Emerging trends: Debt tap remains on

Real estate professionals across Europe expect debt to remain liquid into 2018, amid a riskier market, reports Doug Morrison

One of the challenges facing Europe’s real estate industry in 2018 lies in balancing the pressure to invest with the intrinsic risk that comes from a late-in-the-cycle and highly priced property market.

This risk/reward dilemma has been a recurring theme in recent years in Emerging Trends in Real Estate Europe, the annual forecast published jointly by PwC and property industry body the Urban Land Institute. But as the 800 senior property professionals surveyed and interviewed for the 2018 report acknowledge, the challenge is getting tougher each year.

“We’re clearly somewhere towards the end of the cycle, and it’s foolish to assume that this time it will be any different; it is just when and how we will have a correction,” says one global fund manager, summing up the industry mood.

Yet there is little expectation that liquidity in debt or equity markets will fall in 2018 – just 12 percent of survey respondents believe debt availability for refinancing or new investment will decrease, against 49 percent who think it will increase. The figures are very similar for both development finance and equity investment.

The research indicates that capital markets will remain liquid because of a combination of real estate’s relative value compared with other asset classes and improving economic conditions across much of Europe – with a Brexit-hit UK being the notable exception.

As in previous years, income is the main draw in the prevailing low-interest-rate environment, and arguably it is more important than ever. “I’ve not seen such consistency in what the clients are saying – from Asia and Australia to Europe and North America – the income theme is phenomenally strong,” says one pan-European fund manager.

Another fund manager active across Europe adds: “If you feel that equity markets have had their run, and you can’t make money in bonds, then real estate wins by default.”

In other words, the continuing low yield of other fixed-income instruments is putting pressure on fund managers to invest in real estate, even if some do not feel hugely enthusiastic about it. “Institutional investors that we are selling to are sitting there and saying, ‘it’s expensive, and what I want to do is sit on the sidelines or sell, but what I’m going to do is invest’,” says one global investor. “They’ve got their asset allocators telling them that, on a relative basis, real estate looks cheap.”

The general consensus is that yields in core markets – such as Paris and the major German cities – will not fall further, although they are unlikely to rise, either. “This market has been going up for eight or nine years since 2009, and that keeps us busy but not awake at night,” says one major European pension fund manager. “We still see plenty of signs that we can continue at these levels – the fact that there is still plenty of equity available chasing property. The spread versus treasuries is still very healthy, and the sector is not overleveraged.”

“The market remains very strong,” observes a German institutional investor. “If you look back at 2017, the main takeaway was that there was lots of uncertainty about geopolitics and politics, and in spite of that, we will have invested a record amount.”

There remains, nonetheless, a persistent undercurrent of caution across the industry, and it invariably comes back to the notion that record low prime yields are inherently risky. “A couple of years ago we were saying we would never see yields reach pre-crisis levels again, and now we are well below them,” says one pension fund manager. “As long as rates stay low, 3 percent yields look attractive, but in a couple of years we may look at this period as being crazy.”

At the same time, return expectations are being scaled down – 36 percent of respondents say they are targeting lower returns in 2018. And though most interviewees say the yield gap between real estate and bonds, as well as financing costs, remains compelling, the big question remains, for how much longer?

Interest rates

Interest rates are the most commonly cited factor that might make the market turn. However, unless there is a geopolitical shock to the monetary system causing a very sharp and sudden rise in rates, many see “a slow movement towards normalisation” as the most likely outcome.

PwC and ULI conducted the research before the UK’s 0.25 percent rise in base rates to 0.5 percent but the Bank of England’s November 2 announcement – coinciding with publication of Emerging Trends Europe – was widely anticipated and well within the industry’s comfort zone. Such sentiment is evident across the European Union.

“There is still the room in there to absorb an increase of 100 to 150 basis points without much of a problem,” says one opportunity fund manager, while a Dutch pension fund manager adds: “Low but rising rates will make other sectors more attractive, but we will still see a big spread between bonds and property yields. Property’s position will weaken but not significantly.”

Against this investment backdrop, the survey points to an increase in the availability of debt across all providers – banks, CMBS, debt funds, non-bank institutions and other alternative lenders – with the latter two expected to show the most significant increases in exposure to real estate during 2018.

The interviews, however, offer a more nuanced outlook. Debt remains highly liquid for prime assets, albeit less so for secondary. If anything, widespread geopolitical concerns among borrowers and lenders alike have reinforced the flight to quality that has been evident in Emerging Trends Europe for some years.

What is more, the lenders interviewed for the report claim they are maintaining conservative underwriting standards, which suggests, in theory at least, that debt is not posing a systemic threat to real estate this time around.

Risk averse

“We don’t want to compensate for higher risk by taking a higher margin,” says a German banker. “For a while, competitive pressure has been focusing on pricing, but margins have bottomed out now. The temptation is to compete on risk, but that’s a road we don’t want to go down. We accept that we’d rather lose a deal than increase the risk position.”

Then again, there is little to choose between senior debt availability for large gateway cities as opposed to regional cities. “Germany is still massively overbanked, and in France, French banks are being more aggressive,” says one German lender. “I don’t think in general there is any shortage of liquidity. There are gaps in certain markets like development finance in London or hospitality.”

It is also clear, though, that the industry draws a distinction between different types of development. Two-thirds of survey respondents see redevelopment or development as the most attractive way to acquire prime assets. Further investigation through the interviews indicates that, for many, this means a relatively low-risk strategy, invariably based on refurbishment rather than a hasty return to speculative development.

Smart asset management

Low returns and a lack of product in a late-cycle market have underlined the importance of “smart asset management”, as one pan-European investment manager puts it. “We are not going to be able to generate the returns we want by buying assets and sitting on them. We have to think about the management of the tenants, refurbishment and regearing.”

Equity and debt markets exhibit similar patterns, and survey respondents are not expecting investors from any part of the world to decrease their investment in European real estate. The strongest increases are expected from Asian and European capital, followed by that from the Americas, with the Middle East and Africa bringing up the rear.

“We are seeing a lot of interest from domestic European investors in their home markets when we are looking to sell,” says a sovereign wealth fund investor. “The French life funds have had huge inflows from retail investors and are doing a lot in Paris, and the Germans are doing a lot in Germany.”

Another investor points out: “You have all of these sovereign wealth funds and superannuation funds that have never even spoken about real estate before, like Japan’s Government Investment Pension Fund, that now want 1 percent to 3 percent in real estate; the flows will keep coming from that.”

The message seems to be that as long as the equity inflows keep coming and the real estate yield gap holds, debt will follow. Barring any geopolitical trauma in the global economy, the real problem for 2018 will revolve around sourcing readily available stock in which to deploy the capital.

BREXIT HITS SENTIMENT TOWARDS THE UK

Brexit remains uppermost in the minds of European real estate leaders, with a strong consensus that it will be at least partly responsible for both investment and values falling in the UK during 2018, and rising across the rest of the European Union.

Emerging Trends Europe underlines the slide in sentiment towards the UK where, despite some semblance of normality returning to investment volumes in 2017, there is widespread concern over the economic impact of Brexit in 2018 and beyond.

“We have had very little slowdown or price correction to date and it feels to me like a false market,” observes one London-based investment manager. “It is going to be a protracted slowdown from here, and we are starting to feel the impact of that.”

The CEO of a UK REIT states: “We are in a period where, because of the uncertainty, business is making less investment and delaying decision-making. Those things generally are recessionary. Whether we will have a recession I don’t know but we will be in a very low-growth environment.”

By contrast, the prolonged uncertainty has strengthened the conviction of those who believe the occupier and investment markets in Frankfurt and Dublin will gain from EU-related businesses and jobs relocating from London. “In Ireland and Germany, Brexit has pushed out the end of the cycle by maybe another two to three years,” says a big international investor.

Paris, Berlin, Luxembourg and Madrid are frequently mentioned as potential Brexit beneficiaries. But, if anything, the interviews conducted in the rest of Europe indicate a far wider circle of would-be Brexit winners than initially anticipated a year ago. Interviewees as far afield as Helsinki, Milan and Warsaw believe their cities stand to gain.

No one on the continent believes there will be an outright city winner at the expense of London, although 72 percent of survey respondents think Brexit will reduce the UK’s ability to attract international talent in 2018.

The one other area of consensus is in the Brexit uncertainty continuing for the foreseeable future but few in the industry question London’s position as a key destination for long-term investment. “There’s no way London is going to lose its place as the financial capital of Europe but we’re undoubtedly beginning to see rents soften,” concludes one global investment manager. “But then, we shouldn’t be too surprised by that. I think it’s a short-term blip, and London will remain strong whatever happens.”

INVESTORS DRAWN TO DEFENSIVE DEBT

In this late-cycle economy, leading investment managers and their institutional clients are increasingly drawn to the defensive qualities of real estate debt rather than investing in prime assets that are widely considered expensive.

Nearly three-quarters of respondents to the Emerging Trends Europe survey expect non-bank institutions to increase their lending activity in 2018, and 69 percent believe debt funds and other non-bank lenders will also up the ante during the year.

“The big push for us is CRE debt,” says one investment manager, and it is clear debt as a means of exposure to real estate has broad appeal. The interviews with managers raising capital for debt funds reveal that the investor interest is evident not just in Europe but in the Middle East and Asia.

“If we buy a building at 3.5 percent yield, we cannot assume that in 10 years interest rates will be as low as they are now, and the building will have aged 10 years,” explains a pan-European player. “Therefore, you’ve got to move yield out from 3.5 percent to 4 percent. Then you’re into negative capital return territory, unless you’re in a market where you think there’s very good long-term growth. And that’s why debt is a good position to take right now; you can generate great income return while protecting your capital and seeing how markets play out.”

Another global manager observes: “It’s very much defensive, with an attractive current yield and a more senior position in the capital stack than equity. We all recognise that we are relatively late in the economic cycle, so if you think there is going to be a downturn somehow, somewhere, sometime in the next few years, it’s a good place to be.”

THE SECTORS AND CITIES TO WATCH

Logistics

A perennial high-achiever in Emerging Trends Europe, logistics is ranked number one for investment and development prospects in 2018, largely on the back of the growth in online retail sales.

“Technological change is clearly playing out in the retail sector, and as retail shrinks, logistics expands, as does the last-mile delivery convenience to the consumer,” says one global advisor.

If there are any doubts, they are usually around the sheer weight of capital bearing down on logistics, and its effect on values beyond 2018. “Not all logistics markets are the same; there will be winners and losers,” says one interviewee.

Residential

The Emerging Trends Europe survey reveals housing shortages as one of the key social problems facing the industry in 2018.

At the same time, the industry is starting to acknowledge the opportunities in a sector where “the fundamental demand-supply imbalance is likely to drive rental growth”.
Aside from the major markets, interviewees in countries as diverse as Austria, Benelux, the Czech Republic, Ireland, the Nordics and Poland are drawn to the compelling supply/demand dynamics of rental housing and, in the absence of existing stock, gaining exposure via development.

Berlin

Berlin has been crowned the leading investment destination in Europe for the fourth year in succession, even though prices have soared, and yields are as low as 3 percent for offices and shops.

The key to the German capital’s appeal is that while values are high in most European cities, in Berlin they are widely considered to be sustainable – buoyed by rapid population growth and vigorous business expansion.

“Real pricing is materially below other world cities. It’s got an educated workforce, creative people and culture, as well as the government sector and the benefits that brings,” says one investor.

Copenhagen

The dominance of German cities in the eyes of European investors is broken by Copenhagen, which claims second place – jointly with Frankfurt – following an impressive ascent of the rankings over the years.

Domestic and international players alike are drawn to the Danish capital for its strong employment growth, lively tourist trade and a buoyant residential sector in which transaction volumes doubled in the first half of 2017.

“The flow of capital into Denmark this year has increased significantly, very much in the residential market,” says one Nordics specialist.