Economic turbulence in equities markets also threatens property’s recovery, reports Lauren Parr
Rob Wilkinson, AEW Europe’s chief investment officer, is not exaggerating when he says: “It’s been a more troubled summer than some of us envisaged.” The twin blows of poor Q2 GDP growth in Europe and bleak forecasts for the rest of the year, coupled with another euro crisis triggered by fears of an imminent Greek debt default, set off big falls in stock markets around the world in August.
Banks and insurers were thumped, investment banks started cutting jobs again and the US is in almost as big a mess as Europe – August was the first month since the second world war when jobs creation was so low there that it didn’t officially register. The fragile recovery in investor confidence in European real estate has been shaken as a result, although plenty of investors still see core, prime property as a safe haven. Meanwhile, extreme volatility is having a marked effect on secondary property and has put the kybosh on a string of deals.
“The volatility seen in capital markets as a whole has inevitably had an in impact on confidence across all asset classes,” adds Wilkinson. A fund advised by his team pulled out of a deal to buy the Grange and Pyramids shopping centres in Birkenhead. European Property Investors Special Opportunity Fund (EPISO), managed by AEW and Tristan Capital Partners and advised by asset manager Addington Capital, had been in talks to buy the assets for around £80m, reflecting a blended yield of about 9%, from Lloyds Banking Group.
EPISO felt it was difficult pricing assets in a secondary town and it was not the right time to take that risk. “Market uncertainty coupled with the impact of austerity measures in the UK is hitting consumer confidence, which leaves us cautious about UK retail,” says Wilkinson.
Double dip “a real possibility”
Zubin Irani, managing principal at West-brook Partners, agrees that it is a difficult time to invest in an asset class so tied to the wider economy, because “it’s very clear that a double dip is a real possibility”. Jorrit Arissen, senior portfolio manager of real estate securities at PGGM Investments, also sees a double dip recession as fairly likely, given the need to cut debt, combined with fiscal tightening. “In 2008-2009 we had a hefty shock, followed by a relatively sharp recovery; now we have had a hefty shock that is likely to be followed by a longer period of weak growth, if not mild recession.”
Cash flows may come under greater pressure, particularly for secondary property. A recovery in GDP growth underpinned a recovery of rents in 2010, but in its absence rents could come down. “The sustainability of cash flows is more important now,” Arissen says. “A company could get into trouble if a cash flow is not sustainable and banks question whether or not they want to lend to those companies.”
Tony McGough, global head of forecasting and strategy research at DTZ, adds: “The nervousness has happened in summer, which is quiet for property anyway. So it’s almost given people an excuse not to push deals forward.” London & Stamford recently withdrew a £140m bid to buy Kingfisher shopping centre in Redditch from Scottish Widows Investment Partnership, amid market uncertainty. In Belfast, the CastleCourt shopping centre failed to secure its £170m asking price, with potential investors such as Land Securities and Blackstone only prepared to offer about £140m.
“It indicates that the investment market is reflecting general economic concerns and retail rent levels, but that there remains a strong investment market if the price reflects the strength or weakness of the cash flow,” adds DTZ’s head of shopping centre investment, Mark Williams. All of which is bad news for agents. “At the start of the year we expected quite strong growth in European investment on the back of secondary property coming to the market, as prime is now fully priced,” says McGough. “But that hasn’t happened; European growth has petered out in the investment market.”
Savills predicts a further slowdown in the second half of this year. Eri Mitsostergiou of Savills research says: “Generally the pace and enthusiasm is not as great as it was compared to the beginning of the year.” She admits that uncertainty about a double dip recession “does not help the market”, but still expects deals at an advanced stage to be completed. Other deals could be delayed until the uncertainty is resolved, however.
McGough says deals are taking longer to close because “investors are rechecking numbers and putting in dreadful scenarios to see the outcome if ‘X’ happened. They’re asking ‘would it still make the right return relative to government bonds?’ “That’s what has caused this slowdown people are really making sure they are getting the right property. Investors’ confidence is not necessarily shaken, but an extra note of caution has been added.”
Opportunistic investors are questioning whether they can underwrite deals now, according to Wilkinson. “Concerns over economic growth, or a double dip, make it hard to predict some of the occupational factors driving the real estate market, whether in the office, retail or industrial space,” he says. “Underwriting value-added or opportunistic strategies in this context requires a micro-level understanding of the markets in Europe and asset specifics.
“Given potential volatility in Q4, a lot of investors may adopt a ‘wait and see’ strategy. If the economic outlook or capital markets deteriorate further, that might present interesting acquisition opportunities. Until then, the flow of deals for opportunistic investors will depend on stock-picking and identifying liquidity constraints.
“In some of those situations vendors may be realistic about pricing, but in a number of cases there is still a significant pricing gap. The exception will be where vendors are highly motivated or are forced sellers.” Threadneedle is rumoured to have put a couple of off-market deals on hold in this climate, while a deal for Aldwych House, WC2, has also progressed slowly, following renegotiation of the price by Rowan Asset Management, which is under offer to buy the building for £85m.
One City agent notes: “If you’re spending £150m now you want to make sure it’s not going to be worth 10% less by Christmas.” Wilkinson feels that “in some situations vendors would probably be realistic about trying to get things done; they might say ‘Fine, we hear that – how do you see it?’” There has been wavering and questioning, particularly on the part of buyers, he says, although some vendors that need to exit their investments will accept whatever price is necessary to make the deal happen.
Core properties will continue to trade even if yields rise, but properties missing just one of the many characteristics of a core asset may struggle to be sold. Westbrook Partners’ Irani agrees that: “It’s difficult to take a lot of risk now. Investors have been cautious about what they will invest in. If you’ve got something that’s prime, long term and credit worthy, a lot of money is available for it, because of the gap between base rates and real estate yields. “But there hasn’t been a lot of appetite for out-of-town, secondary real estate with leasing risk. Given what’s happened in the economy, I think it’s going to be even tougher for those markets to recover and for investors to feel comfortable enough to invest and take meaningful risk.”
Risk aversion rules
Legal & General Property managing director Bill Hughes says the economic turmoil “means investors in any asset class will be more discerning and risk averse. There is a preponderance towards stable, safe-haven assets, countries and asset classes. “That means a net positive in favour of good-quality real estate, based on either location or covenant. Good-quality and good-covenant assets retain liquidity, as well as providing less volatility in performance. “By the same token, there’s a more negative view to assets based or dependent on growth, or on poor covenants improving or surviving. There is a more extreme bifurcation between good, safe real estate and poor ‘growth-dependent’ real estate.”
Benson Elliot managing partner Marc Mogull thinks that given the low or volatile returns currently offered by other asset classes, investors may accept lower returns on prime property assets as inevitable if capital growth is taken out of the return equation. But he believes this is a risky strategy because low-yielding prime property is disproportionately exposed to interest rate rises.
He predicts that retail investors will lose their appetite for property as returns fall, while institutions may cut their allocations too if the ‘denominator effect’ – where property is sold to keep exposure in line with percentage targets as the wider portfolio shrinks – becomes an issue once again. Malcolm Naish, Scottish Widows Investment Partnership’s director of real estate, has not seen a significant outflow of capital or deterioration of demand yet.
Neither has Hughes. “We’ve seen close to a stable balance between buyers and sellers of open-ended products,” he says. “For everyone who might be concerned about real estate, someone else out there sees it as a reasonable medium-to long-term strategic bet.” Despite the turmoil, Arissen says long- term institutional clients cannot implement changes in allocation decisions overnight, even if they would deem it appropriate, given the size of assets and the limited liquidity in the market. This makes it difficult to act on short-term market turmoil.
Capital raising “is challenging”
AEW has recently raised a further €176m of equity commitments for its French core retail fund, Fondis, and is also in the market with a number of products including a pan-European core fund. “It’s a diversified strategy for a new fund with an open-ended structure,” says Wilkinson. “Capital raising for these products is challenging but we are beginning to see increased interest.”
McGough expects real estate investment will be supported by a lack of better alternatives. “You’ve had very volatile equity markets and government bonds look overpriced,” he says. By contrast, real estate also benefits from a relatively secure and sustainable yield compared with other assets. Despite Mogull’s concerns about prime yields, low UK interest rates still support real estate’s risk premium. Concerns over real estate’s outlook in Europe have deepened, but it remains attractive on an income-yield basis, relative to government bonds and cash.
This is about how governments says Phil Clark, head of property investment at Kames Capital (formerly AEGON) and chairman of the Investment Property Forum. volatility is not being reflected in good quality real estate values.
If investor confidence is secured in the eurozone’s sovereign debt strategy, that will encourage greater capital flows, will help generate occupier demand, rental growth and therefore support investment values.” But Clark doesn’t deny these are big ifs. “At a global economic level, putting in place an agreed, transparent and credible de-leveraging strategy for the government purse in the eurozone is a very big task and no one is going to do it quickly.”
Increased funding costs could push banks into crisis mode again
It isn’t just investors who have been rattled by the summer’s market volatility – banks have also been hit. Their shares have taken a pummelling – Royal Bank of Scotland’s share price has nearly halved since late July – amid concerns over their sovereign debt exposures in the eurozone, plus fears of a double dip recession in major economies. Moreover, profits have been dragged down, prompting banks such as UBS and Goldman Sachs to cut jobs.
European CMBS spreads continued to widen at all points in the capital stack throughout July and August, with triple A spreads now at their widest since 2009. According to a report by Bank of America Merrill Lynch, compared with early July levels, spreads are now wider by roughly 110 basis points for AAA notes, by 160bps for AAs, 225bps for As and 275bps for BBBs.
Higher funding costs will hit banks’ investment banking activities, while further pressure will be put on them as a result of this month’s final recommendations from the Independent Commission on Banking. Another financial crisis would be a heavy blow to the liquidity of European real estate finance. Bank funding remains a key source of risk for banks’ earnings and their ability to lend, and is a drag on economic recovery, Morgan Stanley research shows. There could be a step change in the pricing and availability of senior unsecured debt, given the fears about sovereign debt.
“There’s no question that funding costs for all banks have gone up quite significantly as a result of market uncertainty,” says Max Sinclair, head of UK debt at Eurohypo, although it is not yet possible to judge whether there is more or less liquidity in the system and what it will be priced at, as there have been no new deals of note lately.
“There has been a lot of volatility over summer and anything that’s happening at the moment is generally business that was agreed prior to the summer,” Sinclair adds. Without a change of government policy, stress on bank funding could lead some lenders to shrink their loan books, increasing the risk of a credit crunch in southern Europe, Morgan Stanley warns.
Banks remain cautious and are being selective about their real estate lending. As well as showing restraint in terms of new business, banks may speed up the pace at which they offload legacy assets, believes Hammerson’s chief executive, David Atkins. Speaking at the annual European Public Real Estate Association conference on 1 September, he said: “The further [recent] shock in the banking market will accelerate disposals of assets held by the banking community. The message coming down from the boards of the banks is that they have to accelerate disposals.”
Recent volatility has made banks less willing to lend to each other, which is reminiscent of the situation in 2008, despite the fact that banks are now better capitalised and less dependent on short-term liquidity. Therefore the rising cost of funding will translate into higher borrowing costs. “European banks’ credit default swap spreads have gone up 20-40 basis points,” says Sinclair. “So it is more expensive for all European banks to borrow and that will be passed on to the borrowers in turn.”