In a fragile recovery, investors are returning selectively to European property, with an eye to top quality assets and income generating potential. Lynn Strongin Dodds examines the market
It is no surprise that in the wake of the worst recession in 60 years institutions are adopting a different approach to investing in real estate in Europe. Instead of scouring each country for opportunities, they are taking a more holistic view and looking at select quality assets in prime locations with long leases. Income generation and not capital growth are the order of the day until the green shoots of economic recovery are more stable.
Although some countries are pulling ahead on the recuperation course, caution remains the watchword. Opinion may be divided over whether the global economy is heading into a V or W-shaped configuration, but industry pundits all agree that the UK, Spain and Ireland are the weakest links in Europe. As Alex Jeffrey, chief executive of MGPA's European operations, says: "The economy is in a challenging place and there are concerns over the outlook after the massive fiscal stimuli programmes undertaken by central banks and governments during the financial crisis are withdrawn. However, France and Germany are in better shape and their economies are likely to grow faster than the UK."
A recent report issued by CB Richard Ellis (CBRE) echoes these sentiments. The property consultancy's estimates suggest that the major European economies shrank by between 2% and 5% in 2009, with France and Germany being the first countries to pull through in the second quarter of last year. It notes that while the risk of a so-called double-dip looms, several forecasters believe that year-on-year growth will resume in early 2010 and that there will be positive (if sub-trend) growth for most European economies. The bigger questions revolve around unemployment, which is approaching 10% in the euro-zone and the timing of governments' decisions to withdraw their stimulus injections and tighten monetary policy. In addition, the spectre of inflation is in the background which, when added to the other forces, could stall the recovery.
In property terms, liquidity remains paramount, according to Stefan Wundrak, research manager at Henderson. He also points out that while most countries in Europe have returned to positive gross domestic product growth, the outlook for 2010 is uncertain. Lacklustre space demand, increased tenant insolvencies, higher vacancies, falling rental values and over-renting are just some of the issues faced by property investors. Longer-term obstacles include mounting government debt levels and the potential for significantly higher interest rates.
However, Wundrak does not believe "there is merit in waiting any longer for stronger signs of recovery before re-entering the European market. History implies, and again supported by the recent UK recovery, that the strongest uplifts in value occur at the early stages of the cycle. Latecomers will miss the boat as globalised property markets react rapidly to capital flows. Investors though are likely to remain cautious and conservative and focus on safe assets in the best locations with the best tenants. Their attention could shift to secondary assets in the second half, although this will depend on the economic recovery."
The CBRE report also pointed out that investors were concentrating on defensive investments - well-let, well-located, modern buildings, secured to good covenants on long leases. In other words, quality and duration of income has moved to centre stage, while avoiding, or at least minimising, short-term exposure to the relatively weak occupational market is the order of the day.
Justin O'Connor, chief executive at global property fund manager Cordea Savills adds: "Investors are looking much more closely at the specifics of a particular asset, namely the performance drivers such as location and the leasing profile as well as the risks attached. Overall, there has definitely been a flight to quality and a concern over the long-term values of secondary properties."
Alistair Seaton, a national director within the investment strategy team at LaSalle Investment Management, agrees, adding: "Investors have returned to the property sector in Europe but we have definitely seen a change of thinking over the past two years. They have gained a better understanding of the role that property plays in a portfolio and what they require on a risk-adjusted return basis. The other trend we saw during the financial crisis is the move towards income preservation rather than capital growth because of the low interest rate environment."
Sabina Kalyan, head of European research at CBRE Investors, the fund manager, adds: "Investors are buying property as an income play because they are looking for real assets that generate cash and are also an inflation hedge. What has happened is that there is now a wide yield gap between prime and secondary as well as short and long leases. Investors do not want to take on short leases because of occupier risk."
While the UK was one of the hotspots, last year figures released in mid-January from CBRE showed that commercial real estate investment strongly revived in the final three months of the year for almost every market in Europe. Overall, €25.7bn of property deals were sealed in the fourth quarter, a 42% hike on the previous quarter and double the levels traded in the first half of the year. This marked the highest level since the collapse of Lehman Brothers in 2008 and the beginning of the sharpest point of the property slump.
The robust fourth quarter brought total 2009 turnover to about €70bn which, although it seems impressive, was still lower than the €121bn in 2008. The UK, which accounted for the largest chunk at about a third, saw flows jump by 64% in the second half compared with the first six months of the year. Germany came in second, contributing about 15%, while central and eastern Europe reaped the sharpest rise of 231%, although it was coming from a low base. The region's commercial property sales were about €2.5bn, with the most popular venues being the central European capital city markets of Prague, Warsaw and Budapest, which increased their share of total CEE turnover to 34% in 2009 from 21% in 2008.
Michael Haddock, director, EMEA Capital Markets Research, CBRE, says: "We have definitely seen an upturn in activity in the second half, with a total of €46.7bn - including the UK - up from only €26bn in the first half of last year. Although the total is still significantly less than 2008, we have not seen any signs of slowing down in the near term. However, it is important to note that the fourth quarter is typically the most active of any year as investors feel pressure to get deals completed by year-end. We could see an increase of 25% to 30% this year from last, but that depends on the product that comes to the market and the extent to which banks will be forced to sell properties."
The general consensus is that France, Germany, Poland and to a lesser extent the Czech Republic, will be the most popular destinations for real estate investors. Doug Hardman, regional investment director at DTZ, says: "After an encouraging year, especially with the fourth quarter exceeding €4bn invested in France, we anticipate a strong recovery in 2010 which could bring the investment market above €10bn. The yield compression should continue at least in the first half of the year. Today, prime office buildings in the Paris CBD (central business district) are put on the market below 5.75%. We can notice that the yield scale has returned to a normal range, with investors taking into account a risk premium according to the asset quality. France is still considered as one of the major targets for international investors provided that the general economy and the letting market remain at the present level. The greater Paris region is the most focused market."
Tony Smedley, head of European Funds at Invista Real Estate Investment, also favours Paris CBD, "because it offers a very specific opportunity. The market did not get as overheated as London and as a result, capital values did not rise as high. The development pipeline is low, which is good for supply, and the market looks attractive on a relative basis."
As for Germany, Hardman notes that the "outlook for the German investment market has improved significantly recently and consequently there are set to be a plethora of sectors and locations offering opportunities in the short to medium term, depending on the specific requirements of the investor. With rents bottoming out in some of the core office markets, there are good long-term growth opportunities in key centres such as Berlin, with buildings that have been recently let at historically low rents. Core long-term income in regional cities outside of the big five, offer comparably attractive yields internationally."
Neil Turner, head of international property investment and research at Schroders, also believes that Germany is an interesting proposition. "The attitude to debt is fundamentally different to the US and UK and they did not take on large amounts of leverage. As a result, returns may not go up as much in the boom times as other countries but they do not fall away as dramatically in the bad times. The two areas we are focusing on is retail, since consumer spending was not that impacted, and logistics because although exports were hurt, they are now benefiting from the economic recovery in some of the Asian markets."
In general, the once unfashionable industrial sector is attracting renewed interest due to the potential for double-digit returns. There has been a change of mindset because rents are likely to be the most stable in the prime locations as speculative development has been limited. The market might also be further supported by the slump in development of industrial space, with only 2.8m ft2 of space completed in the first half of 2009, the lowest level of development in the past 10 years. In addition, most European markets have been suitably repriced to compensate for the near term deterioration in occupier demand.
Retail has also gathered a following across the region because consumer spending has been more resilient than expected. Locations, of course, as well as the quality of tenants are paramount. There is a divide between the large centres with strong anchors and the discount end, both of which have held up relatively well. Investors are advised to be selective, especially in terms of the catchment area a centre serves. It should be situated near a growing, cash-rich population that has disposable income.
Michael Rhydderch, head of cross-border team capital markets at Cushman & Wakefield, says: "We believe people should look at central Europe, particularly Poland, which is the only EU country to have avoided recession. It has strong economic prospects and asset prices fell quite dramatically in line with investment volumes. Foreign investors curtailed activity dramatically and they have a strong influence on the Polish market. The economic story is less strong in the Czech Republic, although we still see it as a relatively attractive market. Views are mixed over Hungary as the results of the drastic economic surgery are yet to come through although yields are circa 1% higher than in Poland and the Czech Republic, so there is certainly a premium for investing there."
As for markets and sectors, some participants are looking at Spain. Peter Hobbs, head of global research at RREEF, believes that Spain might offer some interesting prospects. "Spain has an attractive institutional property market, and is benefiting from a significant re-pricing through the current cycle. Yields have risen dramatically and rents have fallen, creating the possibility that the market could become attractively priced. Rental growth will resume at some stage, but the huge economic challenges associated with high unemployment and fiscal deficits, means this won't happen much before 2013. More of a worry is the renewed capital interest in the market, whether from domestic private investors or from overseas investors squeezed out of other markets. There is a real risk that the early and strong return of capital will prevent the market from re-pricing sufficiently to offer good value, certainly during the course of 2010."
In the meantime, Simon Mallinson, European research director at Invesco Real Estate, is also seeing growing interest in its pan-European portfolio of leased mid-market hotels. "In general, investors are not looking at non-core assets, but our hotel fund is popular because it carries little risk. The mid-market end of the hotel sector has benefited from businesses scaling down and tourists, who might have stayed budget, able to take advantage of discounted rates. It is the luxury hotels that have suffered more in the recession."