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Magazine Issues » February 2016

REAL ESTATE: Moving into property

CranesCapital has returned to the real estate sector and cranes are back on the skyline. Kit Klarenberg looks at capital flows and considers how to enter property, ETFs included.

In the years following the financial crisis, boarded-up shops and abandoned building sites blighted many European capitals, a reminder of the continent’s ongoing economic strife. 

Now, investors have returned to commercial property as a source of income and portfolio diversification. According to data from Savills, capital invested in 2015 in Europe’s commercial property was around 30% above the long-term average, and nearly 80% of 2007 levels.

Nonetheless, many remain wary of the sector, determined not to get their fingers burned again. How can institutional investors capitalise on the opportunities offered, without taking on too many of its risks?

Due to the sizeable costs involved in purchasing commercial property outright, most investors are precluded from direct investment.  

“Even for institutional investors with €1 billion to invest, it can be hard to have diversified exposure, especially in larger markets like London and Frankfurt where individual buildings can easily be worth over €100 million,” says Simon Redman, managing director of client portfolio management at Invesco Real Estate.

However, from a risk standpoint this barrier is arguably a blessing, in that it obliges investors to seek exposure via a range of indirect vehicles, which invest in a wide portfolio of commercial property assets. Pooled funds are perhaps the most common example. 

“A property fund provides investors with access to a diversified pool of assets so they don’t have to put their eggs all in one basket with one specific property,” says Ian Kelley, European fund director at BMO Real Estate Partners.

“A fund’s returns are underpinned by its assets, with the potential to provide a strong, stable income stream with the prospect of long-term capital growth. An investor’s choice of fund should be driven by their own risk and return requirements.”

Redman says that when picking a fund, two considerations are key: “As a market, Europe is not very transparent, so you have to be embedded locally – having a local network of people who speak the language and live the market. It gives you better access to deal flow and means the right assets are sourced. 

“For investors seeking core returns, size is very important – larger funds can invest in more assets and therefore be more diversified,” he adds.

Still, funds are not the only means of diversifying commercial property investments. Real estate investment trusts (Reits), which invest in property companies, developers and housebuilders, are increasingly favoured. 

“They provide investors with access to stable income streams generated by high-quality commercial buildings and associated property returns,” says Stephen Hayes, head of global property securities at First State Investments.

“The cash flows generated are typically derived from long-term rental contracts, making revenues relatively predictable. Reits pay no corporate tax from passive earnings and distribute most of their net profits, enabling them to pay high and stable dividends to investors.”

Reit investors also benefit from not paying capital gains tax on any growth in value of properties indirectly held by the trust. Although, dividends are taxed as income once distributed.

An alternative to both funds and Reits gaining in popularity are property exchange-traded funds (ETFs). These vehicles are nothing new, but have evolved significantly in recent years. 

As Tom Fekete, head of products for iShares explains, previously commercial property ETFs tracked the performance of Reits.

“While they provided exposure to the property sector, they were also significantly correlated to equity markets and the volatility associated with them,” he says.

Today, while still not a direct investment in physical property per se, commercial property ETFs reflect the characteristics of physical property while preserving the liquidity and ease of access of a Reit. 

They achieve this by tracking the performance of an underlying property index, by either physically buying and holding the securities in an index, or effectively subcontracting index tracking to a bank, buying an index swap to get the returns. 

“Both methods can work well, producing products that reliably track their indices,” says Michael Mohr, head of exchange-traded product development at Deutsche Bank. “Although, an investment in commercial property ETFs is an investment in commercial property companies, not bricks and mortar. Their performance is linked to a number of factors, such as occupancy rates, office space and the wider macroeconomic picture, and also company-specific drivers such as individual levels of debt.”

Moreover, income investors may be better served by direct investment in a commercial property fund or Reit. Almost invariably, the yields offered by ETFs will be smaller as they track a broader market, and dividends are calculated on an average basis. 

This said, there are several benefits to investing in the sector via an ETF. Costs and fees are low, investors achieve diverse exposure to the market, and they offer a highly liquid means of investing in a fundamentally illiquid asset. While ETF investors can easily exit if and when they wish, direct investors are stuck with a property they may not be able to shift for some time. 

Irrespective of the pros and cons, one thing’s for certain – despite their relative infancy and somewhat limited availability, commercial property ETFs have already taken off with retail and institutional investors alike. 

“We are seeing strong demand, and they are being used in a variety of ways,” Fekete says.

“For example, property managers consider them an alternative to some of the cash weighting in their portfolios, while retail investors like that they can cheaply and easily gain exposure to an asset class traditionally expensive and difficult to access.”

At present, there are a number ofEuropean commercial property ETFs available to investors; some are country-specific (such as the iShares MSCI Target UK Real Estate Ucits ETF), others region-wide.

The influx of capital into real estate is reducing the number of investible properties on the market, and pushing prices higher. Despite this, many continue to see opportunities, both in established markets and cities in emergent regions. 

“While some areas are nearing excess, and most valuations aren’t cheap, they’re not terrifically expensive either,” says Mark Abramson, managing director of real estate investment manager Heitman.

Others such as Fergus Hicks, associate director at commercial property services firm Cushman & Wakefield, believe pockets of the market to be actively underpriced. The firm’s most recent quarterly analysis classified 47 European markets as underpriced. Central and Eastern Europe, the Eurozone periphery and the Benelux regions have the highest share of underpriced markets and are said to boast the most attractive opportunities for investors.

Hicks’ colleague Matteo Vaglio Gralin sees the best returns in industrial property: 70% of the sector remains underpriced, according to Cushman & Wakefield’s analysis. 

“Ongoing changes in retail distribution and the impact of the internet continue to bring about change in the logistics sector,” he says. “The higher yields available compared to retail and offices are making for good investment opportunities.”  

Nevertheless, Hicks does expect opportunities to diminish in future, as strong investor demand will drive yields lower and cause the number of fully priced markets to increase. 

“The likely extension of the [European Central Bank’s] quantitative easing programme would be supportive of real estate and we think prime property yields in core Eurozone markets will not rise until 2018,” he says. 

Those disquieted by inflows nearing levels akin to those immediately preceding the financial crisis may be deterred from investing. This time around though, investment is primarily being driven by investors simply not being able to find a better destination for their equity, not debt. Those wishing to access the sector should move quickly, while good returns can still be found.

©2016 funds europe