May 2013

INSIDE VIEW: A tale of many parts

Building facadeThe value of prime property in major European cities is on the rise, while in southern Europe and elsewhere the outlook is troubled. Neil Blake and Graham Barnes, at real estate service firm CBRE, discuss the mixed fortunes. After dramatic movements in real estate values between 2005 and 2010, the past couple of years have seen a relatively stable performance from commercial property. Nevertheless, there have been marked differences in the performance of different market segments. Capital values have continued to increase at the prime end of the market in core European countries: modern office buildings in major business districts, catchment dominating shopping centres and the best located logistics and high street retail property. CBRE’s Prime Capital Value Index for western Europe shows average growth of 1.5% across all sectors in 2012. But rental growth, even for prime property, has generally been negligible. Growth is dependent on stronger occupier demand which has generally not been forthcoming. However, the lack of new development since the start of the financial crisis has meant that after an initial increase during 2008-09, vacancy rates for most types of prime property have stabilised, which has helped to maintain rental levels and returns for investors. The main exceptions are high-end retail property in a limited number of major European cities, where international retailers are bidding up retail rents by competing for the highest footfall locations. CBRE’s Prime Rent Indices for western Europe show 5% growth in prime retail rents over the past year, but a fall of 0.3% for prime offices and a fall of 1.5% for prime industrial property. For southern Europe, and for secondary property elsewhere, the past two years have seen capital values declining. Investors were already highly risk averse in the aftermath of the financial crisis, and the return of the eurozone crisis in mid-2011 amplified this trend. While investment in some higher risk asset classes has risen, particularly corporate bonds, so far this has not been seen in the real estate sector. There are a small number of potential buyers for such properties and, because of the legacy of bad debts across Europe, there is a substantial supply of product that is available or which could come to market if investor demand was stronger. Weak economic growth has also had a disproportionate effect on occupier demand. In Italy, Spain and Portugal, falling GDP has meant overall occupier demand is still contracting, vacancy rates increasing and rental values falling. Even in countries where occupier demand is stronger, demand is gravitating to more modern space in core locations. LOOKING FORWARD
In some ways markets are either “in” or “out” and not always for the reasons one would expect. Is it natural for shopping centre yields to fall in austerity Britain? Yet recent deals in Guildford and Milton Keynes provide evidence of yield compression at the prime end of the market. At the same time, France has long been seen as core Europe and home of the largest European real estate investment trust (Reit), Unibail. But Axa, the largest French manager of real estate assets, is aiming to reduce its exposure to French property, citing “poor fundamentals”. The divergence in fortunes is not limited to markets or sectors. There is a division between those with access to capital and the rest. The superannuation funds of the world’s emerging or commodity rich economies are in a similar position to the UK’s baby boomer fuelled pension funds of the past. The cost of capital for the favoured few is extremely low by historic measures on the back of low or even negative real interest rates. These distinctions are still to play out, and it is likely that the established trends will continue and, if anything, intensify. The relatively secure income from prime property, in terms of occupancy rates and rental values, is still cheap compared with other asset classes and will continue to attract capital, especially from the international, multi asset class investors for whom relative value is a key driver of asset allocation. This is what drives yields on UK shopping centres. Likewise, the favoured status of large Reits in the capital markets provides them with a demonstrable advantage in terms of doing deals. Less immediately positive is the deterioration of revealed pricing for secondary assets. In the same way that prime assets and markets are likely to see upside as the relative value story plays out, the evolution of stressed capital structures and stressed underlying assets will see material downside for secondary asset pricing. While relatively risk averse investors chase the secure incomes of well-let assets with fairly stable rental values, the only available money for, say, southern European retail property will be from opportunity fund sources with return targets of up to 20% or more. The implications are obvious. One positive note is that the same factors driving inflows from pension funds and insurance companies into property are causing a rise in real estate debt investment. The present value of margins over benchmark yields on real estate senior debt with five to ten-year maturities is very attractive compared with even 20-year corporate bonds. The shortage of real estate debt is likely to ease and margins are already under pressure for the most favoured deals. Good secondary assets may also attract more attention as the spreads between the truly prime and the rest continue to widen. This is where entrepreneurial real estate professionals will find most value. Activity in this space has been thin and values have eroded, so expect a stabilisation and a reverse. Neil Blake is head of UK and Emea research and Graham Barnes is senior director in CBRE’s real estate finance team ©2013 funds europe

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