When should investors re-enter the market? Do we need someone to call the bottom or do we need a more fundamental return to stability in the banking sector? Richard Lowe investigates
The volume of global real estate transactions in February 2008 was approximately half of that measured during the same period last year, according to Real Capital Analytics. In its latest Global Capital Trends report, the real estate research company reveals that Germany, the US, Canada and Australia have all seen property sales drop by more than 70% in the first two months of the year compared with the same period in 2007. And the decline in sales affects all sectors with the exception of developable land, and with offices being affected the most.
Robin Priest, partner at Deloitte, describes the European markets as experiencing a current hiatus in activity. He says: "The overall picture is that while there is still foreign money coming into Europe, it is much more selective and it is down in volume, because the general trend is people believe the markets are moving towards them as buyers rather than away from them."
Nowhere is this more marked than in the UK where asset prices have corrected significantly since the summer of 2007, and investors are beginning to see the potential investment opportunities at attractive prices. "Clearly, values are generally still falling," Priest says. "That means yields are still rising, which means that quite a lot of investors have continued to sit on the sidelines and say: if the market is moving towards me, why should I come in now?"
The big question concerning the UK real estate market is, when will the market bottom out, so investors can stop sitting on their hands and jump back in?
Priest believes prices still have the potential to drop a further 15-20% and that the current downturn could last all year.
Michael Clarke, head of property distribution at Schroder PIM, believes the market will bottom out in the latter half of 2008. He says that values in the UK are "probably at or around fair value" already, but this of course doesn't take into account the fact that market swings always over-correct, both on the upside and the downside, meaning values have further to fall before stabilising.
Both of Schroder Property's existing funds are "tending to buy opportunistically", says Clarke. And, of course, the fund manager is one of a number of market players raising capital for a UK opportunity fund with which to re-enter the UK market when the time is right.
Clarke believes investors are looking to take alternative approaches in the current environment. Some see "retrenching back into core" as the most advisable, given its defensive nature and ability to generate income. But Clarke believes that more institutional investors are focusing on opportunistic strategies that allow them to "buy into the weakness and exploit other people's discomfort". He says: "Out of the two schools of thought, the opportunistic strategy is the one that is taking precedence."
Of course, a number of investors have already taken the plunge and re-entered the UK market and these are not necessarily opportunistic investors. German open-ended funds have reportedly already purchased over £500m (€626m) of London office assets in the first quarter of 2008.
"The non-UK investors are continuing to invest in the market," Priest says. "The German funds have already come in. They have a particular tax advantage and they have a funding advantage. You still have sovereign wealth funds with lots of money, selectively buying. But it's pretty patchy generally.
"The general picture in the UK is that some investors have come back in, more are watching and I would expect more to come in the second half of the year as value returns."
The buyers who definitely are not active are those that have traditionally relied on securing debt for investments. Today, equity-rich investors such as pension funds find they have a lot more room in markets in the absence of their highly leveraged counterparts.
Real Capital Analytics' latest report suggests that while the credit crunch is impacting transactions globally, the countries that are being affected most severely are those that rely on commercial mortgage-backed securities (CMBS). In the UK CMBS issuance had been increasing in recent years, accounting for 18% of sales in 2007. CMBS issuance on a global basis has "almost completely stalled", the report says, with only $6.1bn (€3.84bn) of issuance in the first quarter of 2008, compared with $81.2bn over the same period last year.
The report suggests that the credit market problems will continue to weigh on real estate markets for at least another quarter. Yet, despite the scarcity of debt and the limiting effect this is having on transactional activity, the report makes the point that "equity capital remains plentiful and investors are re-calibrating their strategies".
"The market is moving back towards traditional investors and away from the highly geared investors," Priest says. "It is back to the fundamental principles of asset management, stock selection, working the properties, which suits a lot of traditional investors. They could not compete with the leveraged players for the last few years, but are now back and competitive, because they have money and are not debt-dependent in the same way."
Stephen Barter, group projects developer at Grosvenor Group and UK chairman of the Urban Land Institute, says: "You are going to see a different composition of buyers. You are going to see significant changes in pricing and deals that in the short to medium term have to be financed with substantially greater levels of equity than we have seen in the past five years."
Barter remembers how the German open-ended funds entered the UK market earlier than many other investors following the last UK property downturn in the 1990s and "did very well" as a result.
"It is the all-equity funds that are able to accept quite low rates of initial income return and total return, because of the way they are financed. It is the longer-term, all-equity investors who are prepared to accept lower total returns, who will feel more comfortable coming in. Those who rely more on debt financing and shorter-term trading of transactions and investments will be more reluctant."
Menno Maas, chief executive of development at ING Real Estate, also believes the make-up of the investor base over the foreseeable future will look very different to a year or two years ago.
"Maybe we see some outflows from investors, but at the same time in a lot of markets you see an inflow," he says. "What I see in the development business is all those short-term investors like private equity investors, hedge funds, etc, who wanted to jump on the wave of good results, are going out. But when you look to the long-term investors, from pension funds, insurance companies and money from the East, you see those long-term investors are very interested to invest in real estate."
An area to watch in the UK is the position domestic institutions take given the current activity coming from foreign investors. "There will undoubtedly be some attractive opportunities in the UK real estate market once stability returns, given values will be 20-30% lower than they were last summer," Barter says. "It will be interesting therefore to see how far the UK domestic institutions respond to that, given that quite a few international players will be looking to take advantage of lower prices."
Certainly, there has been some activity from UK pension funds. For example, the £13.8bn BP pension fund has launched a joint venture with Great Portland Estates to gain access to central London property assets by investing funds gained from the sale of its £540m Knightsbridge commercial and retail property portfolio to Quinlan in 2005.
Also, the £30bn Universities Superannuation Scheme has shifted from being a net seller of UK properties over the last 18 months, offloading assets worth approximately £900m to a potential buyer of UK assets and has recently acquired a shopping centre in Kingston-upon-Thames.
However, transaction volumes are still relatively low. For the time being there is little in the way of an incentive for the majority of investors to commit capital, Barter believes, given the potential for further valuation slides and the wider uncertainty and negative sentiment in the global markets.
What needs to happen then before investors begin to re-emerge from the sidelines and start committing capital again? "Somebody needs to call the bottom," Priest offers.
There will generally - when you look back at market trends - be a moment when a particular deal or type of deal happens and people generally start saying ‘if that's happening then we must be either at or close to the bottom, it is time to get back in'.
"Markets are more sentiment-driven than reality-driven, so it is looking for that defining moment that hasn't come yet. Personally, I don't think it is in the next three months, because I think there is a lot more bad news coming."
However, Barter believes the market needs to see the return of stability before an investor is going to make the first major step to call the bottom of the market.
"As each day passes there is still more uncertainty," he explains. "It is making it very difficult for investors to judge. It is pretty clear that when it does stabilise and there is more certainty, investors will come back in, not least because the pricing will be different. But it is worth exploring exactly the sort of conditions that are needed in order for investors to feel comfortable to come back in."
Barter believes investor appetite for real estate has not changed, because the current crisis is not about the fundamental characteristics of real estate but rather it is a case of "the banking market finding its presumptions of the last five years completely destroyed". The market is therefore suffering a "crisis of confidence" which has little to do with the underlying principles of real estate.
Barter admits that the real estate market was looking overvalued prior to the credit crunch and "had started to correct itself in the summer", but he believes the banking crisis has been the equivalent of a "power cut for transactions".
Therefore, it could be that a return to stability in the banking sector is a pre-requisite for investors to return to the market with confidence.
"Until stability returns and the availability of finance returns (property markets are much more sensitive to the availability of financing rather than necessarily its price) a lot of people are going to be cautious about coming back, because they won't be sure they have seen the bottom," Barter says.
"There is still more bad news to come and there will be a lot of uncertainty through the summer. I think it will take an international agreement between central banks and governments to reassure markets that banks can lend to each other again. That will take some time to achieve.
"The good news is there is a strong supply of equity and there is not a debt crisis as we had in the 1990s, where banks were over-lent on speculative development. The percentage of banks lending to the real estate sector as a percentage of total lending is within manageable limits and there is a good supply of equity available when confidence returns."