Market view: liquid refreshment
Two of the most significant trends in the European commercial real estate investment market over the last few years have been:
n The narrowing of the yield gap between the largest western European markets and those in the rest of Europe; and
n The growth in turnover of the market.
The fall in the yield premium between the leading western European cities and the main central and eastern European (CEE) capital cities has been particularly obvious.
As figure 1 shows, in the last five years the average1 of the prime office yields in London, Paris, Madrid, Milan and Frankfurt (EU-5) has fallen by 125 basis points (from 5.75% to 4.50%), whereas over the same period the average of the prime yields in the main CEE capitals (Warsaw, Prague and Budapest) has fallen by 355 basis points (from 9.4% to 5.8%); and if Bucharest and Sofia are included the fall in prime office yields is even more marked.
In contrast to this, there has been no convergence between the yields in the EU-5 and the average yield in the capitals of the remaining 10 western European countries. This ‘EU-10' yield has fallen by just 123 basis points (from 6.6% to 5.3%, almost exactly in line with the fall in EU-5).
The five-year trend in yields needs to be viewed in the context of the growth in turnover of the direct real estate investment market in Europe.
In 2001, the turnover of the direct investment market in Europe was around €75bn. This compares with a turnover of around €235bn in 2006.
More importantly, this enormous growth in the size of the ‘pie' has coincided with a substantial change in its make-up. In 2001 more than half of market turnover was in the UK, with much of the remainder being in the next most liquid markets; France, Germany and Sweden. In 2006 the UK represented only around a third of total market turnover.
In absolute terms the increase in liquidity is even more dramatic. Eleven countries (UK, Germany, France, Sweden, Norway, Netherlands, Italy, Spain, Belgium, Finland and Poland) generated investment market turnover in excess of €4bn.
In 2001 only three countries (UK, France and Germany) would have passed this hurdle. The increase in investment activity in the CEE has been particularly notable. In 2001 institutional investment activity in the whole CEE area was less than €0.5bn, a total which had grown to nearly €9.5bn by 2006. The turnover of the Polish market alone in 2006 had grown to €4.5bn.
The change in liquidity is important to market pricing. Previous research (such as that by Tony Key of Cass Business School) has suggested that investor returns are systematically lower in the most liquid markets.
This finding implies that investors are highly sensitive to liquidity risk and that they have paid higher prices - on a risk adjusted basis - for certain types of investment opportunity (for example, offices in major capital cities) to reflect this preference for liquidity.
The growth in liquidity in the CEE investment markets, therefore, may go some way to explaining the convergence in yields with western European cities.
A much more convincing explanation of the convergence in yields between western and central Europe is the change in the political risk profile over the last five years.
The last five years have seen Poland, Hungary and the Czech Republic move from just being candidates for EU entry to confirming the timetable for entry in 2003 and then completing entry in May 2004. This has undoubtedly had a significant impact on the perception of the political risk that the potential real estate investor faces.
Although Austria, Finland and Sweden did not join the EU until 1995 none had a recent history of political instability. Therefore the last comparable entry to the EU was that of Spain and Portugal in 1986, both of which became democracies only in the late 1970s. Spain and Portugal are also a good match in economic terms for the main CEE countries. The population of Spain is roughly the same as that of Poland and both Hungary and the Czech Republic have populations similar to that of Portugal. GDP per head was also substantially lower than the EU average in Spain and Portugal prior to accession.
Following their EU entry (see figure 2) there was substantial convergence in prime office yields with existing EU members. In the five years immediately after EU entry the average prime office yield in Madrid, Barcelona and Lisbon fell by 442 basis points (from 11.1% to 6.7%) compared with a fall of just 13 basis points in the average for London, Paris, Milan and Frankfurt (from 5.4% to 5.3%).
It is an interesting comment on the accelerated nature of the property market that 20 years on, the convergence between the CEE markets and western Europe began well before entry was confirmed, rather than after, as was the case with Spain and Portugal. This also raises the question of whether this yield convergence has happened too quickly and investors are taking on risk that they are not being compensated for.
The potential for instability was well illustrated in Hungary in September 2006 when comments by the prime minister about the recent election campaign led to violent protests in Budapest. However, it was also interesting to note that the impact on the currency and the stock market was quite small.
everal conclusions seem evident from this analysis.
Firstly, with regard to the 2004 entrants to the EU it is hard to see scope for any further convergence in yields with the largest western European cities.
The premium that they offer relative to the five largest EU countries is already smaller than that for Spain and Portugal five years after their entry.
The 2007 entrants to the EU (Bulgaria and Romania) still offer a significant yield premium over western Europe. Comparison with the experience of other countries that have joined the EU suggests that this could result in a fall of a further 200 basis points in prime yields. While rationally this fall should take place over perhaps the next five years, in the hectic investment market that we are currently seeing it is likely that the adjustment will be somewhat faster.
Finally, the lack of convergence between the yields in the largest EU countries and the remainder does not seem to reflect the growing liquidity of these smaller countries.
This suggests that there is room for yields to fall in these markets relative to those in London, Paris, Frankfurt, Milan and Madrid.
1The ‘average' is a simple, unweighted average of the prime office yield in the respective groups of cities.
n EU-5: London, Madrid, Paris, Milan and Frankfurt;
n EU-10: Stockholm, Lisbon, Amsterdam, Luxembourg City, Athens, Dublin, Vienna, Brussels, Copenhagen and Helsinki;
n CEE: Warsaw, Prague and Budapest.
Michael Haddock is director of EMEA investment research at CB Richard Ellis