Europe's recovery in core markets is benefiting from strong overseas demand but local investors are showing more interest in other regions, as Gail Moss reports

Europe's property market is now emerging, bloody but unbowed, from the wreckage of the financial crash. However, there is a catch.

One of the changes since the market peaked in 2007 is the pivotal role now being played by the banks. In Germany and the UK - two of the region's biggest markets - much of the commercial stock is owned by the banking sector.

And in France, the third main market, lending to investors has been restricted, but with different consequences in each country.

"Post-crisis, there's a new landscape in the French property market," says Antonin Prade, head of real estate research, UFG-LFP. "First, there is no debt any more for risk strategies. Transactional volumes are one-third of those at the 2007 peak, and this matches the gap in available debt. The average LTV in 2007 was 75% - now it is 30%."

There is still the same amount of equity available, according to Prade, but now it is targeting different strategies, namely core assets.

"We are still seeing a very good appetite for real estate from long-term investors such as pension funds, especially the French, Germans and Dutch," says Prade. "But the US private equity firms have almost all left the market, along with the Spanish and Irish."
Even so, all this means that some markets, especially the Paris office market, are doing well.

"There were no new tenants for prime assets in the Paris central business district in the second half of 2009, and yields were standing at 6% to 6.25%," says Prade. "Now, because France is in a strong recovery, the letting market is doing better, with yields running at 4.50 to 4.75%."

Prade points to a two-speed market, both in offices and retail, with yields on prime assets in the top cities - Lyon, Lille, Marseille and Toulouse, in addition to Paris - coming in, while secondary cities, such as Rennes, Nancy and Grenoble, are lagging behind.

Apart from the perceived inferior locations, this is caused by the amount of development land available.

"There is no room in Paris, but there is land for new building in Rennes," says Prade. "A new-build let to a public tenant can command a 7%-plus yield. This is a very high return because of the built-in risk premium against the tenant moving out and leaving you with 10,000m2 to fill."

Notable transactions in last year's regional new-build office market were 14,400m2 in Lille bought by Assurances du Crédit Mutuel for €45m, and 10,000m2 in Marseille's second arrondissement, bought by Caisse d'Epargne Provence Alpes Corse for €39m.
But ageing buildings that do not comply with regulatory standards are still a problem.
"Improving the conservation of energy, for example, will require capital expenditure and I am not sure this has been 100% factored into the value of existing portfolios," says Prade.

Over the next 12 months, he expects the recovery in the office letting market to continue, with yields stabilising or even going up.

"Interest rates are rising in Europe because of inflation fears," he says. "For instance, 10-year French bonds have gone up 70bps to 3.50 over the past six to nine months. But I don't see real estate investors accepting a shrinking of the premium over risk-free returns. However, this won't lead to lower returns - what you lose in capital you make up in increasing indexed rents."

Like France, the UK is also experiencing a two-speed story, according to Jos Short, founding partner and executive chairman of Internos Real Investors.

But rather than first versus second division cities, it is London and the South East versus the rest.

"Central London has regained about half the 40% of value it lost during the crash, and yields are still firming," says Short. "But the regional centres are difficult. The banks own a lot of property and aren't lending there so much, so yields are drifting out."

Unlike France, however, this significant involvement by the banks has led to new financing opportunities for investors. Banks repossessing properties from bankrupt borrowers may then offer the properties with a large slice of debt financing "stapled" to the property.

"Whereas previously a borrower might only have been able to get, say, 60% LTV, staple debt can offer them up to 90%," says Short. "However, the properties concerned may need a lot of money spending on them."

"Central London offices have, over the last 18 months or so, become very popular," agrees Douglas Crawshaw, senior investment consultant at Towers Watson. "Investors want stability and have been looking for trophy-type buildings, with long-term stable cash flows. After London, they may also look at other major cities like Birmingham, but London and the South East are considered to be the safest locations."

And even cities lower down the rankings can offer investment opportunities, he says.

"A good secondary location, such as a prime pitch in a secondary city, may be attractive to a core-plus-style investor willing to tolerate slightly more risk than a comparable pitch in London," he says.

But investors are still uncertain about the provinces, especially in retail. Crawshaw says: "The sector has been slightly more stable, but following some high-profile tenant failures, people are now nervous about this sector, especially given the current economy."

In the industrial sector, he says investors appear to be focusing on multi-let estates, as they represent a more diversified asset and hence income stream than a single building such as a big distribution warehouse.

The total return from commercial property was 9.9% for the 12 months to 30 April 2011, with the office sector at 10.5% shading retail, at 9.8%, according to the Investment Property Databank (IPD).

Meanwhile, Germany's economy is powering ahead, sucking in labour and expected to grow by 4-5% over the next five years.

Particularly appealing to income investors, German property made a total return of 4.2% over the 12 months to 31 December 2010, with an income return of 5.1%, and a small capital loss (0.9%), according to IPD. Retail performed noticeably better than offices, posting a 5.4% total return compared with 3.1%.

"This makes it attractive to core investors," says Short. "Furthermore, its central European neighbours will also benefit."

Outside the three main markets, investors looking for other core assets are likely to opt for the major northern European cities, or even the Nordic countries and the Netherlands.

Less risk-averse investors might look at Poland, a strategic location within Europe, at the heart of the main trade routes.

"Meanwhile, there is a degree of nervousness about southern Europe, such as Portugal and Greece, so there may be some opportunities in those countries for those investors able to fully understand the risks there," says Crawshaw.

Overall, foreign capital is continuing to flow into Europe.

"The unrest in the Middle East has exacerbated the demand for prime, well-built structures in capital cities with decent covenants, with capital from Saudi Arabia and neighbouring countries looking for high-quality buildings in London, Paris and Munich," says Short.

But he does not see a ripple effect throughout the wider property market.

"Global investors look at cities, rather than countries," he says. "So they're not going to be heading for Edinburgh and Leeds."

But on the whole, Short says even European property investors seem to prefer other parts of the world to their own backyard, at present.

"The region is seen as having a benign but low-growth economy, which pushes it into third place behind Asia and the US, which are attracting more global capital from the big European institutions," he says.

"And even more high-risk locations such as Brazil and Mexico might be considered more interesting."