How should investors balance their European real estate portfolios in a low-growth environment? Mike Keogh provides some answers
It is risky business these days penning articles on property prospects, with the political and economic terrain prone to seismic shifts between keyboard and print. That said, property investor sentiment remains largely unchanged from 2011, with warranted risk aversion evident in the direction of ‘safe haven' capital flows and competition for quality real estate.
Cross-border investors continue to be wary of southern Europe, evident by the UK, Germany and France together accounting for around two-thirds of all EU-15 investment volumes last year. The game changer in 2012 has been the European Central Bank's (ECB) Long Term Refinancing Operations, which have increased liquidity and removed bank cash-flow fears. These have diminished some of the systemic risk in the financial system and halted fears of a wider ‘flood' of maturing real estate debt to the market. But this is still only a temporary solution, and far greater European agreement on economic, structural, banking and labour market reform is needed.
The deleveraging task facing the economies of the industrialised world, and the challenge to deliver property performance alongside the twin headaches of weak occupier demand and restrictive funding markets, is unprecedented.
So what is the property outlook for 2012? With a pricing bubble arguably already evident for secure income producing assets in some markets, question marks surround projected investment volumes and direction. The recent improvement in financial markets perhaps implies the belief that we have passed the point of maximum uncertainty, but with politics, rather than markets, being the dominant influence this year, the possibility of further financial ‘heart attacks' makes it hard to be anything but cautious. In this uncertain climate, difficulties in raising funds in the wholesale market and tight lending standards will persist - such are the concerns over counterparty risk as we enter a recessionary climate.
What about growth? This is year four of a 10-year sporadic European recovery. Recent confirmation that the euro-zone contracted in Q4 2011, due to falls in investment, household spending and exports, supports the latest economic growth downgrades. These forecasts are now arguably more realistic than those politically constructed during 2011 in attempts to fend off the bond markets. Italy, Spain and the Netherlands are poised to rejoin Greece and Portugal in recession in 2012, as the economies of Germany and France stagnate compared with stronger, albeit relative, growth in the Nordics.
Recent survey evidence has hinted that Europe may avoid a technical recession for now, but rising unemployment and domestic spending under pressure via fiscal tightening, reiterates the mammoth task ahead. Furthermore, Greece's membership of the single currency remains precarious despite the bailout programmes, largely because the fiscal assumptions upon which the rescue deal is agreed - namely Greek growth - are extremely unrealistic.
Without a seemingly credible plan to tackle sovereign debt, Europe is likely to witness ‘more of the same' in reference to property investment. This view is largely based on risk being currently elevated, but Henderson has run different scenario approaches to highlight potential European strategies. The difficulty in meeting return requirements for core investors implies investment volumes will fall in 2012, unless investors are willing to run the risk of capital erosion tomorrow in return for secure income distribution today.
The figure allocates European markets to core or periphery and outlines how Henderson expects occupier and investment markets to fare under two scenarios: first, prolonged slower economic growth, and second, a shock to the banking system via multiple disorderly defaults and a deeper recession. The medium term outlook is also considered, since there are important distinctions for property performance between core and periphery markets, depending upon which economic scenario pans out.
Henderson expects prime assets in core markets to withstand the pressure of a slowdown, although annualised returns would be low over a five-year view. If core markets avoid outright recession, headline rents will hold up, although growth will certainly stall. The safe haven status of these countries suggests low bond yields will underpin prime pricing as investors are attracted to the bond characteristics of long, secure income. The lack of bank liquidity for non-prime assets indicates performance will be much weaker as yields increase and rental values fall.
Under the weaker scenario, prime rents and yields do not avoid a marked correction and short-term performance would be highly negative as yields rise and rents fall. Digging for a positive angle, the halt in development should at least support an eventual recovery in grade-A rents, but yields on non-prime assets would not be expected to return to today's levels, as a return to growth would be heavily impeded by excessive levels of availability.
Will risk-taking in the periphery be rewarded? The fortunes of the periphery markets will depend on the willingness of banks to finance transactions and demand from overseas investors, but southern European real estate should not be tarnished with the same debt brush. In Italy's case, the concern is growth not debt, and so quality opportunities that emerge due to liquidity pressures will be attractive given the resilience prime pricing in past financial downturns. Near-term performance will, however, be undoubtedly challenging. But by 2014 the outlook for prime assets in the periphery will be more attractive than that for core markets, as the economies eventually turn the corner and rental growth begins to accelerate from a very low base.
Aside from a euro-zone break up, core investment namely in Italy, Spain and even Ireland will appeal to global investors, should strides to rebalance their economies prove successful, in what are currently solely domestic investor markets. Until this point, Italy and Spain will prove a stock-pickers' market. Assets that benefit from excellent local demand and supply fundamentals, coupled with much reduced rents, have the potential to perform well, as long as pricing reflects the macro-level risks and lower competitor demand.
Henderson Research attaches an 80% probability to weak growth in core countries/mild recession in the periphery and a 20% chance to the more severe recession scenario. These probabilities will inevitably shift over time to reflect the relative successes and failures of governments to manage the sovereign debt situation and, eventually, to kick-start growth.
Core acquisition strategies in this climate of uncertainty need to remain flexible enough to incorporate the changing balance of risk. Investors are likely to accept lower returns from perceived ‘safe-haven' markets in the core and prime yields could even shift lower. In order to access relatively higher yielding prime assets, investors might prefer to target particular countries within the periphery, which they believe will survive a potential restructuring of the euro bloc.
Investing in defensive retail rather than volatile office markets, and targeting lot sizes that are within the grasp of domestic investors
- in particular, private individuals or family offices that take a very long-term view of real estate - could be the best way forward, as these investors would limit the degree of any adverse pricing correction. With these caveats in mind, an 80-20 mix of core-periphery seems most appropriate at present.
Mike Keogh is senior investment and economic analyst at Henderson Global Investors