Property investors have treated the Nordics as a safe haven, but the region offers a range of opportunities and risks, says Kiran Raichura

Just as the rest of the western world, the Nordic economies experienced sharp falls in economic output in 2009. But it was during the recovery that the region differentiated itself, as fixed investment rose by 13% in the first six quarters of recovery, compared with only 3% in Europe, while household consumption rose by 6% compared with 2%. The real estate markets evolved along a similar pattern, with large capital value declines in 2008-09 followed by a recovery between 2010 and 2012 on the back of positive rental-value growth and yield reductions. The resulting strong performance has stimulated investor interest in the Nordic markets, with competition for prime stock closing the gap between property yields in the region and those of core Europe.

But that, as they say, is history. With prime Nordic yields now well below their long-term averages, can investors still achieve their required performance in these markets?
With the notable exception of Denmark – where a peak-to-trough fall in house prices of 20% reduced consumer spending by nearly 4% from its Q4 2007 peak – the Nordic economies’ growth in 2012 was broadly based, with consumer spending, business investment and government spending all contributing positively. Conversely, throughout the whole of 2012, the only positive contribution to growth in the euro-zone came from net exports.

Although the latest indicators suggest that a recovery is almost under way in the European economies, the outlook for the next five years remains weak. GDP growth is forecast to average just 1.2% pa for Europe, compared with 1.9% pa for the Nordics over the same period. The underlying cause of this expected outperformance is low government debt levels (sub-60%). These mean that, in contrast to the austerity requirements in most other European economies, the Nordic governments have no need to reduce spending or increase taxes. Indeed, the relatively positive state of the public finances in the Nordic economies has enabled the governments to announce expansionary fiscal measures in recent budgets, including corporate tax rate cuts in all four countries.

While the timing of these expansionary measures primarily reflects the weak external environment and, arguably, upcoming elections in Norway (2013) and Sweden (2014), these measures are part of many years of reforms following the region’s 1993 financial crisis and should not be characterised simply as responses to economic weakness. In fact, between 1993 and 2012, Sweden reduced its government spending as a proportion of GDP from 67% to 50% – a level that is in line with the EU27 average.

But the recent strength of the Nordic economies is not without risk. House prices have risen by 156% in 15 years (6.5% pa) in the Nordic region ex-Denmark, in line with France and not far behind the UK, to what might be described as “bubble” levels. The household debt-to-income ratio stands at an average of 148% in the Nordics ex-Denmark (this figure is over 250% in Denmark) and mortgage terms have tended to be softer than those in most other advanced economies. The high proportion of homeowners on variable rates (around 65% in Sweden) means that when interest rates rise, there will be a significant impact on mortgage repayments, while the bulk of mortgages granted in recent years have been interest-only, making them particularly sensitive to interest rate changes.

While the risk of a severe housing downturn is being addressed by policymakers (LTV ratios have been limited in Finland, Norway and Sweden, while Sweden is moving towards requiring amortisation over shorter periods than previously), the retail sector in particular would face a severe negative impact from such an eventuality. However, the structural state of the economies is such that the governments are in a position to stimulate demand if a substantial slowdown should occur.

So we can see why the Nordics are expected to outperform the rest of Europe on economic growth measures and where the major risk lies in these economies. But do the prospects for the office-occupier markets correspond with this?

Demand for office space in the Nordic capital cities has rebounded sharply since the recession. Although some of this demand could be regarded as normal market churn, there has also been a degree of expansionary activity, with net absorption positive since 2010. On the other hand, net new supply has been low, with only 0.6% of stock being added per annum between 2009 and 2012. This compares with 1.2% for Europe as a whole in the same period.

The result is that prime office rental values have risen by 19% since their trough in Q1 2010 – outstripping all other European markets except for the UK – and by 1.6% in H1 2013 (compared with 0.7% for Europe as a whole). We expect strong occupier demand for limited prime CBD stock to continue to push rental levels upwards in the Nordic office markets, with average rental growth of 1.7% pa in the 2013-15 period compared with 0.8% pa in Europe over the same period.

However, this outperformance is not expected to persist indefinitely. In Stockholm, large businesses are increasingly being forced to abandon the CBD in the search for either efficient modern floor plates, or cheaper space, as rising rents have contributed to concerns about increasing occupational costs. With further tenant moves already announced for 2014 and 2015, we expect to see a rise in CBD vacancy and a commensurate fall in prime rental values in 2016 and 2017 once this space is refurbished and returned to the market. This means that for the 2014-17 period, our forecasts predict 1.1% pa rental value growth in both the Nordics and Europe as a whole.

The short-to-medium-term positive outlook for the office occupational markets helps explain the strong investor interest for office assets in the region, but does this correspond with the outlook for the capital markets?

Rising bond yields will limit prime performance
With economic risks set to gradually reduce and the risk of interest rate rises increasing, our expectations are for gradual rises in European bond yields through to 2017, with German bund yields expected to rise to above 3% by the end of the period. Nordic government bond yields are unlikely to perform differently and may rise earlier than bunds due to the stronger economic recovery expected and the movement of investor demand away from safe-havens (Sweden, in particular, has been seen as a ‘second Switzerland’ by some investors). We therefore expect prime office yields in the Nordic region to rise by 5-10bps on average in 2014 and a further 50bps in 2015-17, as investors shift their target from capital preservation to growth and pricing adjusts to the higher bond yield environment.

Along with the yield rises being brought forward to 2014, the outlook has also been heavily impacted by the shift in the time period covered by the forecasts. Figure 3 shows the change in our forecasts between December 2012 and August 2013, driven by both an earlier rise in bond yields and the shift in the forecast period, as 2013 total returns fall from the expected performance. The latter of these factors is more pronounced in the four Nordic markets than for the European average, as we expected to see (and have seen) further yield reductions for prime stock. This reflected the strength of the occupier markets and the continued investor demand for core product in markets where the perception of risk has been low.

The result of these changes is that prime offices in the Nordic markets are forecast to produce total returns of only 3.8% pa in 2014-17 and, although excluding Stockholm increases this to 6%, the relative performance compared with the European average has fallen substantially. While, for many investors, a 6% total return may be sufficient, in a rising bond yield environment, we perceive the risks as being to the downside. This makes it difficult to recommend purchasing prime assets in these markets at current pricing.  

Moreover, there are further concerns that reduce the attractiveness of these investments.
First, if we consider the volatility of European prime office markets over the past 15 years, we find that Norway has been among the most volatile, with the standard deviation of total returns reaching 26%, second only to Ireland at 27%. Sweden was also above average, at 17%. As a result of this high observed level of volatility, Sweden and Norway are forecast to be two of our worst-performing prime office markets on a risk-return basis in the 2014-17 period, ahead of only Switzerland. This suggests that, for a risk-averse investor, both of these markets might be fully priced. Meanwhile, Denmark and Finland, in particular, with below-average volatility in the past 15 years, appear to offer better value to investors wishing to increase their Nordic exposure.

Secondly, for a euro-denominated investor, there is an additional risk stemming from currency effects, as both Norway and Sweden have currencies that are free-floating against the euro (the Danish krone is pegged to the euro with a very narrow band and is managed by the Danish central bank through currency purchases and interest rate movements). To quantify this risk, we have assumed a fully-hedged investment (although in practice, many property investors do not hedge at the asset level). The cost to a euro-denominated investor of fully hedging a five-year investment in Sweden (through a forward contract) would be 1.3% pa at current rates, while the cost would be 1.8% pa for the equivalent in Norway. The net result of these costs is that foreign investors’ returns would be even further diminished. This comes as little surprise considering that both currencies appear to be heavily overvalued against long-term averages and purchasing power parity.

However, while it is possible to buy a forward contract in Denmark, this would incur a cost of only 0.1% pa, because of Denmark’s peg to the euro. As a member of the euro-zone, Finland bears no currency risk for a euro-based investor.

The combined impact of our total return forecasts and these two factors – volatility and foreign exchange risk – therefore leads us to conclude that euro-denominated investors should reduce exposure to prime assets in both Stockholm and Oslo. However, the relatively low historic volatility and limited or zero currency risk in Denmark and Finland, along with reasonable returns for prime property suggests that, on a relative basis at least, assets in these markets should be held, with selective purchasing when mispriced opportunities are identified.

Target out-of-town Stockholm, resi conversions in Copenhagen, Helsinki
Nevertheless, with the economic outlook gradually improving and with bond yields rising alongside rising risk appetite, investors are beginning to demand higher returns and are willing to accept higher risks in exchange for this. Indeed, with increasing signs of a concerted economic recovery, opportunities exist for achieving office sector total returns in the 7-10% range for more core-plus to value-add type strategies.

We believe that these sorts of returns are possible in the emerging out-of-town hubs in Stockholm, where improvements to road and rail infrastructure will improve connectivity and large corporate occupiers are driving an improvement in the quality of office stock.
Over time we expect these markets to attract a greater breadth and depth of occupier which, in turn, will attract increased institutional investor demand. We also see opportunities for office-to-residential conversions in the region generally, but particularly in Copenhagen and Helsinki, where the downside risks to residential prices are limited and rents for apartments are expected to continue to rise at least in line with inflation.
In the current economic and property market environment, it is for these types of assets where we perceive the greatest value to be – investments with stable or improving macro fundamentals, that also provide investors with opportunities to re-position assets to meet occupier requirements.

Kiran Raichura is a research analyst at AXA Real Estate