Our panel of industry experts discuss the opportunities on offer as many observers call the bottom of the continental European property market, and where investors should be heading in search of higher returns. David Hatcher reports.
With an apparently unstoppable resurgence of confidence in Europe’s real estate market, Real Estate Capital’s most recent roundtable concentrated on the continent and aimed to determine whether its recovery was fundamentally justified, and where the opportunities and pitfalls are.
Thrashing this out were chiefs of two of the largest pan-European fund managers – Mike Sales, managing director of Europe at TIAA-Henderson Real Estate and Simon Redman, managing director and head of product management in Europe at Invesco Real Estate. Both firms are looking to find the right opportunities to provide strong returns for their investors in an increasingly competitive, bull market.
They were joined by Rob Harper, senior managing director and head of Europe for Blackstone Real Estate Debt Strategies. As one of Europe’s most active alternative lenders, BREDS aims to pick up the slack from where banks have decamped following their relative, continued conservatism.
Contributing on the advisory side was Blair Lewis, the newly appointed chief executive of Hatfield Philips International, who is at the centre of some of Europe’s largest work-outs of CMBS loans and non-performing loan portfolio sales, as he aims to redirect the business away from pure servicing to include more debt advisory work.
A JUSTIFIED REVIVAL?
SIMON REDMAN: We haven’t underwritten significant growth for a long time. An increased real estate allocation from some European institutions is driving the market, while from Asia, some very big institutions that traditionally only held bonds are broadening their asset allocation. Even if that is only a relatively small amount for real estate, it’s still an enormous amount of money.
MIKE SALES: Economic growth hasn’t emerged in most of Europe so first and foremost you are looking at income yield, which still looks very interesting, given historically low bond markets and attractive borrowing rates.
Property has been a really good diversifier for asset allocators who need to get higher income than government bonds to achieve the 3-4% income required to pay policy holders. In addition, when economic and rental growth return, you will hopefully get some capital growth too. A lot of investors, though, aren’t focused on total returns, they are far more concerned with a sustainable dividend from the property.
SR: We hear a lot about markets becoming expensive, but it depends on your viewpoint.If you’re only getting 2.5% in your domesticmarket, 4% looks good in Europe and 5-6% looks really good.
ROB HARPER: We are not super optimistic about growth in Europe on a macro level – maybe on a specific city area or assets – but you can still buy assets at a big discount to physical replacement cost, which is attractive. That means that no-one is going to be building anything to compete with you until you do get some growth. If someone does decide to build a new building to compete, you’ve had a lot of uplift and if it is something that is going to really compete, you have 24 months’ notice, as it takes a long time to build a building.
BLAIR LEWIS: Over the past three or four years plenty of money has been there, Asian capital in particular, for core assets in Paris, London, Milan or wherever they may be. What has changed in the past nine to 18 months is the availability of finance and people spending more time looking at property in Europe more broadly and calling the bottom of the market.
You have a weird market now with massive loan portfolio trades, hundreds of billions of property still on banks’ balance sheets and core assets trading very well. What is becoming interesting is the bits in the middle: secondary property outside London or regional cities in France or Germany, where people are being forced to move up the risk curve.
BL: Those calling the bottom of the market are working to create product for the second phase of investors who are seeking more established, cashflow-driven income plays, but there is a lot of asset management that needs to be done to do that.
SR: I wonder if value and opportunity is still always there. A lot of capital is looking to buy into it without very much, or not enough, thought, buying hugely distressed loans in an aggressive market. Some capital is not being sufficiently discerning about what it’s buying.
MS: We’ve had a lot of yield compression in the core markets. Pricing is now looking historically scary and the key now in delivering returns is all about growth coming through and the exit yield.
We were successful in prising development projects out of the hands of the banks in 2009 and 2010, like 40 Leadenhall Street and Smithfield in central London, which were heavily distressed and you could, over time, create a core product. With those opportunities today, you are paying up front for growth. For example, with a London development appraisal you have to factor in the growth to begin with to compete to buy it, and at higher rates of growth than are currently expected.
As time goes on institutional investors may start to look at cash in a different way. Cash is a drag on performance now, but there will come a time when it might be right to sit on the sidelines if perhaps the weight of money drives yields too low. That doesn’t just mean interest rates going up, but core pricing may hit such a level that it does not return to investors what they are aiming for and they contemplate a re-rating for real estate.
RH: There is a psychological element to what’s going on in the market. Investors’ cumulative experience since we hit the bottom in 2009 or 2010, especially for global investors in the US looking at Europe,is that if they haven’t bought something sincethen they’ve generally regretted not doing it.
SR: If you have capital just chasing yields in different markets, that’s concerning and not necessarily a good thing. If people buy secondary property in secondary locations in a low-growth environment, they’re doing the wrong thing because those assets will be like that forever. They are usually secondary assets in a bank’s hands for pretty good reasons and they come with additional risk.
RH: Europe’s public real estate sector has been much smaller than that of the US. The US REIT sector as we think of it today was formed out of the early 1990s downturn as vehicles were set up to buy a lot of distressed real estate. During the most recent US downturn, blind pools for specific purposes and existing companies provided a lot of capital to recapitalise real estate and we’re starting to see a little of that in Europe.
I think public real estate ownership will grow as the cycle continues in Europe. You get the liquidity, good asset management and access to capital that is needed. A few blind pool REITs in Ireland and Spain have been successful, as has Kennedy Wilson on a pan-European basis. These vehicles can raise money, manage it professionally and operate in markets with a good supply of deals.
MS: The public markets can be an effective way to secure capital quickly. If it takes roughly nine to 15 months from inception to launch to raise private capital, you say goodbye to the returns you targeted at the outset, as the fast-paced market we now live in will, if markets continue to rise, have eaten up most of the returns promoted at the outset, unless you have secured assets at the outset. It can be achieved overnight in the public markets. I think the window for doing that is closing, though.
RH: The market will only back a few of them at a time. Some will consolidate with other smaller players.
SR: I hope we don’t get to the situation like in the last cycle where any man and his dog can go out and raise capital, though. I think that did a lot of harm.
MS: I don’t think that’s possible on the fund management side. With all the regulation that has come in, the plethora of small, niche managers are unlikely to raise significant sums from institutional investors, as they won’t have the platform depth and resources required. The market is more sophisticated and demanding than it was seven years ago and despite pricing, most of us haven’t forgotten what happened in 2006/07.
ON THE SHOPPING LIST
RH: Whether for our equity fund or debt fund, we will be looking at value-added deals in core markets – hotels that need refurbishment, empty office buildings – specific value-added plays. We are looking for projects where if you deliver them on time and on budget, and execute your business plan, you will be able to sell them into a liquid market with demand for large, core assets – it’s a ‘future core’ strategy.
There are going to be lots of opportunities in Ireland, the Netherlands and Italy. A lot of assets today are held by those who are not long-term real estate owners and those assets have not received the spending or professional management they need.
MS: We like Spain and prime retail. Retailers have struggled there since the global financial crisis and the great thing is that the dominant schemes have survived and rents have been rebased at very low levels. We also like the Nordics, as they are generally transparent markets where there is GDP growth.
SR: We are looking at the fundamentals of markets where you can still buy below replacement cost, which is one of our key metrics, and our geographical spread is broadening as we see more opportunity. We have bought in Spain and have put quite a lot of money into Poland, but not in Italy yet.
We are looking for value-added investments where we can create core property, be it offices in key gateway cities or retail that is dominant regionally or locally. We also want to expand the definition of what’s been seen as real estate, having been active in hotels for many years; we very much like multi-family housing in Germany and are interested in that emerging sector in the UK.
BL: A huge amount of volume will still come from banks and more leverage will be used to buy it, with more stratifying of the capital stack. About €65bn of sales are in the pipeline and around €200bn-300bn of non-core assets on banks’ balance sheets. We will work as a servicer for CMBS work-outs but there will be plenty of non-CMBS work, as many loan portfolio buyers will want help with what they buy.
RH: Across the UK and Ireland billions have sold in loan portfolios, involving thousands of pieces of real estate yet to hit the market. Investors will try and buy out of them, borrowers will negotiate discounted payoffs and debt funds like ours will look at refinancing opportunities.
This starts a chain reaction that is theoretically the next wave of the cycle and we will see if the market ultimately absorbs all of this property.■
AVAILABILITY OF DEBT
Over-reliance on bank debt was a major factor that brought about the last downturn and although there is some caution over leveraging investments in this cycle, there appears to be a slow reversion back to more aggressive financing.
SR: What is different this time around is that the cycle is being driven less by debt and more by a weight of equity. While we are seeing people move up the risk curve it is nowhere near the levels of debt you were seeing pre 2007.
MS: We are deleveraging in some core markets, as low yields arguably present a higher level of risk. We have gone from 40% to 25% in some instances, as we know what can happen when yields are driven down and things start to move away from you.
RH: We are miles away from the 85% leverage deals we regularly saw before. That inspires confidence. With our debt fund, for example, it is very common to have a situation where we are comfortable going to a higher loan-to-value level to get a higher spread, but buyers are pulling us back and saying: ‘Actually, we like the equity deal and we want to put more equity in to capture the vintage and invest our fund.’
BL: With non-performing loans, the market is getting so competitive now that if you are buying a portfolio of €1bn of loans for €500m then you need to finance up to at least around €400m to get to 13% or 15% internal rates of return. Buyers are getting amazing returns through financial engineering and that was the risk in the past cycle.
If you asked someone 12 or even six months ago about the senior debt market they would have said that there was a ceiling of 65% LTV ratios at 200 basis points, but now we are moving to 75% LTVs at 120bps. Nine months ago you could barely get loan-on-loan financing at a 40% LTV. Now you can get 70%, maybe 75% at 250bps and as a result buyers are paying more. I suspect leverage will continue to fuel certain buyers’ aspirations. We may not get to the 95% LTVs of 2007, but the trend is heading towards it.■
THE PERILS OF THE NPL MARKET
Non-performing loan portfolio sales hit €40.7bn for the first half of 2014, according to Cushman & Wakefield data, with a further €65bn in the pipeline. Despite investors piling in to try and maximise their exposure to the recovering European market, there was scepticism over how easy it would be to ultimately achieve strong returns.
BL: The game now is taking a macro view on a market, then making a wholesale-to-retail play. Investors are holding non-performing loans for two years and moving them on.
SR: We look at non-performing loans but I suspect there will never be amazing bargains any more, as so many people are looking. It’s interesting that people are so desperate to buy the whole thing and think they will be able to sell it off easily. You have to be very discerning.
RH: With these big portfolios, a lot of stuff gets put in that people wouldn’t be willing to buy on an individual basis and to sell them at a price that works, you are going to need local and regional buyers, with both equity and a banking system that is willing to finance these transactions. I’m not saying it won’t happen, but I don’t think the market has got there yet.■
At the start of this year Blair Lewis took up the role of chief executive at Hatfield Philips International. The loan servicer has £18.5bn of assets under management in Europe
and holds a 50% share of Europe’s special servicing market. Lewis joined HPI from Royal Bank of Scotland, where he had been head of structuring and origination for Europe.
London-based Rob Harper is senior managing director and head of Europe for Blackstone Real Estate Debt Strategies. The private equity firm can tap into both its New York-listed REIT, the Blackstone Mortgage Trust, which specialises in senior lending, and its $3.5bn BREDS II fund, which concentrates on mezzanine and whole-loan financing.
In his role as managing director of Europe, Mike Sales oversees the running and investment of TIAA-Henderson Real Estate’s European business, having been at the company for 20 years. The company has around £13bn of assets under management across the continent. TIAA-Henderson was formed out of a merger between TIAA-CREF and Henderson Global investors in April.
As managing director and head of product management in Europe, Simon Redman helps oversee $7.5bn of real estate assets managed from Invesco’s eight offices in Europe, out of total global assets of $60bn. Redman joined the company in 2007, having previously been a board director at RREEF, where he developed the company’s European and Middle East private client business.■