Investors survey wider horizons
Most European investors have prepared their stock and bond investment strategies for the impact of the euro. This is not the case for property investments. The consequences for property of the introduction of a single currency in Euroland have not yet been thoroughly absorbed.
The main impacts of the euro are a transformation of the economic environment and the creation of an economic block larger than the sum of the individual countries.
For continental European investors the merit of investing in property has been as a hedge against inflation and for its risk/return characteristics, which are different from those of stocks and bonds. Property as an asset class has been a relatively good diversifier in the asset mix.
In Euroland the inflation hedge argument will change. The overall average inflation will decrease in Euroland because of strict public finance controls. For historically low long-term inflation countries like the Netherlands and Germany the new inflation level might well be above the past level. For southern European countries this will certainly be lower. The diversifier argument for property is based on the inflation risk as well as performance that is better than on government bonds but lower than on stocks and at the same time a relatively low and stable risk profile.
For institutional property investors two markets are always of importance: the tenant or occupier market and the investor market. The euro will have the following long-term economic impacts: a larger home market, lower costs of capital due to lower interest rate, price transparency, increasing competition and improved efficiency.
Countries that already have favourable business conditions in terms of labour flexibility, tax and bureaucracy – Ireland and the Netherlands, for example – will have a competitive advantage within Euroland.
More specifically, the economic growth effect of the euro will be largest in sectors with homogeneous products/services that already operate on an international scale. This means that rental increases and reduced covenant risk can be awaited in these industries.
An example of an industry that will benefit more than average is the logistics sector. The larger home market, the reduced costs and the increased potential of electronic commerce will cause an additional demand for logistic space. But only locations with suitable facilities (road, rail, air and water transport) will benefit.
Euroland as an important economic block will attract new institutional property investors from the US, Asia and the UK. On the other hand Euroland investors will see their home market increasing as well and have to decide on a new investment strategy.
For their present home market most professional property investors apply return hurdle rates consisting of the risk-free rate of return (10-year government bonds) and a risk premium for property risk. Although the risk-free rate of return will be the same throughout Euroland, it is essential to apply different risk premiums.
For each individual country in Euroland the risk on property returns is still very different. Entrance and exit barriers still vary a lot. Taxes, such as transfer tax, capital gains tax and tax-exemption possibilities for pension funds, are an extremely important issue. Legal, agency and other property transaction costs differ as well. Tax efficient vehicles for non-domestic investors exist in the Netherlands, Luxembourg and Germany. Measurability of property returns varies from country to country. In only a few countries is a recognised real estate index available. The same applies to sufficient transparency.
The replicability of property returns – can one replicate as a foreign investor the risk/ return profile of a home investor – depends on market capitalisation of the property investment market and the existence of indirect instruments. Only Germany, France and the Netherlands have an acceptable level of market capitalisation, mainly because of the presence of mature institutional investors. For the remaining countries an additional risk premium should be applied.
Lease structures, an important element of income risk, differ all over Euroland. In Belgium and France the three, six and nine-year leases are landlord-unfriendly and require an additional risk premium. All leases in Euroland are indexed to inflation – mostly consumer price inflation. For some countries the danger exists that cost inflation is higher than consumer price indexation.
Interest sensitivity, an important risk issue, differs a lot in Europe. In the Netherlands, Germany and France credit facilities are made up of approximately 40% variable interest rate loans and 60% fixed interest rate loans, where in all other countries the share of variable interest loans is 75% or even more.
The national hurdle rates should be employed for direct property investments as well as for indirect investment vehicles like funds. Hurdle rates have to be set off against the expected returns and opportunities. Opportunities are present in southern Europe retail where deferred consumer demand still exists. For office property the Netherlands, Belgium and Germany are of interest. For residential the Netherlands and for logistics, a segment of industrial, the Netherlands and Germany is quite attractive.
Not adapting a Euroland investment strategy by focusing on the existing home country will ultimately increase the portfolio risk in comparison with the market risk. For UK property investors this applies even more. At present the general perception is that their currency is overvalued to the euro. By diversifying now they can buy relatively cheaply.
To implement a direct Euroland property investment strategy it is essential to make use of reliable local knowledge and experience of independent property investment managers. For smaller investors the key to success is to find a tax-efficient, pan-European, sector-specific investment vehicle. For this reason Celexa is setting up a pan-European logistic and distribution fund. This segment, undervalued in most institutional portfolios, has a good economic perspective and enjoys a relatively high direct return.
Nico Tates is managing director of Celexa in Amsterdam