UK & European capital flows: Investors weigh up risks of step beyond core safety zone

Investment rose in 2010 as equity buyers sought core assets. Is this the future? asks Jane Roberts

The big issue for European investors this year and next will be how far and how fast to move up the risk curve from the core investing strategy that dominated the market last year.

Opinion is split as to how this theme will play out. On one side are those who believe the sheer weight of money means investors will have to gradually adopt more core-plus or value-added strategies, because of the limited amount of core product available and its recent rise in price.

On the other side are the many investors who have capital, but remain cautious, claiming that they are not in any hurry to deploy it. Many are still averse to the use of gearing, despite respected managers telling them now is the time to take some on.

With the market so finely balanced it is not surprising that agents and managers are predicting increases in investment volumes this year, but modest ones, based on a continuation of last year’s trends.

Michael Haddock, director of Europe, Middle East and Africa research at CB Richard Ellis, says: “There is no shortage of capital targeting Europe’s real estate market, but it is mainly risk averse and hence strongly focused on security of income. Moreover, there is no obvious catalyst for  a recovery in the secondary market. The focus of activity in 2011 will be firmly on the prime end of the market.”

Last year this weight of capital, much of it equity, drove European investment volumes up 40-50% (depending on whose statistics you read) compared with 2009, as recovery took hold.

Laurent Luccioni, European CEO of  investment manager MGPA, sees last year’s investment volumes as normal. He says: “That was twice as much as 2009 – which was abnormal – and much less than 2007, which was also abnormal, when there was excess liquidity and a lot of capital flushing around. Last year is not far off representing what we should expect over the next two to three years, with maybe a bit of growth.”

‘Wall of money’ totals $281m

In its last Great Wall of Money report, DTZ estimated in October 2010 that there might be $281m of capital available to target property…globally this year, with $112m  earmarked for Europe (see chart below).

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Europe’s largest markets, the UK, France and Germany, accounted for more than half of direct deal volumes in the region last year, confirming the global trend of investor appetite for core product in mature and transparent markets, according to Jones Lang LaSalle.

AEW Europe had €2.3bn of deals completed or agreed by the end of 2010, including office buildings bought in five separate deals for €350m for its core fund, Euroffice, which is now fully invested.

One of the most striking trends last year was the clear preference by large investors to deploy their new capital directly, or through joint-venture or club deals, rather than via funds. This trend will have a significant effect in the coming years on investment managers who previously operated in a growing funds market.

Sovereign wealth funds dominate

The largest European deals last year were dominated by sovereign wealth funds and big pension funds. The buyers include Dutch pension fund adviser APG; Canadian pension funds OMERs and Canada Pension Plan Investment Board; the National Pension Service of Korea; Australia’s Future Fund; the Malaysian Employees Provident Fund; and Norway’s Norges Bank Invest-ment Management.

In line with this trend, the number of joint-venture deals rose sharply: DTZ estimates that there were 213 joint acquisi-tions last year, compared with 129 in 2009 and only 89 in 2008 (see ‘European joint venture deals’ chart).

Henderson Global Investors, which specialises in core retail investing among other things, advised investors on two of the UK’s largest joint-venture deals from the past 18 months: Australia Future Fund’s £210m acquisition of one-third of the Bull Ring shopping centre in Birmingham; and APG and Canada Pension Plan’s £870m commitment to buy 50% of the Westfield Centre in Stratford, east London.

Henderson’s director of institutional business, Albert Yang, says separate accounts and club deals are not new to Henderson, “but with current market sentiment and investor demand it has become more prevalent.

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“Quite a few investors invested in funds that were over-leveraged, so there is a retrenchment to core markets and more conservative styles and structures. A lot of these investors are deploying sums above $100m and not many funds now are big enough. And anyway, investors don’t have control over their exit route [in funds].”

Yang adds: “I don’t see this changing in the medium-term, for four to five years.” Jeremy Eddy, director of EMEA retail capital markets at JLL, and his office director colleague Chris Staveley, say there has been a big increase in cash-rich investors looking to team up with those that have specialist expertise to own assets jointly. “For me, that is the trend,” Eddy says.

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“It started with Canada Pension Plan  and Hammerson on Silverburn shopping centre in Glasgow and continued through 2010; for example, with Hammerson selling half of O’Parinor to the National Pension Service of Korea, which was advised by Rockspring, and Corio buying in Italy with Allianz. They all want that model now.”

Getting close to the real estate

Staveley adds: “I see this very much in offices as well. It began in 2009 with the State of Oman buying into Bishops Square with Hammerson and continued last year with the South Koreans, advised by Hines, buying Berlin’s Sony Center from MSREF VI, and Corpus Sireo and the Malaysians buying Sheldon Square in Paddington with RREEF. Investors want to be as close to the real estate as they can.”

CBRE believes there will be a gradual divergence in the type of assets investors want to buy over the next 12-24 months, with three strategies in particular standing out. “First there will be those who are happy staying with core,” says Haddock. “These investors will live with the high-ish prices because when you measure property against bonds, the extra yield of the asset class looks attractive. And these are often big investors with big bond portfolios.

“Then we have had several investors in January who said: ‘We feel priced out of buying prime core assets’.” Haddock believes these investors will divide into two groups: those that take  more property risk in core markets, either through letting, development or location risk; and those that take more market risk.

The sovereign wealth funds that have fallen back in love with property (see ‘sovereign wealth funds demand meter’ chart), are likely be in the former camp. Fund managers will be hoping for mandates for the second and third strategies. The strongest-performing German open-ended funds have already taken on more market risk, because they are focused on yield. German fund managers including Union and Deka have been targeting core locations in out-of-favour countries – or ones that were out of favour in early 2010, at least – where they can get higher yields, such as Poland and Spain.

Last year, Deka bought the Ballonti mall in Bilbao and the Avenida Diagonal 640 office building in Barcelona, while Union is an underbidder for Barcelona’s Sant Cugat mall, which EuroCommercial hopes to clinch. CBRE expects to see more value-added investing, “particularly because lack of development creates opportunities for more value-added investment in good locations”, Haddock says. As in the City in the mid 1990s, huge value can be created by finding assets with two years or so left on the lease.

JLL’s Staveley says: “The market would really benefit in 2011/2012 if third-party funds could raise more core-plus and value-added capital, as that drives the mid-market. Managers have the expertise and teams and this model of investment will come back. We are already seeing growing investor demand. The lack of funds raised is partly because the case for core-plus capital has been challenging, with falling rents and lack of finance.”

During 2010 there was a noticeable rise in the flow of secondary assets – or good assets in distressed structures – appearing, a trend that is expected to increase this year. There is talk of more opportunities to buy secondary property at realistic values, which comes through in the ULI’s Emerging Trends in Real Estate Europe 2011 report.

The statistics on deals last year, particularly in the UK, reveal that a surprisingly high proportion were bank-induced sales. There has also been an uptick in recapitalising deals, with investors accessing returns via debt investment.

Announcing Blackstone’s final year results last month, president and chief operating officer Tony James said the US private equity real estate firm expects to be more active in Europe in 2011: “In Europe, creditors are much less transparent and a lot slower to deal with the credit problems in real estate. It’s just about to break open and become more active.” Or as Haddock puts it: “Money will be drifting rather galloping away from core.”