OUTLOOK BRIEFING: Global capital flows spark rethink of strategies

As global capital continues to pour into European real estate, investors are being forced to rethink - and refine - their strategies, attendees at PropertyEU's recent Outlook Briefing at the Paris office of law firm Taylor Wessing heard.

Following another cut in interest rates in early June by the European Central Bank, the big question facing many real estate investors in Europe is: can they go any lower? As Marcus Cieleback, head of research at German listed investment company Patrizia Immobilien, pointed out during a presentation at the Briefing , the interest rate environment is the key driver affecting real estate investment behaviour.

‘The question is: when will interest rates turn and how will that affect investors? A lot of international capital may not be that reliant on the level at which the ECB keeps interest rates, but looking at a European level, ECB rates are one of the main drivers for continental European investors and investment flows.’

At the same time, global capital flows are becoming more diversified and the rationales for real estate investment are diverging accordingly, noted Nils Hübener, Head of Real Estate Investment at SEB Investment. ‘We’re seeing more diverse rationales and more scope for buyers that can act in different cycles. That should have an impact on the volatility of yields to some degree. You could argue that there will always be significant demand, even when it is weaker from other parts of the world.’

The weight of global capital targeting Europe is already having an impact on investment strategies, Hübener said. ‘The biggest impact in the short term is that we’re seeing interest picking up again in what is considered core plus in Europe. There’s more equity - and debt - available.’ While lending conditions are easing across Europe, it is on the equity side where the biggest change is visible, he added. ‘Two years ago, there was a pure focus on core. But now we’re seeing much more interest in going higher up the risk curve. Where interest is also going to increase is in the value-add area where there’s an improving occupational market meeting stronger equity. There is much more volume there as well.’

CAPITAL MARKET ALTERNATIVES FAIL TO ATTRACT
The huge amount of equity targeting Europe from Asia and the US is indeed driving investors to move up the risk curve, Patrizia’s Cieleback agreed. ‘But the ongoing compression of prime property yields in Europe is also being driven by the simple fact that alternatives on the capital markets like bonds and equities are generating such low returns at present,’ he argued. ‘In other words, the weight of capital continues to push property yields lower. But what happens if central bank rates and bond yields go up? When will we see the turning point? The longer we stay at this lower level, the question comes up are there bigger challenges in the European financial system that the ECB is not mentioning officially right now that will keep interest rates lower than we would like? I can imagine that the Bank of England and Federal Reserve (US Treasury ed.) may start to move in autumn or some time in 2015, but the question is when will the ECB turn around.’

Another key question is how will the ECB deal with the threat of inflation, Cieleback noted. If the ECB waits too long to raise interest rates, inflation may kick in while the European economy is still struggling. ‘On the one side, inflation could be beneficial for index-linked rental contracts, but if the economy is not on a solid footing, will we see market rental growth coming in? In that case, the challenges will remain and how will the ECB react to that?’

While it is still anyone’s guess when the current low-interest rate environment will turn, one thing is becoming clearer, Cieleback said: ‘Investors need to move up the risk curve just to get a decent return and generate portfolio-level returns on an asset class comparison. Some investors don’t care so much about yields because they’re simply interested in capital preservation, especially in the prime segment of the market. But if the prime segment is already moving, the secondary and tertiary segments will be affected as well.’

Looking for a little higher return with value-add doesn’t necessarily entail a substantial amount of higher risk, he added. ‘Value-add assets may provide opportunities for repositioning, re-letting or reconfiguring some of the buildings that can generate substantially higher returns in a classical buy and hold strategy. But you have to know the market. Going forward, I think asset management and these kinds of activities that form a large part of a traditional real estate business will be the main success drivers for investors in the coming years. You can’t just play the cycle, you have to actively manage the assets you’re working on, otherwise the returns won’t be so satisfying.’

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