The European property market resurrection
Written by Anne Koeman
After collapsing in value during the worst of the credit crunch, property has been identified as one of the winners in the aftermath of the financial crisis. In the wake of a surge in values in the UK, a recovery is now underway in Europe. Despite economic woes tormenting parts of the region, the stable markets of “core” Europe provide the right foundations for institutional investors to seek diversification within their property portfolio.
The financial crisis taking hold of global capital markets in the autumn of 2008 resulted in a widespread “flight to safety” among investors. Perceived risks to property investment increased rapidly. Property yields moved out across markets, while yields on long-dated government bonds were pushed in the opposite direction. In the UK, the spread between the average property yield and 15 year gilt yields shot up by nearly 350 basis points over the course of half a year, to reach briefly 6% in April 2009 .
For most of 2009, the European property market remained in the doldrums: as property allocations narrowed, institutions generally served as net sellers in the property space, while few opportunistic investors could get access to finance to take advantage of bargain prices. However, during the summer of 2009 this slowly started to change as the wider investment community began to realise the relative value on offer in property.
To start, capital began to target the deepest market in the region: London. Liquidity surged. London transaction volumes in the fourth quarter of 2009 were almost three times higher than six months earlier . UK yields compressed dramatically during a short space of time leading to record capital growth in the fourth quarter of 2009. On the continent, while activity started picking up, no significant yield compression was recorded until the start of 2010. The first quarter of 2010 then finally signalled the resurrection of the continental markets. Paris, Europe’s second primary business location, became the next place to be.
A divergent investment landscape
Although the “flight to safety” became a feature of the financial crisis, in the recovery phase investors have remained equally cautious and selective. In specific property markets this has led to a narrow focus on prime properties. However, the manifestation of price correction across different markets is a direct reflection of what has been happening in Europe’s tumultuous bond markets – showing a strong divergence between “core” Europe and its periphery.
Despite the €750 billion rescue package agreed in May, the fiscal woes of the Eurozone seem far from over since Greece's debt crisis in the spring of 2010. In recent weeks, the weak state of the Irish economy and government has been sharply priced in: at their worst ten-year Irish bond yields rose to nearly 9%, six and a half percentage points more than German bunds. Sovereign bond spreads in Portugal, Spain and Italy have also increased.
The property markets paint a very similar picture. Yields on office investments in Dublin have doubled since their low point in the middle of 2008 and continue to rise. In Portugal (and Spain for that matter), office yields might have stabilised just below peak levels but it is questionable whether the full range of risks are appropriately priced in.
On the other end of the spectrum, since the spring of 2009, prime office yields in London’s West End have fallen by 150 basis points and in Paris CBD are 100 basis points lower . Currently, the German property market is recording strong levels of interest from international investors. Similarly, in the Nordics, a selection of domestic and foreign funds is buying aggressively as they perceive a window of opportunity.
Investor preferences for 2011
A number of studies looking at investor intentions signal a potential increase of transaction volumes in 2011. Institutions seem likely to become net investors into European real estate in 2011. DTZ’s ‘Great Wall of Money’ report also indicates that that more capital targets the wider European region than has been raised locally – implying an increase of cross border activity.
The same report signalled a greater share of capital flows going into single country funds in 2010 – particularly in Asia. However, with diversification being a key driver for institutional investors to take the step into European property, Europe might not follow this trend. Diversification benefits are far easier to pursue when seeking exposure to either Pan European funds or funds focusing on a particular group of countries.
While demand is set to intensify, there are few signs that investors will be moving up the risk curve. Prime properties with strong tenants will stay on the on the top of every investor’s wish list, while secondary types of assets should generate little interest. This might lead to a market of “trophy and trauma” as Jones Lang LaSalle recently described it.
In the aftermath of the debt-fuelled property boom, investors are primarily looking to secure plain-vanilla property deals with little or no leverage involved. Income generation from property is of primary importance, making tenant ratings and lease structures ever more vital. As a holder of direct property this means that asset management gains in appeal.
European property outlook
In the year ahead, relative market performance is likely to reflect economic performance as investors have become increasingly discerning about fundamentals. This leads to the expectation that market performance across Europe will experience deepening divergence.
Looking at the latest November Consensus Economic forecasts, GDP growth of between 1.5 and 2% is expected for Germany and France, while even healthier performance is expected in the Nordics, Austria and Switzerland. This, however, contrasts sharply with the outlook for the Southern periphery, where sluggish economic growth is forecast at best.
Within the stronger countries, the prime end of the market is likely to outperform as an increase in demand for these assets will be met with a scarcity of supply. While the focus in 2010 was largely on investment in capital cities, prime assets in regional cities in strong economies are likely to see a renewed interest from a wider range of funds. Indeed as the main markets will already have experienced some price correction, regional markets with the right features have the potential to provide an “investment edge” going forward.
On the whole, while some further yield compression may be expected in the immediate future, capital growth will need to be driven by rental growth in the medium term. In this respect, a continued focus on economic fundamentals provides the right approach. By and large, when dismissing the periphery, economic fundamentals in many European countries are looking relatively sound. Together with tough planning regulations and high barriers to entry, this leaves the foundations for steady property performance going forward.
Anne Koeman is senior research analyst for the M&G European Property Fund.