European real estate faces many challenges: regulation, lending, uncertainty and obsolescence; meanwhile the repositioning of secondary assets may provide significant opportunities. Christian Schulte Eistrup and Nigel Alsopp report
Three years after the global financial crisis hit, real estate faces as many headwinds as ever. Although the banking system has been brought back from the brink, obtaining finance is difficult, investors are risk averse as ever and there is regulatory reform on the horizon. In spite of all this, there may be opportunity in adversity.
Much has been said about the regulatory challenges facing the real estate sector. If the proposed European Market Infrastructure Regulation is applied to genuine hedging transactions, as opposed to speculative transactions, this will create a disincentive to hedge interest rate and/or currency risk. The Alternative Investment Fund Manager Directive will create another layer of red tape, but stands to provide a competitive advantage to more established firms already pursuing best practice, and streamline cross-border marketing via EU-wide passporting.
In recent months, the real estate sector has focused on Solvency II. To many in the industry the proposed capital charge of 25% on real estate is punitive. A recent IPD study concludes that it should be nearer 15%. Solvency II's treatment of leverage is perhaps its most controversial aspect, with leveraged real estate (irrespective of amount of leverage) attracting a 49% capital charge. This may encourage an ‘all or nothing' approach to leverage, hardly commensurate with promoting financial market stability.
Capital costs aside, real estate offers strong cash-flow characteristics and adds diversification to a portfolio. Insurers seeking exposure to real estate type returns, but without the high capital charge, might target a form of regulatory arbitrage via real estate debt.
While the change in capital requirements will undoubtedly affect allocations, this is only half the story. The accounting basis for insurance company liabilities will change under Solvency II from ‘prudent' to ‘best estimate'. This is a significant change that in many cases will reduce insurer liabilities, increase shareholder equity and partially offset additional capital requirements.
The impact of Solvency II on insurers will vary by country. A recent study found that today 15% of European insurers would fail the solvency test, with as many as 20% of UK insurers and as few as 10% of German insurers failing the same test. It was originally hoped that the directive would coincide with the harmonisation of accounting standards. However, unlisted European insurers have yet to adopt International Financial Reporting Standards (IFRS) and still use national accounting standards, with significant differences between jurisdictions.
Furthermore, many insurers with the relevant internal capacity will seek regulatory approval to use internal models, shunning the standard model. Given the differences in accounting treatment and modelling, it is not clear if the directive will necessarily bring the insurance sector to a level playing field in the short term.
Since the Great Depression, 32 of 33 major financial crises have resulted in economy-wide deleveraging. Given the banking system's exposure to commercial real estate, the withdrawal of credit from the sector appears inevitable. Basel III is simply another reason for banks to reduce exposure to commercial real estate.
The slow and painful process of deleveraging is finally underway. Gross lending to commercial real estate in the UK fell by nearly a quarter to £34bn last year, £14bn of which was loan extensions. This compares with £105bn due for payment over the next two years. As lenders become selective, refinancing prime assets and well-let or ‘fixable' secondary assets will be more realistic than those dependent on optimism and market recovery.
Prime lending terms remain tight across Europe, although they vary across key markets. Typical margins for mainstream transactions are 140bps in Germany, 150bps in France, 215bps in the UK and 325bps in Spain. While the European securitisation market might reopen with the expected Chiswick Park CMBS in three tranches, the triple-A pricing at 175-200bps over LIBOR is a long way from the 12-15bps seen a few years ago.
Germany's covered bond market continues to thrive and Pfandbrief banks took a 20% market share of UK senior lending in the first half of 2010. Interestingly, many European insurers appear interested in property lending due to favourable risk-return characteristics and lower capital charges under Solvency II. In the UK, Aviva has been active since the 1980s, and others look to follow suit. AXA intends to commit €1.5bn, M&G and Allianz are active, and Legal & General and Henderson Global Investors are looking to establish lending businesses.
Since the crisis began, the proportion of institutional investors preferring core real estate has increased thirteen-fold from 5% in 2008 to 65% in 2011. Accordingly, prime real estate has witnessed the sharpest recovery on record. Surprisingly, this has had no material effect on institutional investors' target rate of returns.
Prime office yields in London's West End fell by a record 100bps during 2009 and again in 2010. Similarly, prime office yields in Paris CBD fell at a record 75bps last year. These core markets are regarded as safe havens, yet the resultant prime yield movement makes total returns and capital values there highly volatile in the European context. The recent flight to core by many investors might not amount to the intended flight to safety.
Notwithstanding the recovery in global capital markets, risk spreads are extremely high for commercial real estate; both the spread of secondary yields over prime yields and the spread of mezzanine loan margins over senior debt margins are historically high. In some markets, the scale of the debt funding gap might prove insurmountable - Ireland and Spain are cases in point. However, there will be opportunities to transform secondary assets, acquired at reasonable yields, into core quality assets and consequently attract better tenants and show capital value growth.
The supply-side fundamentals in many European core markets remain supportive of rental growth. As development reaches a cyclical low, the supply of new stock fails to keep pace with depreciation in many markets. For example, 2-3% of Central London office stock will become obsolete over the next three years, even taking into account new supply. In Central Paris, 2-3% of office stock will become obsolete by 2016.
However, this is part of a trend, as depreciation has outstripped new supply in 18 of the last 19 years. In this environment, which is mirrored to different degrees across Europe, the well-timed manufacture of modern stock through refurbishment and redevelopment can be attractive for occupiers and landlords alike.
Although creating challenges, regulation should not prove insurmountable. There is some misunderstanding around Solvency II, and a more holistic view of insurers' balance sheets might find some cause for hope. While Basel III will further limit bank lending to real estate, Solvency II might encourage insurers to help bridge the funding gap. For investors, pricing is still opportunistic in some markets and there will be good assets that just require refinancing. An unprecedented fall in lending has also led to much reduced development activity.
Given strong demand for prime assets in occupational and investment markets, there will be opportunities to reposition secondary assets.
Christian Schulte Eistrup is managing director, capital markets - Europe at MGPA. Nigel Allsopp is a capital markets associate at MGPA