 September 2016 » Real Estate - Nordics: Stable Economic Fundamentals Support Positive But Slower Rental Growth, High Occupancy Rates, 24 May 2016 To access any of these reports, click on the entry above. Note that these references are current as of the date of publication of this report and that more recent reports may be available. All research may not be available to all clients. 8 29 March 2017 Real Estate - Sweden: Buoyant Property Market To Support Credit Quality In Next 12-18 Months, But Risks Loom in Longer Term MOODY'S INVESTORS SERVICE CORPORATES Endnotes 1 Source: Cushman & Wakefield 2 Source: CBRE 3 Source: Cushman & Wakefield 9 29 March 2017 Real Estate - Sweden: Buoyant Property Market To Support Credit Quality In Next 12-18 Months, But Risks Loom in Longer Term MOODY'S INVESTORS SERVICE CORPORATES © 2017 Moody’s Corporation, Moody’s Investors Service, Inc., Moody’s Analytics, Inc. and/or their licensors and affiliates (collectively, “MOODY’S”). All rights reserved. CREDIT RATINGS ISSUED BY MOODY'S INVESTORS SERVICE, INC. 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