Continued weight of money implies greater emphasis
The volume of capital targeting European real estate is running at unprecedented levels. Based on CB Richard Ellis data, total investment market activity last year is estimated to have been about 25% higher than in 2003, with the increase being driven by a broad range of equity and leveraged investors. A number of reasons exist for this increased interest, and although some are a function of cyclical factors, several stem from structural changes in the market.
Increased allocations by European pension funds and insurance companies can be attributed to a reappraisal of the merits of real estate in a multi-asset portfolio, namely a high and stable income return, good overall performance (short and long term), portfolio diversification and its role in asset/liability matching. Greater awareness of these characteristics (and more emphasis on liability matching going forward) has led many institutional fund advisers in Europe to recommend a real estate weighting significantly higher than current levels.
In addition, the real estate capital base has widened, for example, through greater flexibility in loan terms in the private debt market, the emergence in Europe of new instruments, such as commercial mortgage-backed securities (CMBS), and more widespread use of REITs. As a result of this greater capital market sophistication, arbitrage opportunities in real estate can be exploited more quickly, and consequently the liquidity risk premium that investors require has fallen.
Clearly, there has also been a structural change in the level of interest rates since the early 1990s and while this has had an important impact on the real estate market, it is arguably the fall in interest rate volatility that has had a greater influence. Lower volatility has undoubtedly reduced the uncertainty of holding debt by reducing the probability of loan default. As a result the optimal capital structure for households, corporates and governments necessitates a higher debt to equity ratio. Other things being equal, a given level of investor equity buys considerably more real estate than a decade ago.
Similarly, the proliferation and increasing sophistication of investment strategies and vehicles should, in theory, provide a more rational allocation of capital due to better alignment between investors’ objectives and investment strategies. A natural consequence of this is a lower cost of capital and increased availability, and other things being equal, more debt in the market.
At the same time, transparency in the European real estate market is increasing. This has been driven, in part, by the widespread introduction of performance benchmarks, which provide investors with a long-term analytical framework for portfolio appraisal. This has increased the credibility of real estate as an institutional asset class, reduced the risk premium it commands and thereby opened the market to new entrants.
Key to the future performance of real estate is the market’s response to this increased level of interest. The market can accommodate higher capital flows in several ways. First, increased investor demand can drive up real estate prices. This has been a feature of the market for the last few years (see Exhibit 1) but cannot continue indefinitely. Eventually the yield premium of real estate over cash would be insufficient to compensate investors for the additional risk. Nevertheless, scope remains for further yield compression in some markets and sectors over the course of 2005.
In markets with less capacity for further yield compression, capital can be accommodated by increased development activity, by new sectors and locations, or by mainstream assets not now part of the real estate investment market (i.e., corporate and government dispositions or sale-leasebacks). Given the economic growth prospects for Europe, increased development activity is unlikely to be a significant recipient of capital in 2005. With an estimated 70% of European real estate owner-occupied by corporations and governments, the potential for property externalisation to absorb some of the capital targeting real estate is more substantial. Indeed, according to DTZ Research, the European market has seen more than €50bn enter the European real estate investment market in this way over the last five years (Exhibit 2).
Investors have also been targeting new European locations. This is evidenced by increased cross-border investment activity (up 25% last year relative to 2003, according to DTZ Research). Although some of this increase can be attributed to higher acquisition activity from non-European investors there has also been an increase in intra-European activity. Some of this increase stems from scarcity of product and competitive pressures in fully priced domestic markets. Also, investor interest has been spurred by a greater awareness of the benefits of real estate generally, increasing market transparency and unprecedented accessibility through a significant rise in the number of vehicles available to investors. Appetite is varied in terms of country risk: while activity remains focused on developed markets, interest is increasing in emerging countries, particularly those Central European countries newly admitted to the EU (see Exhibit 3).
Non-mainstream sectors will also benefit from increased demand for European real estate in 2005. Call centres, logistics, leisure and self-storage are among those sectors that have emerged over the last few years in Europe. Over the medium term, other sectors (retirement homes and educational property, for example) will come into focus. As they become established and more institutionally accepted as part of the European real estate investment market, yields are likely to fall. To this extent, this class of investment may provide investors with a good opportunity for capital growth in an environment where scope for yield compression is limited.
Despite the significant downward shift in yields over the last couple of years, most parts of the European real estate market remain fairly priced. With the strong capital flows to the sector set to continue this year, it is important that investors price the risks associated with real estate rationally: further yield shift must be linked to an improvement in underlying market fundamentals rather than simply a response to the weight of money targeting the asset class.
In other words, total return expectations should stem from capital growth created by rental increases and active management of real estate. Since at a European level, however, rental growth is expected to be modest this year, real estate performance is unlikely to be as strong as that seen over the last couple of years. By implication, investors seeking to maintain returns at recent levels must place greater emphasis on value-added strategies.