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EUROPEAN PROPERTY: BACK TO BASICS? 2008 TRENDS / 2009 OUTLOOK
by Nick Axford, Head of EMEA Research & Consulting and Michael Haddock, Director, EMEA Research & Consulting
FOREWORD The European real estate market is clearly in a period of significant change. The financial engineering, high levels of gearing and yield compression that were such a feature of previous years are now a thing of the past. Instead, investors will be focussing on long-term performance and the more conventional ways of generating returns: buying quality buildings in good locations that benefit from strong occupier demand and rental growth; and adding value to investments through active management of the physical property and its tenancy characteristics. The future now looks much more like a traditional real estate market than has been the case recently. This will come as a welcome change for those who found it difficult to identify value in the market over the last few years - and offers exciting opportunities for those with the abilities to take advantage of them.
From Wall Street to High Street … The US sub-prime crisis of 2007 has evolved into a wider global credit squeeze, which in turn has now triggered an economic recession across much of Europe, if not the globe. At present, the outlook remains volatile and unclear with economic forecasts continuing to deteriorate. However, what seems certain is that the dramatic changes we have seen in the financial markets are having – and will continue to have – significant impacts on the commercial property market in Europe. These impacts are being seen in a number of areas, including investment transaction volumes and pricing, occupational demand from financial services occupiers, and the more diverse impacts of a broader economic slowdown.
Figure 1 – Investment market turnover in Europe Q4 Turnover slowed to 19.5 billion, 67% down on the quarterly average for the previous two years Million 80,000 70,000
Quarterly Avge 2006-7 = 60bn
The impact on investment volumes First, there has been an impact on property investment activity and pricing. As Figure 1 shows, the volume of investment transactions across Europe has fallen dramatically. Having averaged over €60 billion per quarter in 2006 and 2007, the final quarter of the year saw only a third of this volume. This reduction in activity is a function of a number of factors. Over the last two years, much of the investment activity seen in Europe was financed with debt – often at loan-to-value ratios of 85% or more.
0 Q1 06 Q2 06 Q3 06 Q4 06 Q4 07 Q2 07 Q3 07 Q4 07 Q1 08 Q2 08 Q3 08 Q4 08 Source: CB Richard Ellis, Property Data, VastGoedMarkt, KTI
The changes in the wider capital markets mean that debt finance has become progressively more difficult to secure and more expensive. There are still only the earliest signs that the widespread bank bailouts are starting to free up the lending markets, and it seems likely that it will take some time for any significant volumes of property lending to reappear. As a result, many of the debt-financed purchasers have been removed from the pool of potential buyers.
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Nevertheless, there clearly are equity investors looking to put money into the market when they perceive that the time is right. This group includes the Sovereign Wealth Funds, German Open-ended Funds and a variety of other institutional investors, property funds and listed property companies. The last twelve months have also seen the emergence of shorter term “opportunity fund” investors. Finally, wealthy private individuals have been very much in evidence in certain parts of the market. However, at present most investors are biding their time. The issue of when this equity will enter the market strikes at the heart of the case for real estate investment generally. There are fundamentally three reasons why an investor might want to put money into the real estate sector: Diversification: In the past, the returns from real estate have had a low correlation with those from other assets such as bonds and equities. Real estate is therefore an asset class which is considered to add considerably to the risk-adjusted returns from a portfolio. However, the diversification case for real estate has taken something of a hit over the last year. In the current cycle, the downturn in real estate prices has coincided with a downturn in the equities market. Yet with equity markets falling by around 40% or more during 2008, there is an argument that real estate still offers more stable capital values than equities. In the UK, where historic time series exist to enable longer term analysis of the period since 1971, according to IPD property has almost zero correlation with government bonds (0.02) and a correlation of 0.29 with equities – compared with 0.59 between equities and bonds.
High income component of returns: Real estate generally delivers a higher proportion of its returns in the form of income than is the case for other asset classes. In fact, the repricing that has occurred over the last year has reinforced this position, with initial yields having increased significantly. Whilst the income return on equities has also increased there is greater uncertainty surrounding that income and many companies are starting to cut dividends as a result of the recession. This reinforces the fact that while rental income is contractually guaranteed, dividends are discretionary.
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Relative/risk adjusted returns: Historically, the returns from real estate have fallen between those of bonds and equities and the lower-risk profile of property means that on a risk adjusted basis the asset class looks very attractive. Looking forward, it is certainly arguable that the extent of the repricing that has occurred is already making real estate look attractive in the long term. The average yield in the UK (according to the IPD monthly index as at January 2009) is now 8.7% compared to a long-term average of 8.1% – and it is likely that this figure lags behind the actual market. This is also the case for several other asset classes (for example equities and some corporate bonds) and it may be that they offer better relative long-term value at the moment. However, what appears to be playing the biggest part in preventing equity investors from entering the real estate market is the short-term value trend. Investors are unwilling to enter the market while they perceive that the same (or at least similar) properties will be available for less in the near future. THE CHANGING INVESTOR BASE We still believe that there is significant equity that will be available for investment, but the picture has changed somewhat in recent months. It was the Sovereign Wealth Funds and particularly the German Open-ended Funds (GOEFs) that were expected to be a major source of acquisitions; whilst still likely to be evident in the market, they have faced significant challenges recently. Sovereign funds have come under pressure from various directions: previous investments into the financial sector have proved costly, and their wider investment portfolios have fallen sharply in value along with the equity markets. Moreover, many of the funds exist in order to invest surplus revenues from the sale of natural resources – notably oil, the price of which has been cut by around two-thirds over the latter part of 2008 – thus significantly reducing the level of capital inflows. As a result, in the short term they will be less active in the property market than initially envisaged.
All this changed with the German government’s unconditional guarantee of all bank deposits at the start of October, which triggered a major inflow of funds into the now zero-risk banking sector, a proportion of which came from the OEF. Whilst there were other factors involved, coupled with some significant withdrawals by institutional investors this ultimately led to the temporary closure of a significant number of the open-ended property funds to prevent a disorderly run of redemptions. For the market as a whole, this has turned the OEF sector from a significant net purchaser of European real estate to potential sellers of assets over the next six months. That said, it remains the case that several of the major funds remain very much open for business – and are in some cases actively seeking out investment opportunities that meet their longf term investment criteria. Thus far, however, the European property market has been characterised by inactivity. Those investors who are looking to take advantage of market conditions to buy are in no rush to do so. They increasingly recognise that the equity they have at their disposal is a rare commodity and may not be easy to replace once it is spent: the phrase “keeping our powder dry” is commonly used. This is just as true of the long-term funds looking to make strategic purchases as it is of the short-term opportunity funds looking to acquire distressed assets at bargain prices in the hope of making a quick return. Both groups believe that prices have further to fall – not least because in most markets we have not yet seen a significant volume of distressed sellers in the market. So where would such sellers come from?
SOURCES OF INVESTMENT SALES The key feature of the credit crunch has been a reduction in the volume of debt finance available, and an increase in its cost. Real estate investment has been a debt-intensive business in recent years; the vast majority of transactions utilise leverage to some degree, and in some cases 85% or more of the finance might have been debt. Together with the open-ended investment funds (which are vulnerable to outflows of equity), it is the more leveraged investors that are likely to be the source of distressed sales. This is for two main reasons.
The GOEFs are also facing a more challenging environment, in part due to the actions of their own government. After the difficulties of 2005-6, the open-ended property funds had successfully restructured and regained the confidence of German investors such that by early 2007, they were once again seeing strong inflows of capital. These flows actually accelerated as the credit crunch evolved, as German investors sought the relative security of the asset-backed, stable returns offered by the OEFs. The sector was seen as a safe haven during uncertain times, where investors were focused far more on capital preservation than on achieving significant positive returns.
First, whether the debt is private (more conventional mortgage finance from banks) or public (securitised into Commercial Mortgage Backed Securities (CBMS) or other products and sold to a range of investors), it will have conditions or “covenants” attached. The two most important relate to interest coverage (ICR) and loan-to-value (LTV) ratio. If either of these covenants are breached, the lender may require repayment of the loan – which in the current environment, where alternative finance is unlikely to be available, will usually trigger the sale of the property. Thus far, most breaches which have occurred have been of LTV covenants, as rising yields and falling values have caused technical breaches of the maximum permitted LTV ratio. However, provided they have faith in the solvency of the borrower and the quality of the underlying asset, few lenders would be likely to foreclose purely on this basis. Forcing sales of property in the current market may not realise the full value of the loan, thereby crystallising a loss, and would probably reduce the values of other assets on which the bank had lent, potentially triggering problems for other borrowers, and so on. Where possible, it is in the interests of both borrower and lender to renegotiate the terms of the loan rather than undertake a sale – and we have seen many such renegotiations successfully completed in recent months. (In other cases, lenders have allowed financing to remain in place during the sale of the property, with the loan “rolled over” to the buyer; other such “seller financing” arrangements are being developed to try to facilitate sales). It has also been suggested that many banks have other issues on which they need to concentrate, and thus – for the moment at least – they have been willing to take a benign view of many technical breaches of banking covenants. It should also be noted, however, that depending on how the debt is structured, CMBS lenders may have significantly less flexibility in their approach to covenant enforcement than traditional private lenders.
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Source: CB Richard Ellis
Figure 3 – Prime Office Yield Shift – from the low point in this cycle Yield (Percent) 8.00 7.50 7.00 6.50 6.00
Prime yield as at Q4 2008 Lowest yield in this cycle
5.50 5.00 4.50 4.00 3.50 3.00
Source: CB Richard Ellis
120 100 80 60 40 20 0 -20 -40 -60 -80 -100
It therefore seems likely that a combination of worsening economic conditions and a hardening of bank attitudes to default or renewal of loans will trigger more forced sales in 2009 than were seen in 2008. Whilst potentially having an adverse impact on values, such sales could also have some positive effects on the market. First, more deals will at least help to clarify where values have reached and provide some clearer evidence for valuers and investors alike. Second, they would test the true strength of investor demand for real estate, and encourage buyers into the market. Investors may currently be sitting on the sidelines in the expectation of further value declines, but they will also be aware that property is not like the equity market. If you think that shares in a particular company are likely to fall, you can wait for them to do so and then subsequently enter the market to buy exactly the same shares at the lower price. Property isn’t the same: if a particular shopping centre or office building is put up for sale, you have no certainty about when the next opportunity to buy it will arise. Thus even if they believe that the market may have further to fall, investors who have ultimate faith in a particular market may well be motivated to buy when a strategically attractive building becomes available.
Figure 2 – Yields Rising Across All Sectors
The second reason why leveraged buyers may be a source of sales is refinancing of existing loans. The terms of each loan are different, but each will be for a finite period, after which is has to be repaid. In some cases, loans were structured to cover the intended period of ownership in full – often seven or 10 years. However, in recent years some investors were either intending to hold the property for a shorter period (before selling to take advantage of rising prices) or took out shorter-term loans to take advantage of very low short-term interest rates, intending to renew them as necessary. It is impossible to know for certain what volume of loans fall due for repayment during 2009, but estimates suggest it could be as much as €27 billion in the UK alone. With debt finance in short supply, and that which is available being more expensive and on more restrictive terms, it seems likely that a significant proportion of those borrowers will be forced to sell.
THE OUTLOOK FOR PROPERTY VALUES So where do values stand at present? As Figure 2 shows, after a four-year period from mid-2003 during which yields fell and values rose across Europe, prime yields moved out sharply in all three main commercial sectors during 2008. CBRE’s EU-15 Prime Yield Indices have risen by 80-100 basis points over the last year, and this probably underestimates the full impact on the market as a whole. Yields have been slower to respond in some markets where there has been limited transaction evidence, and equally it is true that some markets have been less affected than others. In the larger, more liquid and most transparent European markets, prime yields have generally risen by 100-200 basis points (or more in some cases) from their low point, which In most cases was in mid-2007 (Figure 3). The UK market has moved furthest and fastest, but the impacts are now being seen across most of the continent.
Zurich Munich Hamburg Dusseldorf Stockholm Frankfurt London (west end) Vienna Copenhagen Paris Milan Rome Barcelona Madrid La Defense Amsterdam Luxembourg Brussels Warsaw Lyon Prague London (city) Bratislava Lisbon Budapest Lille Athens Edinburgh Birmingham Manchester Dublin
Breaches of interest coverage conditions are viewed more seriously, as they suggest a more direct potential threat to the ability of the borrower to repay the loan. However, such covenants tend to be breached as a result of tenants vacating a building (either through relocation or closure) which – whilst it may become more common as the current economic slowdown progresses – has been relatively uncommon to date.
This is not to say that current pricing does not take rental growth prospects into account. Across Europe, it is a consistent theme that secondary property has seen more significant outward movement of yields than prime property. Of course, it is difficult to define “secondary” with any consistency, as there are numerous reasons why a building may not be considered prime – including location, building quality or condition, tenant quality or lease characteristics. Secondary property is inherently far more vulnerable to any downturn in demand, and thus has weaker rental growth prospects. As a more risky asset, it is less attractive to investors in the current, risk averse environment. This helps explain why secondary yields have generally moved out rapidly in most markets and sectors – and why the majority of the buildings that have traded in the market recently have been relatively high quality.
Figure 4 – Yields Have Been Driving Values Since 2003 EU-15 Offices Capital Value Growth, % per annum 30% Yield Impact Rental Growth
In trying to form a view on the outlook for property values, it is important to distinguish two related but fundamentally separate components of the price equation. The value of any investment asset is ultimately determined by the future income it will generate (in property’s case, the future rent), and the risk associated with receiving that income (which will be reflected in the multiple of current income that the investor will pay). The majority of the re-pricing that we have seen in the market to date has been the result of a re-appraisal of risk in the investment markets generally, and the readjustment of pricing to reflect the returns that equity investors (the new dominant buyers) will require rather than the geared returns that the more highly leveraged buyers were able to achieve. This is evidenced by the fact that yields have shifted across Europe in a way that leaves property priced much more consistently relative to 10-year government bonds. The prime office yield in most markets thus reflects differences in government bond yields, plus a fairly uniform risk premium for property, rather than any rigorous assessment of differential rental growth potential.
0% -10% -20% -30%
Dec-88 Dec-90 Dec-92 Dec-94 Dec-96 Dec-98 Dec-00 Dec-02 Dec-04 Dec-06 Dec-08 Source: CB Richard Ellis
Looking forward, once the financial markets start to show some signs of greater stability, we would expect property prices across Europe to start to differentiate more clearly between markets on the basis of their rental growth potential. As Figure 4 shows, having come through a period when falling yields were the principal drivers of capital values – and a shorter period when rising yields were responsible for driving values back down again – the property market is set to return to more normal conditions. This means that it will be rental growth that will determine prices. So what state are the occupier markets in? ECONOMIC AND OCCUPIER MARKET PROSPECTS As economic prospects weaken, there is no question that we expect occupier demand and rental performance to be significantly lower than previously anticipated. This is true across almost all sectors and markets. At present, whilst there is no shortage of economists making predictions about the economy over the next few years, there is a significant lack of consensus over exactly what lies in store. Many are referring to the recession of the early 1990s as a reference point, and this is perhaps a convenient place from which to start thinking about property market prospects. The origins of the 1990s property cycle lay in the strong economic growth that was experienced across much of Europe in the late 1980s. Strong absorption resulted in low levels of vacancy in most office markets, which in turn drove strong rental growth. At the start of the 1990s, falling demand (due to a sharp economic slowdown) coincided with a two-year period of development completions as buildings that had been started in response to tightening supply entered the market after demand had started to fall.
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CB Richard Ellis EU-15 Rent Indices
Current vacancy plus developments scheduled for completion by end 2010, as % of total current stock
% per annum 30%
As percent of Stock
Development Pipeline 2009 – 2010 Vacant Q4 2008
The resulting collapse in rents had a major impact on capital values. From arguably over-inflated levels at their peak, rents collapsed as new supply exacerbated the effects of falling demand. In a number of markets, office capital values fell by 50%60%, with anything up to two-thirds of this decline due to falling rents. Returning to the present, it is clear that whatever the superficial similarities with the 1990s, the circumstances of the current cycle are very different in a number of ways. First, whilst rents have risen over the last four years, the increase has not been anything like as strong or prolonged as was the case in the late 1980s (Figure 4). As a result, whilst rents in some markets are currently viewed as somewhat “frothy”, in general rents are not at “excessive” levels and thus not as prone to collapse if demand weakens or new supply is introduced. Second, because the rental and economic cycle of recent years has been more muted – and because developers still bear the mental scars of excess development at the start of this decade – the scale of development currently underway is far more modest. As Figure 5 shows, whilst vacancy is already quite high in some markets (such as Frankfurt and Amsterdam), elsewhere supply is very limited – even taking into account space that is under construction.
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Ile de France
London West End
Source: CB Richard Ellis
Dec-87 Dec-88 Dec-89 Dec-90 Dec-91 Dec-92 Dec-93 Dec-94 Dec-95 Dec-96 Dec-97 Dec-98 Dec-99 Dec-00 Dec-01 Dec-02 Dec-03 Dec-04 Dec-05 Dec-06 Dec-07 Dec-08
Figure 6 – Supply Pipeline Limited In Many Markets
Figure 5 – Rental Growth In Europe
Source: CB Richard Ellis
Thus as occupier demand weakens, as we must anticipate that it will, even if the economic downturn is as bad as in the 1990s (or even worse) this does not necessarily mean that the impact on rents will be the same. Even in those markets where the development cycle is further advanced, there are signs that developers have been quick to react by putting schemes on hold or cancelling them altogether; this won’t prevent rental declines completely, but will reduce the level of new supply entering the market. Clearly it is important to look at the specific situation in each market, but in general the signs are that the occupier markets are better placed to weather a downturn in demand than was the case 20 years ago. PROSPECTS FOR RETAIL In the retail sector, the dynamics are rather different. Weakening economic growth, rising unemployment and falling house prices are likely to combine to reduce consumer confidence and retail sales growth over the next 12-18 months. At first glance this would appear to be bad news for investors in the retail sector, and indeed it is likely that rental growth in the sector will slow. However, the effects of a consumer slowdown will not be evenly distributed. Bulky goods retailers, selling “big ticket” items closely linked to the fortunes of the housing market such as furniture and white goods, are clearly vulnerable. Luxury retailers may be relatively less affected, and “budget” retailers in both the food and non-food sectors are already showing signs of increasing their market share. Generally, it is the mid-market that suffers most in a downturn. It seems likely that prime locations – core high streets and larger, more dominant regional shopping centres – will also prosper relative to secondary and tertiary locations that will see falling rents at best, and long-term vacant units at worst.
OPPORTUNITIES FOR OCCUPIERS Many of the trends that are being seen in the real estate market stem from the very severe dislocations still evident in the financial markets and the consequent decline in activity in the real economy – neither of which are, in the widest sense, helpful to occupiers. However, in contrast to the majority of property investors for whom, falling values are universally bad news, the implications for occupiers are more mixed. First, falling rents and rising vacancy means that occupiers are experiencing increased lease flexibility, greater choice of premises and greater incentives across all property sectors and most markets. Whilst not every occupier is in a position to renegotiate the details of their occupation, landlords currently have a vested interest in keeping their properties let – and their tenants profitable. Thus many landlords are prepared (if not always completely willing!) to enter into negotiations with tenants over various aspects of their occupation.
Whilst property values have clearly fallen, and thus owner-occupiers are able to realise less from the sale of corporate real estate assets, we are also likely to continue to see an increased flow of “sale and leasebacks” or similar deals. Growth is being driven by three factors: corporates seeking to raise capital for specific business initiatives at a time when other sources of debt or equity are either highly constrained or too expensive; the more significant corporates seeking to build up liquidity within their own balance sheet, often to create a “war-chest” to enable them to take advantage of attractive corporate acquisition opportunities; and investors increasingly recognising the opportunity for what are effectively strong-performing asset-backed bonds with quality covenants. Whilst the pool of potential buyers has shrunk, the bond-like characteristics of well secured high quality corporate real estate assets are exactly the kind of investment that many are looking for. CONCLUSIONS So what can we conclude about the outlook? As ever, property investment is ultimately about individual markets and buildings, so it is dangerous to generalise too much. The key is to understand the detail of the markets you are looking to invest in – and get top quality advice from a qualified local specialist! What we can say is that, however long it takes, we do believe that the historic reasons for investing in real estate will re-assert themselves once again. Property offers diversification benefits in a multi-asset portfolio, with a high income return, good capital security because it is a “real” asset, and a good track record of delivering robust performance over the medium to long-term. The market will, however, look very different to what we have become used to. Property investment will be dominated by equity players rather than debt, and will target above average economic growth and positive market rental growth prospects, with an emphasis on properties which offer asset management opportunities to generate income growth. They will target good locations which have a strong “story” to tell in terms of the current prospects or future re-positioning within their wider market. Compared to the last few years, as the market begins to return to normal it will feel like the dawning of a new era. In truth, those that have been active in the market for a while will recognise that this is actually a return to the traditional investment model that has dominated the sector for many decades in the past. It is time for real estate to get back to basics.
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It is anticipated that there will be pockets of new leasing activity as opportunistic occupiers who are in a position to break tenancies will seek to move to cheaper buildings or further consolidate their portfolio by taking additional space in an existing location. Other tenants will leverage their improved negotiating positions to upgrade office premises, securing attractive terms on buildings which might previously have been beyond their reach. Despite the fact that the development pipeline is contracting rapidly, completions of buildings under construction and companies choosing not to occupy buildings they had pre-let will mean that there is an increased supply of top quality space available, particularly in the office sector. Equally, it must be recognised that with lower levels of demand and rising vacancy in most markets, occupiers with vacant space in their
portfolio will find it increasingly difficult to sublet surplus accommodation.
Major shopping centres have significant advantages for investors during economic downturns, and are viewed by many as a good defensive sector. Retailers are less likely than office occupiers to downsize or relocate to cheaper or smaller units, as their business is far more location-sensitive. Because shopping centres are multi-tenanted, rental default by any particular retailer tends to have less of an impact on overall income than in an office building. Furthermore, when vacancies do occur, units in prime centres are also easier to re-let than in an office building. Many international retailers are still looking to expand their network into new markets, and will actively seek to take advantage of weaker market conditions to acquire prime units – and market share – in cities that would previously have been harder to penetrate.
For further information, contact: Nick Axford Head of EMEA Research and Consulting t: +44 (0)20 7182 3039 e: email@example.com Michael Haddock Director, EMEA Research and Consulting t: +44 (0)20 7182 3274 e: firstname.lastname@example.org
Disclaimer 2009 CB Richard Ellis
Information herein has been obtained from sources believed reliable. While we do not doubt its accuracy, we have not verified it and make no guarantee, warranty or representation about it. It is your responsibility to independently confirm its accuracy and completeness. Any projections, opinions, assumptions or estimates used are for example only and do not represent the current or future performance of the market. This information is designed exclusively for use by CB Richard Ellis clients, and cannot be reproduced without prior written permission of CB Richard Ellis.
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