Levelling the playing field
One of the greatest challenges for real estate investment managers operating internationally is ‘levelling the playing field’. Every market has its own customs and traditions that turn the business of making real estate investments into a complex process. As a result, most skilled international real estate investment managers come equipped with a set of tools to demystify markets and will know how to communicate effectively with their clients.
Ideally, investing capital in international markets should feel much the same as it does in your domestic market and any portfolio manager should be able to build a strategically balanced portfolio with exposure in all the major stable international markets.
However, in many stable developed markets there are still forces that prevent investors from committing their time, effort and capital. Factors such as tax can have a major influence on a decision but most often the decision to zero weight a market results from a disconnect between the capital markets and the fundamentals of supply and demand which the investment manager cannot reconcile. Omitting a large stable market from an investment strategy on the grounds that it is difficult to understand strikes fear into the heart of international investors. This leads to the requirement for a blanket risk premium that in turn makes capital less competitive, which then impacts on the investment manager’s ability to build a deeply diversified portfolio.
The most striking example of this conundrum is in Germany. Germany is the largest European economy and any balanced portfolio would be expected to have an allocation to German real estate. However, capitalisation rates in the German real estate market currently seem to be out of sync with the expected growth rate in values in the short/medium term. Cap rates imply that the market should show relatively strong growth over the next three years, a recovery story that does not fully reflect the underlying economics.
One possible explanation is a lack of liquidity – in other words there is little or no transactional activity and as a result market price cannot be established. This is clearly not the case – Germany has a well-developed real estate market – the total stock of buildings in the five major cities Berlin, Munich, Hamburg, Frankfurt and Dusseldorf with a total of over 56m square metres. In fact the propensity for investing in real estate extends from institutions right through to private individuals. The biggest buyers, the German open-ended real estate funds have major holdings (just under E300bn of assets at the end of 2001). Their success in attracting private and high net worth capital reflects a number of factors – but mainly on a tax advantaged structure and the private investor’s appetite for real assets.
The other substantive argument relates to the underlying fundamentals. Cap rates usually adjust as investor sentiment improves or weakens. If sentiment does not diminish in response to weaker fundamentals then cap rates may move out of sync. This argument holds water in Germany. Investor’s treat real estate as something of a safe-haven investment and domestically they regard their planning and development control system as very constrained. As a result, capital continues to flow into real estate despite weakening demand fundamentals, with capitalisation rates holding stable in spite of the underlying market conditions.
To understand this anomaly it helps to examine investor psychology. In Europe, hyperinflation and armed conflict has historically increased the appetite for real assets. Although European unification and weaker inflationary pressures should diminish the desire to own real assets, reducing job security and increasing globalisation have stepped in to maintain European’s individuals risk aversion. As a result, the German individual’s appetite for a ‘safe-haven’ remains undiminished.
This argument works conceptually but is it borne out in practice? Risk aversion in its own right would have had to remain extremely high for a prolonged period of time. In addition any decrease in economic or market risks should have triggered outflows from the German retail funds. This is exactly what has happened. The economic impact of reunification and monetary union held back German economic growth for the vast majority of the 1990s (averaging 1.42% between 1992 and 1998), keeping a lid on consumer confidence. At the same time between 1992 and 1997 real estate accounted for 26% of total capital invested in German retail funds (compared with 28% inflow to equity funds).
During 1999 and 2000 the revival of German growth (average GDP growth was 2.4% pa) renewed economic confidence leading to significant private inflows into the German equity markets. Equity funds attracted e118bn compared with e7bn in real estate. As predicted, in 2000, redemptions accelerated markedly from the real estate funds. Most recently, the sharp about-turn in German growth in 2001, the technology bust and the events of 11 September sent most investors running for cover – and concurrently has meant that in the last six months German open and closed funds have posted net inflows totalling over e10bn. In fact, looking back to 1989 there is a negative correlation of 0.32 between net flows into retail property funds and net flows into retail equity funds. It would seem that the aversion has been and continues to be a very (if not the most) powerful driver of private investors allocation strategy.
This process has a major distorting influence on the way in which real estate prices move. The funds themselves have liquidity rules which limit their ability to hold cash. As a result, if they have net inflows they are compelled to continue to invest even when the market fundamentals are deteriorating. When you add in tax distortions that lower the funds long term required return on capital, this means that weight of money holds down capitalisation rates irrespective of the market fundamentals. Again, this process was clearly visible through the early to mid 1990s where despite some pronounced economic distress capitalisation rates remained stable (albeit some of the stability was due to banks warehousing distressed assets rather than conducting ‘fire-sales’). Similarly, in the late 1990s cap rates remained relatively stable. Even when the funds faced with redemptions did sell assets they were able to sell to other purchasers who were underwriting a continued recovery and hence were comfortable that they could match their return expectations despite low ‘going-in’ yields. There may be some investors whose expectations have not been met but overall capitalisation rates have been rock solid for the last 10 years.
There are, of course, caveats to be considered. In the long run a sustained shift out of real estate in response to better economic growth or revived equity markets could lead to German funds selling assets. Unless, the system itself changes substantially the status quo is likely to be maintained.
In the short-term it is also somewhat disingenuous to suggest the system itself is at fault. The funds are well aware that with relatively low income yields and little short-term growth they cannot afford to run the risk that their buildings lose tenants. They therefore focus activity on ‘AAA’ low risk assets with long leases in place to good credit tenants, in essence hedging themselves against substantial volatility and providing them with an acceptable risk adjusted returns (given their long term investment horizon).
However, the funds activity does have a negative influence. The surfeit of capital looking for this type of risk adjusted returns can pull down cap rates for assets which are at the margin. With vendor’s expectations driven up by the pricing achieved on the very best propositions, the fundamentals make it difficult for other investors to compete for assets in ‘growth markets’ (markets maturing and consolidating) or for ‘value-added’ investments (assets which require some upgrading or re-leasing) and still meet their return targets. While low risk/low return strategies make some degree of sense – higher risk strategies carry a pricing premium that makes investment in this market difficult and requires the manager to be extremely focussed.
Approaching investment strategy without this degree of due diligence may mean a manager takes a major strategic decision and passes over markets, a decision which, while it makes their life easier in the short-term, significantly increases the ‘fear factor’. The ‘price of fear’ manifests itself as a risk premium. This premium then inhibits the manager’s ability to build a diversified portfolio for their clients. This tends to further increase the level of risk they assume on their client’s behalf, in effect creating a vicious circle. Whether they recognise it or not, real estate investment managers have a duty to understand, rationalise and overcome the incongruities of the European property markets.
Simon Martin is director of research and strategy at Curzon Global Partners, in London