Fear is back

The fifth edition of ‘Emerging Trends in Real Estate Europe 2008' shows that the most obvious sign of market fear is in the debt markets, say its authors, John Forbes and Chuck DiRocco

Emerging Trends is produced jointly by PricewaterhouseCoopers and the Urban Land Institute and covers 27 markets in countries throughout Europe. The report, launched at MIPIM, is based on surveys and interviews with nearly 500 of the industry's leading authorities. It contains predictions for individual property sectors as well as markets, along with insights regarding real estate capital markets and the economy in general.

The overall sentiment of last year's report was that markets were reaching a peak. As one investor put it: "If 12 o'clock is the top of the cycle, we are at five or 10 minutes to 12". In the UK, that peak had been passed and yields were already starting to soften even before the impact of the credit crunch. The liquidity crisis accelerated the downward cycle and real estate markets also slowed elsewhere in Europe.

What is the sentiment of the 2008 Emerging Trends report? Perhaps it can be summed up by the opening quote from an investor - "fear is back".

The most obvious sign of that fear is in debt markets. This year will be tough for lenders due to a lack of liquidity caused by US sub-prime problems. As one respondent to the survey put it: "It's tough. I haven't known debt markets like this since 1991." Another said: "A lot of banks have been whacked in the balance sheet and their ability to lend is impaired. It is not clear who still has the capacity or appetite."

Things only look to get tougher, as nearly 85% of survey participants see debt underwriting standards becoming more stringent this year. Debt will be harder to find and will cost more. Depending on who you are, where you are, how much you want, and what you are willing to pay for it, borrowing is still possible.

At this point, lenders in the best shape are local and regional banks that have a deposit base. "We can get reasonably priced debt in continental Europe...regional banks," said one real estate executive. "Balance sheet lenders remain very keen to do business with us," remarked a core investor.

Regardless of local and regional lenders, debt capital is drying up and stopping many real estate deals in the pipeline.

A market that has seemed to come to a complete stop is commercial mortgage-backed securities (CMBS). As one executive stated: "CMBS is effectively dead at the moment."

In the European CMBS market, the big question is whether underwriting standards were strict enough to control bad deals. Financials state that they are not, but banks are stuck with €30-40bn in ‘hung loans' in European commercial property debt that has not been securitised off their balance sheet. Therefore, analysts project more than €2.6bn in writedowns on these bad deals.

To correct these problems, issuers are going to need to standardise deals and improve disclosure. For it to be successful again, one professional said: "The debt markets need to rebuild trust with consumers of CMBS. To accomplish this, the regulatory environment will need to be overhauled or go through a renewal process."

Obviously, many investors miss the constant flow of debt into the market, but one executive believes that "the positive of the sub-prime crisis is that, because it ties up lending, it kills off speculative development".

With a decline in the number of leveraged buyers, long-term institutional equity opportunities are on the horizon. According to Emerging Trends, "equity is back on the march in a big way," and "the market is great for pure equity players only".

In 2008, institutional investors, private property, and open-ended funds look to lead all others as the primary source of equity capital. These investors plan to focus on their home markets, but take advantage of diversifying their assets beyond local regions.

Much of the real estate-focused capital crossing into Europe continues to originate from the Middle East, the Asia Pacific region, and Australia, according to the survey.

One interviewee said: "US institutions are pulling back, but sovereign funds and other Middle Eastern money are there to replace it." Change in real estate financial markets is not always bad. As an executive stated: "It's going to come back to ‘real' real estate people and [fewer] financial players."

Not only has there been a change in the capital markets, but there also has been a change from optimism to caution in European real estate investing in 2008. "The future outlook is less certain than at any time in recent economic cycles," stated one interviewee. London has been hardest hit by the knock-on effects of the liquidity crisis, falling from 2nd to 15th place for investment prospects, and 13th place for development prospects.

Many investors commented on the extent to which London is exposed to the fortunes of the financial services industry more than other European cities. One interviewee commented: "London is particularly exposed to a downturn in the financial services sector. There is uncertainty as to space requirements for financial services companies. [There is a] lack of clarity as to the amount of ‘grey space' that financial services companies are sitting on."

Although confidence levels in the financial services sector are currently very low, the key question is, how quickly they will recover? While this situation may be discouraging overall investment in London, opportunistic investors who had been priced out of the market in recent years are looking to come back.

London, more than any other market in the report, is also experiencing declining economic conditions similar to those in the US, including a drop in consumer spending, falling house prices, a rise in personal indebtedness, worries over home repossession and turmoil in the financial sector. One survey respondent remarked that "the UK economy is starting the year under the yellow flag". 

At the other end of the spectrum, Moscow and Istanbul top the table for returns.
Many interviewees said: "Moscow is booming." The top-ranked city is "top for rental growth". Out of all 27 cities, Moscow ranks first or second in buy recommendations for all major property types, with retail being investors' main interest area. One interviewee agrees: "The big story continues to be retail—the market has huge depth and breadth."

New opportunities are often followed by new challenges. "It is not easy to get access to sites. Without local partners, market entry is difficult." Another executive said: "There are huge opportunities, but bigger risks." Survey participants agree, rating Moscow the riskiest city out of all 27.

The chase for yield and performance will lead many new investors into Turkey's real estate market. One interviewee summarises the situation: "Turkey is the India of Europe, with a huge population, fantastic GDP growth, favourable economic fundamentals." As with Moscow, survey participants fear risk in Istanbul, ranking it the fifth riskiest city in Europe. In spite of the risk, the city offers higher buy ratings in 2008 than in 2007 for all five major property sectors, according to the survey.

Overall ratings for investment prospects are down compared with last year, and if anything sentiment has become more negative since interviews for the report were conducted in November and December 2007.

In 2008, the survey results rank the top three major property sectors - retail, mixed use and hotels - as modestly good investment and development prospects. On the investment side, the retail sector leads the chase, with the southern, central, and eastern Europe markets in the crosshairs. One interviewee said: "While some markets in central Europe are reaching saturation, the best opportunities are seen in the new European markets east of the EU members."

Looking at development, the mixed-use sector leads the rest as it did in the 2007 report. The continued importance of mixed-use properties follows city and urban planning efforts looking to add urban value and multi-functional use. "Mixed-use schemes [are] becoming more prevalent as urban regeneration becomes more important," claimed one developer.

Some additional areas of concentration in Europe will be on infrastructure, green property, and human resources.

Infrastructure is often looked at as a long-term, fixed income investment strategy by many large institutional investors. According to RREEF, the European economic infrastructure market was worth between €4-5trn in 2006-2007. As one executive stated: "Infrastructure is a huge growth area."

Concern about environmental issues and creating green properties are two of the hottest topics of discussion throughout Europe. Many interviewees are already ‘greening' up. "We install geothermal heating." "Water cleansing with plants." "Energy and electricity from green sources." However, many still dismiss greenness until higher rents are rewarded or threats of penalties for not meeting standards are enforced.

Finally, across Europe there seems to be a decline in ‘quality human capital'. A lack of skilled employees at all real estate levels often leaves management scrambling and many projects not as successful as projected. One executive said: "There is a lot of average."

Regardless of a projected real estate market slowdown, survey respondents and interview participants say they believe that there are still investment and development opportunities across Europe. With less leverage in the market, many true real estate investors will return to the fundamentals of being an owner or a developer.

No matter what their strategy in 2008, the European real estate market can expect western corrections, continental stabilisation, and a rush to take advantage of all that the East has to offer.

Chuck DiRocco is managing director of industry trends and analysis at the Urban Land Institute. John Forbes is UK Real Estate Industry Leader at PricewaterhouseCoopers LLP