Growth buoys European market
The economic picture is looking bright for Europe. Last year’s slowdown was not as bad as initially expected, because of strong world economic growth. Expectations for this year’s GDP growth figures in European countries have been constantly revised upwards during 1999. Europe is now expected to fire on all cylinders, which will make 2000 a good start to the new millennium (see Figure 1). This rosy picture has been reinforced in the past few months by indications of an ever-strong American economy and a recovering Japan. One of the indications of strong economic growth is that industrial and consumer confidence are no longer developing in opposite directions, they are again moving in parallel as has historically been the case (see Figure 2). Also, consumer confidence is higher than it has been at any time in the past decade.
There are now many reasons to expect not only that this year will show good economic growth, but that the next decade will also be better than the last. One reason is that the Maastricht criteria enforced sound government finances across Europe. Compliance with Maastricht has been a drag on economic growth, but this effect has now passed. Another reason is that the 1990s saw a wave of deregulation of inflexible economic structures, which will not only continue at full speed in the next decade, but will also produce the positive effects on economic growth that were intended. This process will be enhanced by increased price transparency with the introduction of the euro. In other words, Europe is on the road to becoming more competitive, which is good for economic growth. Optimists are even saying that Europe will catch up with the US, as the size of its GDP is comparable, but GDP per capita is still about 30% lower in Europe.
The 1990s started with trouble ahead in European real estate markets, especially in the office sector. At the start of the decade construction was booming, while demand for space was heading for the doldrums because of the approaching world economic recession. Vacancy rates shot up and reached their highest levels for most real estate markets in the first half of the 1990s. Speculative development got hit badly, and with it the banking sector, which had so enthusiastically supported the boom.
The situation at the start of the new millennium is completely different. Real estate markets are settling down and recovering from the difficult times in the past decade. Vacancy rates have peaked, and are now at much lower levels. Speculative development is cautiously returning, but with little backing from bank lending and mostly under the condition of a substantial pre-let. Initial yields presently are at the level of 10-year interest rates or higher, while at the beginning of the 1990s initial yields were (in some instances much) lower than 10-year interest rates around Europe. In other words, from an investment point of view, real estate markets are more attractive now than they were at the beginning of the past decade.
If there is one thing that became painfully clear in the 1990s, it is that bank loans are not a suitable form of finance for the real estate market. In the US the capital market quickly took over this role from the banks. The real estate investment trust (REIT) market ballooned in size from around e10bn to about e120bn in one decade. The indirect real estate market in Europe is quite different from the REIT market in the US, because there are many different vehicles available, including open and closed end funds, tax transparent and corporation tax liable structures. The entire market grew from roughly e25bn to more than e100bn during the 1990s.
But this is not the only thing that has changed. The poor performance of real estate at the beginning of the 1990s generated a debate concerning property investment, looking for the causes of what went wrong and appropriate remedies. The general conclusion was that real estate should be more professionally managed, similarly to other financial assets. Property investment management attracted attention and quickly became a recognised industry across Europe. The tremendous growth of the indirect market is one example of this phenomenon, but real estate portfolios of pension funds and insurance companies were also put at arm’s length into investment management companies. The same has been happening in the corporate real estate world. In the second half of the 1990s merger and acquisition activity was seen in the property investment management industry consolidating small players into larger national ones or creating cross-border investment management companies, some with super-regional or even worldwide coverage. The 1990s changed the face of property investment management for good.
Real estate is a separate asset class to equities and bonds. The late cycle performance and low volatility of returns are factors often mentioned by institutional investors for their weighting in this asset class. These factors have not changed much over the years. The weighting has, however. The very good performance of stock and bond markets around the world caused a relative derating of the real estate sector and so reduced the weighting of real estate in institutional portfolios around Europe. Confronted with these lower weightings, institutional investors are repositioning real estate investments again in their asset mix.
At this point in time real estate is becoming more and more attractive due to its direct returns. At the beginning of the 1990s 10-year interest rates in Europe ranged from 8 to 11%, while at the moment these rates range from 5 to 6%. Initial yields on real estate (retail, offices and industrial) in various local markets in the major countries in Europe are at roughly the same level now as they were then. These yields are now around or above present 10-year interest rate levels. Whereas interest levels fell by 300 to 500 basis points, initial yields across the real estate sectors and markets generally stayed the same. However, rental growth prospects are much better now than at the beginning of the 1990s. An investment in real estate now clearly competes with bonds, because with real estate investments cash flow growth can again be realised, while that is not possible with a standard bond investment.
Looking ahead to the coming decade, the main theme for property investment will be higher weightings of real estate by institutional investors and an ongoing professionalisation of the property investment management industry. Higher weightings will be the outcome of a repositioning of real estate in the asset mix. Clearly real estate has become more attractive in the 1990s compared to other asset classes, while at the same time it is seen as an excellent diversifier in an asset mix. The professionalisation of the property investment industry will provide for more choice in real estate products. The quoted real estate sector has already grown tremendously in the 1990s and this growth does not seem to be slowing. The non-quoted real estate sector will follow, with a range of real estate investment products to meet the needs of institutional investors for diversification into this asset class. At the end of the decade institutional investors will be able to allocate within real estate in the sector and country of their choice. Segregated accounts, non-quoted specialised real estate pools and maybe even index products will accommodate this.
Wim Fieggen is head of European research at RoProperty Investment Management
Sources: BVI Bundesverband Deutscher Investment Gesellschaften, Consensus Forecasts, Datastream, Salomon Smith Barney, RoProperty Investment Management database of European real estate data