With Brexit and the US election outcome front of mind, political instability is making financiers more cautious. Doug Morrison reports on the key findings of a new report into industry sentiment for the coming year.
Uncertainty clouds the outlook for Europe in 2017 and, as a consequence, industry leaders are applying a “risk-off” strategy to property investment, according to Emerging Trends in Real Estate Europe, the annual forecast published jointly by PwC and the Urban Land Institute.
The spectre of Brexit undoubtedly weighs heavily on the minds of the 781 senior property professionals interviewed and surveyed for the report. But the UK’s 23 June referendum vote to leave the European Union is far from the whole story.
There are widespread fears over political instability, and with it the potential to derail the Eurozone’s still fragile economic recovery. Some 89 percent of respondents to Emerging Trends Europe’s survey rank international political instability at the top of their list of concerns, and 63 percent say they are anxious about national stability.
Publication of the report in November coincided with Donald Trump’s shock US Presidential election victory, which served to underline the mood of uncertainty. “The US election has driven home in people’s minds the idea that political instability is not isolated to one locale. We might have thought that this was a UK phenomenon with respect to Brexit, and maybe there will be some spill-over to continental Europe,” said John Barakat, M&G Investments’ head of real estate finance, at the launch in London of Emerging Trends Europe.
Barakat added: “The US election will create some level of concern about political instability in Western economies, and there will be some recognition now that what Europe faces in the next 12 months, with elections across three or four jurisdictions, is slightly more questionable. There is no question that for the time being, just like there was post 23 June, there will be some pause, some reassessment, maybe some re-balancing, and some pull-back.”
Italy and Austria next
It is clear from Emerging Trends Europe that industry leaders will be closely watching the outcome of the Italian referendum and Austrian election – both due before the end of 2016 – followed by national or presidential elections in the Netherlands, France and Germany in 2017. What is more, nearly two-thirds of survey respondents expect political instability to worsen over the next three to five years. “Never in my career have I had so many risks from a political perspective in so many places at the same time,” says one industry player.
Migration and social inequality are also key concerns. Mass migration into Europe is expected to get worse by 45 percent of respondents; social inequality by 52 percent. “If we move towards more isolation, it will be more expensive to cross borders, and it will affect the ﬂow of business and capital,” warns an international broker.
The process of underwriting geopolitical risk is feeding through in more cautious approaches to deploying capital, equity and debt. A US investor declares that “in Europe in general we are definitely seeing a more ‘risk-off’ attitude”.
There is certainly a general post-Brexit slump in sentiment towards the UK, and yet investors continue to see value in real estate across many parts of the rest of Europe. In the search for safe havens, German cities will be Europe’s most preferred real estate investment and development destinations in 2017. Berlin, Hamburg, Frankfurt and Munich occupy four of the top five spots for investment and development prospects in the coming year. At the same time, return expectations are being scaled down: 35 percent of respondents say they are targeting lower returns in 2017. More than two-thirds believe that out-performance will be more difficult to achieve.
Even so, European real estate will continue to see large inﬂows of equity, particularly looking for prime assets. Of those surveyed by Emerging Trends Europe, 48 percent expect equity available to the sector to increase – less than the 55 percent who expressed this sentiment last year, but still a healthy cohort.
Interviewees are unanimous as to the reasons. Low global interest rates and bond yields are making real estate yields look attractive, even if in most countries they are at record lows.
“The allocation to real estate was 10 percent at the end of last year; that has moved up from 5 percent,” says one sovereign wealth fund manager. “It is based on returns we’re getting from other asset classes – we’re not getting any returns. The fixed-income portfolio is not having its best days so it made perfect sense to take that money and put it into real estate.”
“Real estate is awash with equity, and this is unlikely to change,” adds one insurance company investor. “If we could, we would increase our own allocation by 50 percent – in other words, take half as much again.”
There is less confidence in Europe about debt, however. Those expecting an increase in debt for new investments has fallen from 55 percent last year to 40 percent this year. Lenders are concerned about recent volatility, part of a longer-term trend towards banks pulling back from real estate.
“It feels like banks remain nervous – they’ve been nervous for the last eight years and we started to see that spike last year,” says one REIT chief executive. “And when they get more nervous that affects construction finance and provincial and secondary markets. I don’t think core, stable assets will have a problem finding debt, but other types of assets will struggle.”
Accordingly, only 11 percent of respondents believe that senior debt for prime acquisitions will fall against 19 percent for secondary ones, and 26 percent reckon development finance will be reined in.
As many as a third of respondents believe bank lending will fall, compared with just 15 percent last year. And this is seen as a golden opportunity for non-bank lenders – including pension funds, insurance companies, debt funds or new lending platforms like crowdsourcing – with at least 64 percent anticipating that they will increase their exposure to the sector.
A pan-European debt advisor notes: “Alternative lenders will have an opportunity for a period to do more lending and on better terms.” If banks do withdraw liquidity from the market, alternative lenders can provide a partial backstop although it should be noted that they currently constitute a very low share of the total debt being provided to European real estate.
Though no-one is expecting a debt freeze, many of Europe’s real estate leaders clearly believe the banking sector will struggle to cope with lending volumes given that capital requirements continue to rise. “All banks have the same problem,” says a German banker, “which is raising capital and managing their existing capital situation.”
As one pan-European fund manager concludes: “In this environment of low or negative interest rates, trying to achieve 20 percent returns means you are either borrowing too much or throwing darts at the board. The clear consensus among global investors is to find safe, reliable return and not place capital at risk.”