REC Decade: A decade shaped by debt

As part of Real Estate Capital’s 10th anniversary retrospective, Tom Leahy of Real Capital Analytics examines how the European commercial real estate market has changed in the last decade.

Ten years after the collapsing US sub-prime mortgage market triggered the start of the global financial crisis, the European real estate market has changed in many ways. Gone are the out-of-office, all-afternoon lunches for a start. But more careful analysis reveals that the changes run far deeper.

The most glaring difference is the use of debt finance by investors. The real estate bubble that formed in the run-up to the crisis was debt-fuelled. In contrast, the European real estate market in 2017 is conservatively leveraged. Memories of a decade ago have ensured a more disciplined use of debt finance by investors, while a rigorous regulatory regime has ensured that bank lending is not – so far, anyway – out of control.

The University of Regensburg’s German Debt Project – of which Real Capital Analytics is the originating sponsor – shows that between 2015 and 2016, average loan-to-value ratios fell for new loans written by banks and other institutions in Germany; a surprising finding given the relative maturity of the real estate cycle.

Equity flood

Another major change in the market since 2007 is that Europe is awash with equity, whereas it was once awash with debt. The central banks’ response to the crisis means investors of every type are starved of income and commercial property is therefore experiencing its moment in the sun.

The capital-raising surveys show that investors in Europe, North America and Asia-Pacific are still under-allocated to real estate. Because of its relative position in the investment cycle and the performances of the continent’s recovering economies, European property is a major target.

The consequence is that there are more sources of non-European capital in the market, investing more significant sums than in 2007. A decade ago, the US was the major source of non-European investment capital, and this remains the case.

Money from China, Hong Kong, South Africa and South Korea was nowhere to be seen in 2007. Players from these countries have invested billions of euros in the market this year alone. Granted, some sources of capital have dried up; the Israelis and Australians are yet to return in force after they invested heavily in 2007.

Within Europe, the Irish, Dutch, Austrian, Spanish and Italian investors which were major players outside their domestic markets in 2007 are no longer present in a meaningful way. Heavily reliant on leverage, Irish investors spent more than €11 billion on European property outside Ireland in 2007. They matched the levels of investment by German-headquartered players, which is a remarkable fact given their relative size.

Indeed, there has been a substantial drop in investment capital deployed by European investors within their home continent. Intra-European cross-border investment totalled €107 billion in 2007, whereas it dwindled to just €42 billion in the first eight months of 2017.

Alternative sectors

The corollary to this is that European players have stepped up investment inside their individual home markets. This reflects some one-off factors, such as the establishment of tax-exempt real estate investment trust regimes in Ireland and Spain, but it also reflects a greater aversion to the risks associated with cross-border investing.

The weight of equity targeting European real estate has heightened competition for assets and had two important effects on the market to differentiate it from 2007: it has pushed transaction prices beyond their previous peak and steered more capital into so-called ‘alternative’ property sectors, including student housing, senior living, data centres and healthcare.

The recently launched RCA global commercial property price indices show that prices in London’s West End district are 80 percent above their 2007 peak, while property in central Paris and the central business districts of Germany’s A-Class cities are 50 percent above their previous peaks. This reflects not only the competition and diversity of capital in the market, but also how the prolonged period of low interest rates has served to inflate asset prices.

The appeal of alternative real estate sectors is a consequence of the high prices in the core markets. In the 12 months to the end of June 2017, just more than €35 billion of these assets transacted, whereas in 2007 the figure was €25 billion. The main driver of this growth has been the expansion of institutional investors into the student and senior housing markets, which has transformed these niche sectors into multi-billion-euro asset classes.

Despite high prices, the European real estate market is well set for a strong finish to 2017. Real Capital Analytics has already recorded more than €10 billion of purchases by new entrants to the market, 40 percent of which come from Asia – emphasising the attraction of the market on a global basis.

Current investment volumes – €153 billion in the year to the end of August – put the market on track to equal the 2016 transaction volumes figure of €277 billion and well above the 10-year average. Perhaps this might be cause for a modest celebration, since Europe’s real estate market is in healthier shape than it was 10 years ago, when the champagne was flowing.

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