Solvency II and demand for secure income are making France's institutional investor community a driving force behind the French real estate recovery. Gail Moss reports

French institutional investors are keeping their domestic real estate market motoring along, thereby increasing competition for core assets, while indicating a nascent revival of higher-risk development projects.

As is the case in other European countries, insurance companies in France - which dominate the domestic institutional investor market - are cutting their equity exposure, largely because of Solvency II. The proposed EU directive demands that insurance companies in future hold more reserve capital for equities and less for bonds. Direct real estate falls in between the two, requiring enough capital to cover a 25% investment loss, according to current proposals. The French real estate market is one of the main beneficiaries.

"France is a very mature market, and is seen as a safe haven, so there is more competition for real estate here," says Philippe Depoux, head of Generali France Immobilier, whose real estate portfolio is invested entirely domestically.

Depoux says that Generali France has probably been the largest investor in the French real estate market during the first half of 2011, with around 10% of total market investment. With net sales worth approximately €350m this year, its real estate portfolio should reach the €6bn-plus mark by the end of this year, compared with €5.3bn at the end of 2010. Property now makes up about 7% of its total investment portfolio. Of its real estate allocation, 88% is held directly, including stakes in partnerships with other institutional investors.

"The changes in real estate started at the end of last year, with yield compression at the prime end of the market," says Mahdi Mokrane, head of research and strategy at AEW Europe. "The Ile de France, and France in general, are seeing increased activity."

Mokrane says that the priority investment area is core real estate, either in terms of location, or by the nature and security of leases (the longer the term, the better).  "However, a number of investors have become moderately active at the higher end of the risk spectrum, shifting to the periphery of Paris or to the regions," he says. "There is some activity in segments which were previously on the sidelines, such as retail parks, industrial and logistics."

Even so, the level of institutional investment in French property is still only half that of 2007, when total investment in commercial real estate was €27.5bn, of which €18bn was foreign money (according to CB Richard Ellis and Immostat). In 2010, only €11bn was invested, but that was an increase of 42% on the year before. And most money - approximately €6.7bn - came from domestic investors.

"In the boom years of 2006 and 2007, the biggest buyers were the Germans, Irish, British and Spanish," says Tristam Larder of the European investment team at Savills based in Paris. "That has certainly turned around, and the biggest buyers are now French institutions and private investors." Larder adds that there have been "massive inflows" from the French retail funds known as SCPIs (Société Civil de Placement Immobilier).

Significantly, however, 40% of the transactions (€4.6bn) took place in the final quarter of 2010. In the first half of 2011 only €4.4bn worth of transactions were recorded. Although the sluggish first quarter was partly a natural slowdown after the usual pressure to close deals before the end of 2010, by the start of spring this year there was no activity at all, say CBRE/Immostat. And the market only got going again in the last few weeks of the second quarter.

However, anecdotally, there are signs of continued activity. "We are seeing an appetite from French investors to increase their real estate allocations," says Laurent Lavergne, head of fund management, AXA Group clients.

Over half of AXA Real Estate's investing is carried out on behalf of the different AXA insurance companies; the other 44% is for external clients. "The average allocation for French investors is between 2% and 6% of their total portfolio, so there is room for more investment," Lavergne says.

This new appetite to invest is partly a decision to diversify, and partly a reaction to Solvency II, he says, because of the less restrictive rules for the direct real estate holdings of insurance companies.

And as the pension fund sector is relatively small, the French institutional sector is dominated by insurance companies. Lavergne says: "The trend among insurance companies towards direct investment is also fuelled by the desire to get more control over transactions. They are using limited or no leverage although, depending on the nature of the arrangement, they are also keen to go via club deals or joint ventures."

New investments for the real estate portfolio of AXA France insurance companies were also made almost entirely in France 2010, primarily for greater control purposes. "Furthermore, the legal security in relation to tenants is comforting for investors," says Lavergne. "In contrast, there are differences throughout the rest of Europe, where there is not always transparency."

However, AXA Real Estate has already carried out €2.13bn of transactions in Europe on behalf of its clients this year so far, much of which has been targeting core real estate outside France. The UK saw the lion's share, accounting for 46% of acquisitions, compared with 25% in 2010.

The shift away from France was further evidenced by the creation of a joint venture between AXA France Insurance Companies and Norges Bank Investment Management, whereby AXA Real Estate sold a 50% stake in seven French office assets to the Norwegian Government Pension Fund. "This arrangement will allow us to keep a good exposure to Paris offices, while freeing up other capital to invest elsewhere," says Lavergne.

Flight to Parisian quality
As ever, interest among French institutional investors has overwhelmingly centred on Paris, which accounts for the majority of investment volumes in France, according to Larder. Second-tier cities include Lyon, Marseille and Lille. "In terms of Paris offices, yields have moved right back in again, with deals being done at 6.25-6.40%, compared with the long-term average of 5.25%," he says. "Prime yields are running at 4.5% at present."

Paris is a city of two halves: the historic centre - where draconian planning restrictions mean that new development is very limited - and the periphery, which includes the burgeoning La Defense business district. "In terms of new construction, many investors were putting things on hold until recently," says Larder. "But now they are coming back, because they believe the lettings market will pick up."

He points to the T1 tower, completed in 2008 and La Defense's highest, at 231 metres; it is now largely let to, among others, Ernst & Young.

"There have been some big letting transactions in La Defense and central Paris," says Larder. "In Q1 this year, 613,000 square metres [of space] was let to users, a jump of 21.4% compared with Q1 2010, reflecting pent-up demand. But there is still a shortage of stock in the centre of Paris, and this will have an impact on values between September and the year-end."

Furthermore, rents have gone up because there has been very little new supply. "Headline rents at the prime end are now around €750 per square metre, although owners are still offering rent-free periods, contributions to capex and other incentives," he says.

Overall, Larder says, the market is showing a slow upwards trend. "Investors are responding to this by deciding to take a risk; there is a surge of new development coming onstream in 2014 and 2015," he says. "However, any wobble could throw us back again to square one."

But individual investors still have their own distinctive objectives. "The major shift in our strategy - decided at group level - is to be more trophy-orientated than before," says Depoux. "This will probably result in lower yields, but will give us more security and more resilience to changing situations."

Generali France had in recent years been selling its existing trophy buildings to take profits, so this policy is intended partly to rebuild that side of the portfolio, focusing on prime addresses in Paris. However, the aim is also to become more defensive.

"These buildings are stable in terms of income stream and the creation of capital gains," says Depoux.

The other trend is to focus more on retail, in order to balance the holdings in offices with an uncorrelated sector. Favoured locations will be boutiques and small shopping centres in prime downtown locations, in the regions as well as Paris. "We are looking for big cities in big employment areas, and big counterparties," says Depoux.

Generali are also looking at limited exposure to development deals, primarily in the office sector. "We are keen on doing that because in France we have a culture of value creation," says Depoux. "We also want to get some direct exposure to risk. Unfortunately, we can't always find the right trophy locations in France. But wherever we do invest, we will not be too exotic in terms of location."

The global Generali Group has also become more selective in terms of development risk, because it is trying to lower the overall risk at group level. Generali Tower, the huge project planned for La Defense, was shelved earlier this year at group level.

At the same time, the current shortage of existing and future stock has made the market more competitive. For instance, Generali was recently interested in the project to develop a landmark office complex next to Balard, the future site of the French Ministry of Defence in Paris, although AXA Real Estate eventually won the partnership deal with the Opale-Defense consortium.

Meanwhile, Depoux says the residential sector is not high on Generali's list of priorities, because prices have not fallen far enough. "The market is being pushed by individuals, and we cannot have yields under 3%," he says. "However, we're monitoring things. Our exposure is 4% of our property portfolio at present, but we would like to go up to 6% or 7%."

Listed real estate, debt investments
As stock market volatility continues, and the demands of Solvency II take on more importance, the relative appeal of listed vehicles, such as SIICs has waned for institutional investors. Generali says it is in a stand-by position in terms of further SIIC purchases until the new solvency rules become clearer.

On a wider scale, non-listed funds are becoming more popular. According to a recent INREV survey, French institutional investors in real estate are planning to increase their allocations to non-listed funds by 56% over the next three years. INREV's Investor Universe France Survey 2011 showed that non-listed real estate fund allocations are expected to rise from €34bn to €53bn, out of a total real estate allocation that currently stands at €130bn.

On average, non-listed real estate makes up around 26% of French investors' portfolios, similar to that for the UK, Germany, the Netherlands and Sweden. This percentage is expected to rise to 30% in the next three years.

The study says French institutional investors are warming to the benefits of non-listed assets, including international diversification, access to new markets and sectors, and access to expert and specialist management.

However, domestic investment accounts for 92% of French investors' real estate assets and 5.2% of their total assets. INREV says this is because the French market is seen as relatively stable, and the investors consider they can achieve sufficient diversification without going abroad. Direct real estate investment however still makes up the lion's share of portfolios, accounting for almost 62% of total real estate allocations.

And in spite of growing interest, the survey confirms that many French investors are still cautious about non-listed real estate investment. "They seem to perceive a lack of control and transparency," says Lonneke Lowik, director, research and market information at INREV. "And given that large insurance companies make up 62% of the French institutional investor universe, regulatory issues such as Solvency II are likely to be impacting their appetite for non-listed real estate vehicles."

Solvency II is also likely to increase the attractiveness of investing in real estate debt, due to lower capital charge associated. Both the domestic and European markets have been bolstered by emerging debt strategies, such as AXA Real Estate's Commercial Real Estate Senior-1 Fund, which raised €530m at second close last April. This means the insurer's capacity to underwrite commercial property debt has now risen to €2.7bn.

The pan-European fund will provide senior loans either directly or by acting in syndication with a bank. It will focus on good quality, income-producing properties, primarily in the euro-zone, and will also seek exposure to sterling and Nordic currencies.

"The structure is similar to AXA's bond funds," says Lavergne. "But we are looking to extend the principle more and more to real estate because we get a better spread than for pure fixed interest vehicles. And as more real estate transactions are underwritten by long-term investors, such as insurance companies, the European property market should become far more liquid and transparent."
 

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