Faced with a desire for more control, Solvency II pressures and an attractive domestic office market, French investors are focusing on their home market. Richard Lowe investigates
French institutional investors have long been big players in their domestic real estate market. Despite there being a gradual move towards international diversification, the global downturn has set minds firmly on the core French market at the moment. It is a recent trend that has been played throughout Europe, but in France institutional investors have one of the most attractive and liquid markets in Europe. "Their market has behaved relatively well compared to many other European markets," says Mahdi Mokrane, head of research and strategy at AEW Europe.
"However, they are keenly aware that international diversification had helped their stocks and bonds portfolios, had probably helped their private equity portfolios, and could potentially help their real estate exposure."
If the French market is an attractive proposition to institutional investors, equally, Mokrane says, greater international investment is being prevented by a desire for liquidity and control of investments - two things less associated with international real estate funds - and an aversion to high levels of leverage - an aspect now synonymous with a breed of funds during the recent past.
Another issue is Solvency II. The French institutional universe is dominated by insurance companies given the small proportion of pension funds compared with other European countries. New regulations which come into effect in 2012, but continue to be subject to alteration, could have significant repercussions on the investment strategies of insurance companies and thus their appetite for real estate.
Insurance companies will need to hold different levels of capital reserves for all of their investments depending on the risks, with more reserve capital for equities and less for bonds. Direct real estate is somewhere in between and requires enough capital to cover a 25% investment loss. Listed real estate investments are counted as equities, while investments using leverage will incur greater capital costs.
Pascal Aujoux, head of transactions at AXA Real Estate Investment Managers France, says the regulations look to be "more or less neutral" on real estate, although the full ramifications of the ever-changing rules is uncertain.
"If you say that, in the first instance, bonds are going to be privileged due to the Solvency II ratios, then real estate might make sense because it is negatively correlated to bonds and it therefore reduces your capital requirements if you add real estate to a bond portfolio," he adds. "Bonds might represent 80% of the total assets, so it does make sense to diversify and reduce the risk by adding real estate to your portfolio if you are an insurance company."
Insurance companies with high allocations to real estate could possibly find they need to reduce their weighting as a result of Solvency II. That said, many are below target allocations and are likely, therefore, to be net-buyers or real estate, despite the incoming regulations.
Generali France, the French subsidiary of Italian group Generali, has €1.5-2bn to spend on French real estate over the next three years, according to Philippe Depoux, head of Generali France Immobilier. Depoux says both he and the Generali group are positive on the French market from a global perspective.
Depoux agrees that nothing certain can be concluded about Solvency II, but he does believe it will have fairly positive implications for core, non-leveraged real estate investments. However, the regulation is likely to dampen interest from insurance companies for listed real estate, which will be treated like equities, and even international funds that use leverage will be less. Generali France's real estate portfolio has a 10% weighting to French SIICs, the country's equivalent of REITs. As well as a desire to have more control over the underlying real estate, Generali France will not be making more SIIC investments.
In terms of the direct French market, which is where French institutions are most comfortable, most have a strong appetite for assets in segments of the market that are perceived as most liquid, namely, core offices in central Paris. However, widespread interest in this sub-sector and a lack of product coming onto the market has led yields to compress significantly.
"They have the conviction that mid-sized offices in the central Paris market is a relatively liquid sub-section of their real estate exposure, and more liquid than other segments, such as large shopping centres, large office towers, logistics platforms or hotels," Mokrane says.
This desire for liquid assets is based on the experience of institutions which struggled during the downturn to sell other types of assets when looking to free up equity. "It is fresh in the memory and these institutions want to have a part of their investment in what is perceived as the most liquid segments. That is what they are looking for, but there is actually a lack of product in those markets, which has actually sharpened yields in those specific markets," Mokrane says.
Offices account for just over 50% of Generali France's real estate portfolio, and Depoux says the portfolio is well diversified across the sectors. For future investments, Generali France is looking at prime offices with secure, long leases, and particularly those with sustainable credentials (or the capacity to make the more sustainable). "This means focusing on the Paris area and more mature markets," Depoux says.
Perhaps more surprisingly, Generali France is also looking for "risky developments", because the organisation has a strong conviction that the office market will face a scarcity of modern green space in 2013, given the halt in new construction in recent months and years. "It's probably time to look at those types of assets when the market is not very hungry to take them and developers are a little bit desperate to sell."
French institutional investors sold out of residential investments over the past 15 years, but the stability of the asset class during the downturn has prompted some to think again about this policy. "Investors that held substantial proportions of residential within their portfolios have seen how resilient that asset class is. So there is increased interest for residential," Mokrane says. However, he also says it can be a challenge to access the residential sector, so interest has not necessarily translated into investment.
"We are considering re-entering this market," Depoux says, but this is predicated on capital values coming down. "Prices are too high at the moment but we are considering reinvesting in that market. We are considering this in terms of demographics and structural evolution in France. We will face scarcity of residential for rent in the next decade."