Opportunities in European cross-border investment
Investor appetite for non-domestic real estate has grown significantly over the last few years. For a variety of reasons such as greater awareness of the benefits of real estate generally, increasing market transparency and greater accessibility, investor interest has reached unprecedented levels. The potential benefits of international real estate investment are well known and can be summarized as follows:
n The expansion of the investment universe in terms of market size and exposure to sectors and opportunities that may be uncommon in domestic markets;
n The ability to match international liability exposure, particularly for pension funds of multinational corporations;
n The opportunity for higher risk-adjusted returns by taking advantage of differences in economic and property market cycles;
n The potential for reducing portfolio risk through diversification, which is particularly important to investors pursuing core and core-plus strategies.
In Europe, the estimated value of cross-border investment transactions last year is about €40 billion (up from €33 billion in 2003), with German, Irish and US investors particularly active (see Exhibit 1). This trend is a function of the increased awareness of the merits of an international element to real estate portfolios (which is also apparent outside Europe) and a number of dynamics specific to the European
Given an estimated European real estate market size of €4.8 trillion, even investors from the largest markets (Germany and the UK) can broaden their opportunity sets significantly by targeting real estate outside their borders (see Exhibit 2). This motivation for international investing has long been recognized in countries such as the Netherlands, where the indigenous investor base is sophisticated and domestic market size is limited.
With 25 countries in the European Union encompassing more than 450 million people and an annual GDP of more than €10 trillion, Europe provides a diverse array of opportunities in numerous developed markets. The characteristics of economic cycles vary considerably across countries. For example, among the larger European countries average GDP growth over the next five years is expected to range from 1.7% per year in Germany to 2.9% in Spain, and their growth profiles differ considerably (the growth range in Germany is more than 0.6 percentage points but less than 0.2 percentage points in Spain). Despite ongoing convergence, structural differences in economies, fiscal regimes, capital markets and real estate markets will ensure continued disparity in leasing and investment market conditions and an ongoing source of opportunity for investors (see Exhibit 3).
Twelve of the current EU members are now using a common currency, which has created some economic convergence over the last decade or so. This will continue as many of the countries that joined the EU last year work toward membership in the Exchange Rate Mechanism and ultimately the euro. Convergence in real estate performance and pricing is expected to follow. This characteristic, which implies a low correlation in real estate performance between markets, provides investors with the opportunity to reduce portfolio risk for a given level of return simply by moving into other markets. Importantly, this argument is independent of whether non-domestic real estate currently represents good value on a risk-adjusted basis.
With the introduction of the euro (and the expected expansion of the euro zone in the medium to long term) investors can now pursue a pan-European strategy with much lower costs of currency hedging than was the case just five years ago. At the same time, transparency in the 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. As the sector attracts more capital (through the expansion of the pension and insurance industries, for example) and barriers to the movement of international real estate capital continue to fall, the transparency of the European market will increase further in the coming years. All these factors are reducing the risk premium associated with European cross-border real estate investment, but significant risks at a country, market and deal level remain (see Myths and Realities of International Real Estate Investing, Prudential Real Estate Investors, November 1999, www.pramericarei.com, for a full discussion).
Some of the recent rising interest in cross-border investment stems from scarcity of product and competitive pressures in fully priced domestic markets. While venturing abroad to play the short-term cyclical game can be rewarding for those seeking opportunistic returns, the majority of investors are likely to benefit more by taking a long-term strategic view on international real estate.
The success of an international real estate strategy critically depends on having clearly defined objectives, a practical framework for constructing portfolios to achieve these objectives and an understanding of the associated risks and how these can be managed. In developing a structure for international investment, investors need to consider the following:
n How much capital should be allocated internationally?
n What is the appropriate investment risk profile, e.g., core, value-added or opportunistic?
n What level of country risk is appropriate, e.g., developed, maturing or emerging market?
n What is an appropriate target rate of return for each risk category?
n How much capital should be allocated to each risk category?
By taking a systematic approach to designing and executing an international real estate portfolio, investors have a better understanding of the sources and magnitude of risk in their portfolios – knowledge that is critical to consistently and predictably achieve the objectives of any portfolio (see A Framework for Constructing International Real Estate Portfolios, Prudential Real Estate Investors, February 2002, www.pramericarei.com, for more details).
Gaining this knowledge, and more importantly, implementing the strategy, involves significant costs, which is one of the principal reasons most investors choose to gain international exposure through pooled vehicles rather than direct acquisition.
Despite the convergence dynamics in Europe stemming from the introduction of the euro and the ongoing eastward expansion of the EU, the real estate market remains heterogeneous and fragmented. Significant information inefficiencies remain, and some of these are quite rigid and will erode only slowly. Nevertheless, the market is more accessible now than ever, partly from the growth of the fund management industry in recent years, which has invested heavily in the resources needed to overcome information barriers. With local knowledge and a well-defined investment management infrastructure, investors with a long-term strategic view can capitalize on the inefficiencies created by the structural differences between countries to consistently produce returns in excess of the market.