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By Danilo Masoni

MILAN (Reuters) - It's hard to be bullish about real estate in an environment of sharply higher interest rates. Yet unloved property stocks in Europe staged a surprise rally this summer, suggesting contrarian investors are starting to look past the worst.

Two years of steep falls have made European property a short-seller favourite as sector valuations and investor positioning plunged to levels last seen during the 2008 global financial crisis.

A gauge of European real estate shares has halved in value to about $131 billion since 2021, but the mood shifted in July as earnings expectations improved.

The index outperformed the broader market in July by as much as 10 percentage points before a volatile August, squeezing short sellers just as inflows into some sector-focused exchange traded funds picked up.

Gerry Fowler, Head of European Equity Strategy at UBS, said bond yields in Europe seemed to have stabilised on bets the European Central Bank would hike interest rates just one more time in September, and that was starting to ease pressure on real estate companies while encouraging more investor interest.

"Things aren't great for real estate companies and that's why they are trading at a huge discount. Do we expect them to immediately go back to full valuation? Probably not. But from a direction of travel perspective things have started turning the corner," he said. "In the last month or two we're starting to get hints of companies' ability to re-focus on profit growth".

Refinitiv data shows earnings revisions turned positive in July after 15 months of downgrades. Profits are now seen rising 1.4% in 2024, versus previous expectations of a slight drop.

However, Zsolt Kohalmi, co-CEO at Pictet Alternative Advisors in London, said interest rates in Europe would need to fall by some 150 basis points to kick-start the market which was struggling due to a "complete standoff" in transactions because buyers and sellers are unable to agree on price.

"Some people this summer are making the bet that it's going to be all rosy. Inflation is going to come down, interest rates are going to come down and some of these structural problems of real estate will be solved," he said.

"It is a scenario. But I don't know how likely it is... I think it's going to take longer and we may have another low before we have ups," he said.

Shares on loan, a proxy for short interest, across Europe's listed real estate management and development firms has fallen by almost a third since a peak in May to below 1.7% of their market capitalisation, according to S&P Global (NYSE:SPGI) Market Intelligence.

Meanwhile, BlackRock's iShares European Property ETF (LON:IPRP) has seen a 10% surge in inflows from late February, according to data on its website.

Most investors are still steering clear. Bank of America (NYSE:BAC)'s fund manager survey (FMS) in August showed investors had capitulated with positioning falling all the way down to 2008 levels, but buying REITs (real estate investment trusts) was its top contrarian trade.

Real estate in Europe is 30% cheaper than its 20-year average price-to-book valuation and displays a 49% discount to the market, its biggest in fifteen years, Refinitiv data shows.

A report in July by the corporate and investment banking unit at Natixis suggested European commercial property transactions dropped 60% year-on-year in the first quarter.

Natixis is modelling for declines in property values and sees risks of rating downgrades for six out of 22 REITs, which could add to challenges of securing debt financing, it said.

Banks are increasingly vigilant about a deterioration in the quality of their loans to real estate firms, with key ratios including loan-to-value under sustained pressure, raising the prospects of covenant breaches which could force borrowers to top up equity or even sell assets.

Societe Generale (OTC:SCGLY), which has had zero real estate exposure for over a year, views the summer bounce as a false start and believes there is no clear direction in the sector's earnings.

"We don't like picking up pennies in a low-liquidity market. Opportunities may emerge... but this doesn't paint a great picture for the sector," said Charles de Boissezon, Head of Equity Strategy at the French bank.

Risks for real estate include another wave of inflation. Pictet's Kohalmi also said the "biggest unknown" was contagion from the next round of refinancing, especially in the highly oversupplied market of office buildings in the U.S.: "Because senior banks don't want to refinance, nobody knows how it will play out".

For UBS's Fowler, however, European real estate stocks have room to keep outperforming into year-end: "The best ideas are when you can't fully justify a bullish case... By the time you know for sure that things are better it's probably already too late".