The sovereign debt crisis in the euro-zone has imposed a new phase of uncertainty on the European real estate markets. Justin O'Connor looks at how investors should respond
For property professionals monitoring recent developments in the euro-zone, the past few months have been a roller-coaster ride. Unfortunately, closing your eyes and wishing it would stop is not an option.
With high drama continuing in sovereign debt markets, the ride is evidently far from over. How do property investors cope and plan for the future in the face of this uncertainty?
Currently, we are seeing some fairly predictable strategies being played out, with the flight to quality much in evidence - so much so, that prime property yields have returned to something like their long-term average in many European markets. Risk-averse investors seek secure income streams and the reassurance that prime assets have less to fear from both inflation and a reduction in capital values.
This has led to the unusual phenomenon of prime property offering lower yields than those of sovereign bonds in some cases. In Dublin, for example, office yields were 412 basis points below Irish sovereign debt in the second quarter. With the notion of ‘risk free' sovereign debt out of the window, investors might well feel that the risk of a good tenant defaulting on payments is less likely than sovereign default.
In this environment, it is entirely understandable to seek security wherever it can be found, but this strategy is unlikely to boost returns. It is also vital to plan for inflation expectations, which we expect to outpace market rental growth in the majority of markets, in the short term at least. Many investors are concerned about asset-liability matching and, as many of their liabilities are linked to inflation (especially in the case of pension funds and life assurance companies), they will increasingly focus on assets that are also inflation-linked, especially if we see a further round of quantitative easing.
An interesting anomaly thrown up by the current situation is the pricing of real estate leases with inflation-linked uplifts compared to government bonds with similar characteristics. While one has to allow for the credit risk of the underlying covenant, the gap between the yield on inflation-linked property leases and government bond pricing is remarkably large. This arbitrage advantage is yet another reason why certain types of property are attracting increasing investment.
We think increasing interest will come from pension funds and insurance companies looking for credit-like investments due to the market shortage of suitable government index-linked bonds. Indeed, we are aware of some investors now seeking to get all their inflation hedging exposure from areas such as property and infrastructure, because they see inflation-linked government bonds as too expensive. Buying opportunities arise when the premiums for property investments far exceed those of, for example, AAA-rated covenant bonds.
It is not always possible to obtain attractively priced fixed uplifts or index-linked leases, but finding opportunities to outperform in this environment demands a strong ability to forecast individual markets and appraise individual opportunities, particularly in respect of the quality and sustainability of the income stream. This is made even more difficult because of the uncertainty regarding the euro-zone's survival in its present form. Whether it continues due to emergency funding or via full fiscal union, there are very different implications for ‘core' and ‘peripheral' member nations.
We see the low growth/demand/interest rate scenario provided by the twin spectres of austerity and bailouts leading to continuing demand for prime property in better-placed economies, with rental growth supported by low levels of supply. Income, rather than capital growth, would continue to be investors' primary focus, with location remaining critically important. However, the core property markets could look relatively unattractive in relation to the global growth markets of Asia, while the peripheral economies would remain exceedingly risky.
Therefore, investors with some risk appetite should consider the current pricing advantages available when accepting shorter leases and/or apparently weaker covenants in prime locations in core countries. Taking a portfolio approach that incorporates staggered lease expiry profiles and/or multiple tenants can offer enhanced value while mitigating the additional risk. And if full fiscal union were to come to pass, this would have very interesting implications for assets in peripheral economies as cap rates begin to converge. Sector-wise, we would favour non-discretionary retail and residential as defensive plays and opportunities which focus on asset management strategies - for example, re-gearing leases prior to expiry, especially within the retail and industrial sectors.
Any decisive solution to the euro-zone's current woes, whether via full fiscal union or disorderly default, should ultimately bring with it the happy outcome of ending a protracted period of uncertainty. In a gradually improving environment, prime property would lose some of its premium rating against secondary property, as would capital cities in relation to second-tier cities. It would accelerate the trend of reducing ‘overweight' positions in European offices to the benefit of other sectors that favour ‘discretionary' spending as consumer confidence returned. In the short term, investors might still have a preference for index-linked leases, but improving economic conditions would eventually favour market rent-based leases.
In the UK, for example, where close to 50% of exports go to the euro-zone, a break-up of the euro and the subsequent potential for relatively rapid improvement might prove a better scenario than that of austerity-constrained growth over the longer term. Currency uncertainty could also benefit sterling through greater levels of investment into sterling assets, including property, as investors hedge against a euro-zone break up.
However, defaulting countries would, no doubt, see instant high inflation/currency devaluation, together with a short-term sell-off of their more liquid and trophy assets. Banking sector problems would lead to lower levels of lending, a higher incidence of distressed sales and potentially a double-dip recession throughout the region. In the short term, the flight to quality would continue in the non-defaulting countries where interest rates would stay low, with the gap between yields of prime and secondary assets becoming ever wider.
However, these peripheral economies would ultimately gain advantage from an exchange rate adjustment which improves competiveness. This would encourage investment into industrials and certain types of offices, with nominal rental growth increasing. On the other hand, the likely higher levels of inflation and interest rates associated with a weaker currency could mean that property yields remained high for some time.
Any purchasing decisions in this environment should focus on rigorous credit risk analysis with consideration given to indexation and currency hedging. Turbulent markets create opportunities, and in a world where investors do not want to take risk, we know the pricing of risk will often be wrong. Excess returns will come from careful evaluation and taking controlled risk.
Justin O'Connor is CEO at Cordea Savills