Debate often focuses on when real estate markets will bottom out. But for a large body of investors, struggling with either leverage or portfolio imbalances, the question is largely irrelevant. Even active investors should be looking at how to create investment value in a falling market rather than seeking to pinpoint the bottom, argues Joe Valente

The beginning of each new year normally brings with it a new wave of optimism and considerable enthusiasm for what lies ahead. Not so this year. What apparently started off as something of a blip - something or other to do with the secondary housing market in the US in 2007 - simmered away to the boiling point where, two years on, every economy and real estate market has been engulfed in a downward spiral.

Initial denial, gave way slowly to the prevailing view that a mild downturn would be the most likely outcome. But, that soon degenerated into talk of recession quickly followed by depression and the stagnation of real estate markets. Two years on, the point of recovery still looks and feels a long way away. Amid the deteriorating news on the economic front, a badly bruised banking system and the weakening of leasing markets worldwide, it can be difficult not only to see the point of recovery, much less the ‘bottom of the market'.

Amid the daily dose of gloom and doom, the increasing stress and distress felt by many investors in real estate, the continuingly wide bid-ask spread which still features in a large number of stagnating markets, there is, inevitably, a continuing imbalance of investors willing to buy and those needing to sell. The number of investors actively looking to increase their exposure to real estate appears to be declining by the day.

Not only are highly leveraged investors out of the game and likely to remain so for some time, but so too are many institutional investors, weighed down by the denominator effect, and investors burdened by the growing need to divert capital back to domestic markets - as is the case for a good number of sovereign wealth funds.

Many of these investor groups recognise the nature of the opportunity that is unfolding across real estate markets worldwide, but they may simply not be in a position to take advantage. To this group, discussions regarding the bottom of the cycle are largely irrelevant.

For those dwindling numbers of investors who are looking to increase investment activity, and so for whom considerations of market cycles is important, most would agree that the task of finding the bottom of the cycle is part of a debate better left to the realms of philosophy and history.

In a year's time, or perhaps two, we will all be able to point, with an uncanny degree of accuracy and considerable hindsight, to the bottom of the cycle. At that point, investors will be able to congratulate themselves for their foresight in either entering the market at the right time or in their decision to delay. Until then, the debate is somewhat futile as so much depends on the type of investor, their overall strategy, as well as their ability to innovate and create value in a market where values are still falling.

Timing is important but there are many other considerations which will need to be taken into account, including the possible ‘trade-off' that may be required between going into a market that is still falling and the ability to tease grade-A assets from distressed investors - assets which would not normally trade in the course of a normal cycle.

In most European markets, pricing will be weaker in the first half of 2009. But during this phase, there are other considerations including the lack of serious competition and the fact that grade-A assets are available. The same assets that are not normally traded are those assets that will be immediately removed from the market as soon as the first signs of recovery become evident or widely recognised.

Calling the bottom of the market is not the converse of calling the ‘top of the market'. The latter was, looking back on it, relatively easy in as much as it was a capital market story. Markets moved in unison, yields compressed to the point where markets and sectors converged to the same pricing level.

Against such a background, warning signs were clearly evident as early as 2006, and a good number of commentators not only pointed to those warning signs, but they called the top of the market loud and clear. The fact that most of the real estate investment community elected to ignore those warnings says more about the inadequate treatment of risk in the industry, and the shamefully poor quality of due diligence and underwriting that remains so evident in the real estate industry.

Calling the bottom of the cycle is a different matter altogether. The yield story has unwound, and recovery will, once again, not only be driven by the broad recovery in the confidence of the capital markets, but, more importantly, driven by leasing markets and rental levels and these are the product of local markets. Across Europe, there are enormous differences in local market conditions, which will go a long way towards determining the bottom of the cycle and the exact point of recovery.

In London, prices have moved significantly during the past 18 months. It still has some way to go, but at least the painful process of re-pricing is well underway. Similarly in Paris, prices have begun to move, but here too there is still some way to go. In contrast, Spanish markets - where real estate should be free - are still in the denial stage and, as a result, there is an awful lot more pain to come before any ‘shoots of recovery' become evident.

What is also clear is that 7.5-8% yields in central London, and 5-6% in many other smaller, less liquid markets throughout Europe, are irrational and will need to unwind during the course of 2009-10. That process will be painful, but it will also be a source of opportunity for the small group of active investors.

Not only are different markets at different points in the cycle, but the different valuation treatments also greatly influence the point of recovery. According to CB Richard Ellis, the period between the top and bottom of European office markets varies from six-eight months in Amsterdam to over six years in the case of Paris - a function of both local supply/demand balance as well as the role of valuers.

This time around, the length of the cycle may be different in each case, but it clearly reinforces the simple point that there is no such thing as the bottom of the cycle.
Investors will clearly be looking to invest at the bottom of the market. However, most will also recognise that this will not only vary between markets but will be difficult to pinpoint with any degree of accuracy. Much more important is the ability to use a falling market to create investment value. That can be achieved whatever the phase of the real estate cycle.

Joe Valente is head of portfolio management and strategy at Allianz Real Estate