The continental European real estate market is gaining ground on the United Kingdom and other markets that have been quicker to recover in this cycle. The start of the recovery in capital values on the continent, coupled with cyclical opportunities to add value through asset management, has drawn investors back to Europe.
Historic cyclical return patterns
Some European markets — such as Switzerland and Austria — demonstrated very little distress after the financial crisis. However, for Europe’s largest and most transparent markets there was a more significant correction in values. The UK real estate market was the first in Europe to recover strongly after the financial crisis, having experienced a significant renaissance in recent quarters. Europe’s recovery has been a more recent event. If we consider the European economic recovery to be in place, combined with the current “lower for longer” interest rate environment, we can expect this trend to continue, closing the gap on performance with the United Kingdom.
According to the annual index released by MSCI IPD, the UK commercial real estate market returned 17.8 percent in 2014, the third highest return in 25 years and the sixth highest since 1981. While income has been the key story for real estate in a low interest rate and low economic growth environment, it was capital growth that stole the show in 2014. The UK total return in 2013 was fairly evenly split between income and capital growth at 5.7 percent and 4.8 percent, respectively, switching to 5.7 percent income and 12.0 percent capital growth in 2014. This reflects a surge of capital into the United Kingdom and the impact of inward yield shift on capital values, followed by improving rental growth in the latter stages of the year — particularly in central London.
This trend is expected to persist. Appetite for UK real estate will likely continue to be strong, as the income component of returns remains attractive relative to prospective income from bonds. With regard to timing, Europe is not as far through the cycle. While the IPD annual return for Europe, excluding the United Kingdom, is yet to be released, it is expected to be in the region of 7 percent to 8 percent, some 10 percent behind the United Kingdom.
Looking ahead, the underlying economic strength is crucial to the return outlook for Europe, as rental growth has been the missing piece of the jigsaw in most markets. The United Kingdom, and specifically London, has seen rents rise, and the anticipation of further increases has helped stimulate yield compression.
These features are dawning in the European market now, with quantitative easing and low oil prices acting as key drivers for the market. The recovery in the occupier market may not be as strong as it has been in the United Kingdom, but in locations such as Dublin, Stockholm and Germany’s regional markets it adds to the momentum initiated by strong capital flows.
Migration of capital flows
Investors are showing confidence in the improving European outlook and changing their capital allocations. According to Real Capital Analytics, investment in the United Kingdom increased by 16 percent in 2014 compared to 2013, but fell by 3 percent in Q4 2014 compared to Q4 2013. This suggests that capital flows are starting to stabilise and may well have peaked in the United Kingdom. Contrast this with the case of continental Europe, where investment volumes rose by 11 percent in 2014 and by 5 percent in Q4 2014.
Country level data provides more granular detail on where capital is heading on the continent. In France, volumes were up in 2014 by 31 percent and accelerated by 59 percent in the final quarter of the year against the same quarter of the previous year. The same trend was prevalent in the Nordics, Ireland, the Netherlands and particularly in Spain. Investment momentum in the European market is highlighted in the “Capital flow momentum” chart to the left. Recent investor intentions surveys support the ongoing commitment of capital to the continent, and we expect this to continue to drive an increase in core and good secondary property values. In turn, this is likely to have a powerful impact on fund performance for continental European funds, similar to the UK experience.
Indeed, recent fund performance indices reveal that we could be heading toward a point of inflection between a stabilisation in the UK returns profile and an increase in the continental European returns outlook. The MSCI IPD Global Property Fund Indices asset-level returns (removing the impact of leverage, costs and fees) show how funds focused on different regions are performing. In Q4 2014, UK fund returns reached 4.3 percent while continental European fund returns hit 3.8 percent in the same period, having risen from 3.2 percent in the previous quarter. This trend in narrowing returns is now into its fourth quarter (see the “Continental European and UK asset-level fund returns” chart on page 32).
The IPD Pan-European Property Fund Index (PEPFI) provides us with more detail regarding the geographic impact on the average fund level return. Many of the continental European funds contain a UK allocation. An allocation to the United Kingdom contributed positively to the overall pan-European return in all but one quarter since Q4 2011. As the United Kingdom gathered momentum through 2014, and with annualised returns approaching 20 percent, the modest 11.4 percent weight to the United Kingdom within the Balanced Funds Index added a total of 1.7 percent to the European portfolio total return. Despite the United Kingdom being a small component of the benchmark, it was responsible for 27 percent of the total return of the index, punching well above its weight.
Standard Life Investments’ latest forecasts suggest that this cyclical outperformance of the United Kingdom will continue for around six to 12 months from Q1 2015. By the second year of our forecasts, we expect the European market to outperform the United Kingdom by around 2 percent. In the third year, that margin is forecast to grow to around 6 percent. In total, we expect continental Europe to outperform the United Kingdom for around two years, providing the base case scenarios for economic growth and monetary policy are largely followed and there are no major exogenous events impacting investor risk appetite.
Regionally, and given increased risk appetite and the ongoing hunt for yield, we anticipate that the strongest absolute returns over the next three years will come from Spain, Ireland and the Netherlands. Core markets will continue to perform well as they attract capital from key investor groups, especially as the yield margins over government bonds in the likes of Paris and Munich remain well in excess of 250 basis points. While strong performance is expected in 2015 from most markets, barring Italy, Finland and Poland, the staggered timing of performance underpins diversification and the overall return is expected to be relatively smooth.
Asset management and currency
The diversified nature of a pan-European real estate portfolio offers investors a comparatively stable return outlook. In addition, managers can boost returns through tactical asset management. Since the global financial crisis, many assets have been underfunded and require significant attention through asset management to bring them up to a lettable standard — a strategy that is of particular benefit at this point in the cycle.
From a global perspective, additional returns from euro zone assets are also available as a result of currency movements. For US-domiciled investors, for example, euro zone–based assets have depreciated by 25 percent over the last 12 months from currency movements alone. To put the currency gain in perspective for US investors, the purchase of a prime €200 million Paris CBD office in Q1 2015 would have cost approximately $40 million (€36 million) less than one year earlier — a significant discount at a time when European asset values are rising in local currency terms.
While there is no assurance that the currency position will recover over the next 12 months, the weak euro does offer an attractive buying opportunity for US investors and indeed from other corners of the globe. This should lead to continued strong capital flows from global sources, from which Europe already attracts a 60 percent share.
Lastly, it is important to mention the impact of leverage. With the cost of debt falling steadily, the large margin between the cost of finance and real estate income yields, combined with growth in capital values, means that even modest leverage will boost returns at this point in the cycle. However, given the low cost and increasing availability of debt, there is a risk that some funds take on too much leverage. It is critical that fund managers do not lose sight of how leverage impacted returns in weaker market environments and refrain from using excessive debt to synthetically enhance returns. This is particularly important if the underlying real estate return is supported by weaker assets with shorter leases, as this would leave LTV and ICR covenants more at risk in the event of a downturn.
Europe is on the comeback trail
European markets are starting to produce strong comparable absolute returns. However, we would recommend that investors display a measure of caution in selecting opportunities. Yields have fallen to cyclical lows in core markets, yet this does not necessarily mean that they are expensive; lower risk funds will find attractive risk-adjusted returns in Europe’s largest and most liquid core markets such as Paris, the top five German cities and Stockholm. Dutch markets look well placed to produce strong returns from both an income return and capital value recovery perspective.
Despite the fact that Europe is recovering, there is still value in the United Kingdom. Against alternative income-producing asset classes, UK real estate yields continue to offer a significant premium over government and corporate bonds. For risk-averse investors, bricks and mortar in Europe’s largest and most transparent market will remain a key focus for domestic and cross-border capital.