Last year was another spectacular year for commercial property across most asset types and locations. The Irish commercial property market was the European leader of the pack in 2006, with returns in excess of 27%. In fact, all of the major European markets produced strong double digit returns last year, with the exception again being Germany.
However, we believe that 2006 marked a turning point in commercial property markets when the key drivers of return changed from yield compression, supplemented by gearing, to an emphasis on rental growth and active asset management of the underlying properties.
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Yield Compression – The Holy GrailThe key driver of returns over the last four to five years was a sharp fall in property yields. Every major European market has experienced some degree of yield compression over this period. For example two of the hotter office markets in Europe are Dublin and London, which have seen yields decline by about 200 basis points to around 3.75%.
Other markets of note include Paris, Stockholm and Madrid, which have all seen yields fall to 4% or lower as can be seen in Figure 1.
The sharp fall in yields was caused by a tidal wave of capital hitting commercial property markets. Over $600 billion was invested last year, up from €200 billion in 2001. Global pension funds are increasing their allocation to commercial property due to the volatility of equity markets and the low yields on global bond markets.
While this institutional allocation to property has still someway to go, the fact that prime initial yields are now as low, if not lower, than long-term bond yields, means the investors will become more discerning.
The problem for private individual investors is becoming even more acute as they are being increasingly priced out of many core-markets across Europe. The vast majority of individual investors rely on using significant amounts of debt to finance commercial property transactions. In fact, the use of debt worked very
well over recent years.
Happy Days…The reason the use of high levels of debt worked so well in recent years was that yields from commercial property in most markets were greater than the underlying cost of funds – and by a decent margin.
This positive yield spread allowed investors to finance deals aggressively and in many cases still have enough free cash flow to amortise or reduce the underlying level of debt. And then, things got even better. Property yields fell as interest rates declined, with property values increasing dramatically.
… Can’t Last Forever!Unfortunately, given the sharp decline, or compression, in yields and the increase in interest rates over the last year or two this happy situation no longer persists.
With property yields low and the cost of funds increasing, this poses obvious problems for highly leveraged investors to actually get into the markets. However, not only does it make it difficult to finance and buy commercial properties, it also poses significant investment risks that can only be offset by strong rental growth.
For example, if you buy a property yielding 4%, and yields move out to 5%, you will need a 25% increase in rents to fully compensate for the fall in value of the property, all else constant.
Search for Rental Growth is On!Put simply, it takes a lot of rental growth to make up for yield widening from low initial yields.
Consequently, the focus of our strategy going forward is either to find markets with strong rental growth prospects, find markets with stable income profiles or find individual properties where we can increase the rental potential by active asset management, refurbishment or redevelopment.
European Office Markets – Rents Growing, Vacancies FallingOur strategy over the last few years focused primarily on core-office properties (that is, Grade A properties, in CBD areas let to blue chip tenants with strong covenants) across Europe, in markets which we felt would be the first to see a pick up in rental growth. This has produced very robust returns. The markets that we targeted included London, regional UK, Paris, Brussels and Stockholm.
As it has transpired, rents in most office markets across Europe are now growing, with momentum gathering steam in many of the individual markets. A strong pick up in occupier demand has led to falling vacancy rates, which in turn have supported the growth in rents. According to Jones Lang LaSalle, Dublin and London saw prime rental growth last year of 26% and 20% respectively – some of the strongest increases in Europe. This in part helps to explain why yields for prime office space in these cities are now close to 3.75%. Other major cities experiencing strengthening rental growth include Paris, Stockholm, Madrid and Barcelona.
Preferred Office LocationsThe markets with the strongest rental prospects include Paris, Stockholm, London, Copenhagen and Dublin, which are also some of the most expensive. For highly-leveraged private investors it makes transacting in these markets very difficult.
Nevertheless, these markets should be some of the best performers over the medium-term as future rental growth will be the main driver of returns.
Looking to the immediate future, out view is that core-office markets in the regional parts of the UK lookfully valued, with limited further rental growth. The London market still offers the prospect of strong rental growth, but the current cost of funds makes London and the rest of the UK difficult to finance. It is worth noting, that in 2006 we sold over €250 million worth of property in the UK, taking advantage of what we think will be high points in some markets in this current cycle.
Dublin, Paris and Stockholm coreoffices should see some of the strongest rental growth over the next three to four years but, again, the prevailing level of yields makes these marketshard to transact in for private investors.
For investors looking for longer term wealth preservation investment we continue to favour the Brussels/ Benelux market and invest there regularly on behalf of individual families, achieving much higher yields for Grade A offices on long leases than are available in most other capital cities.
For core-office opportunities we will be focusing our attention on:
Primary:
-Paris
-Stockholm and the Nordic area
-Brussels
Secondary:
-Luxembourg
-Switzerland
-Regional parts of France
In essence, most Western European core-office markets are becoming increasingly difficult to underwrite at reasonable returns for private investors (especially for investments with a five- to seven-year time horizon). To achieve returns of 8% plus per annum will require some form of additional risk associated with the property, be it the lease, the tenant, the building or the location. We will be focusing our attention on these value-added plays in the above markets, along with:
-London
-Dublin
-Germany
-Amsterdam
European Retail Markets – To Benefit From Stronger Economic GrowthOne of the key strategies investors should concentrate on for the next couple of years should be retail commercial property as we believe that consumer spending will accelerate in Europe. Furthermore, the retail commercial property market is inherently more stable than office markets and is less influenced by the economic or business cycle. The majority of retail markets across Europe experienced some form of prime rental growth last year, although Germany and the UK saw little or no growth. Retail yields across Europe, however, are very demanding, with the Irish, British and Spanish markets being the most expensive. Prime yields are in the region of 2% in Dublin, 4% in the UK and around 4.25% in Spain. It is hard to envisage further yield compression of any consequence in these markets, while the scope for yield compression in other European markets is quite limited as well. Consequently, strong rental growth will be required to justify the level of yields that currently prevail in most markets.
Retail Sales & Floor Space – Critical Determinants of Future Rental GrowthRetail sales in Europe exhibited reasonably strong growth last year, although momentum did wane towards the end of the year. The Nordic region saw the strongest growth in retail sales, particularly in Sweden. Many of the European peripheral markets saw some of the strongest growth in retail sales last year, with Ireland, Greece and the Netherlands featuring prominently. Core-Europe continued to lag behind these hotter markets, with retail activity very weak in Italy and, to a lesser extent, in Germany. Surprisingly, Spanish retail sales were also quite weak in 2006, although the level of activity accelerated over the second half of the year versus a very weak first six months. UK retail sales remained well underpinned last year helped by strong wages and employment growth.
Another important factor in the performance of retail property markets is the availability of modern retail space. For example, while retail sales are sluggish in Italy, one of the very attractive aspects of that market is the lack of retail space on a per capita basis. Italy has seen reasonably strong rental growth over the last
year despite the poor performance of retail sales. Figure 2 shows that the availability of retail space in Italy lags significantly behind the European average, while Sweden, the UK and Ireland are significantly above the European average.
Pricing Power – Key For Retailer ProfitabilityOne of the key issues facing retailers across Europe is pricing power. With rents and labour costs rising, the ability to maintain profit margins is a critical issue for retailers. Most markets are experiencing reasonable price inflation in the key retailing segments of fashion, footwear, home furnishings and household equipment. A striking feature is the extent of the deflationary pressures evident in the UK over the last year. The average decline in clothing and footwear inflation was 4% and nearly 3% in the household goods sector. From a retailer’s perspective, the pricing environment is less competitive in nearly every other country in Europe and this would indicate that there may be greater scope for higher rents in those countries than in the UK over the medium term.
The retail markets that investors should target over the next 12 months include:
Primary:
-Stockholm and the Nordic area
-Paris and regional parts of France
-Southern Europe
-Benelux countries
Secondary:
-London and regional UK
-High-yielding German opportunities
-Ireland
There are different reasons for choosing each of these areas. For example, we like the Paris and Nordic markets because of the strength of the local economies and we like Italy because there is a lack of modern shopping space.
The Southern European markets look interesting for a number of different reasons. Spain, for example, is attractive because of underlying demand, Italy is interesting because it does not have enough modern retail stock and Greece is interesting because of a combination of both these factors.
It might be a bit surprising to see the UK and Irish retail markets on our secondary target list and for the most part we will do little or no dry retail investments in either. The reason is simple: we feel retail property in general is expensive and that rental growth will be limited over the coming years in both these countries.
We believe that the retail markets in the UK and, to a lesser extent, Ireland only make sense if there is some form of value-added play that will underpin future rental growth.
Broadening HorizonsWe have actively pursued strategies outside of Europe and a number of opportunities stand out to us at the moment. We believe that US multifamily is a compelling opportunity at the moment. The multi-family commercial property market is one of the four major commercial property markets in the US (the other three being retail, office and industrial). Multi-family commercial property consists of a unit of five or more apartments/townhouses available for rent. The average is in the region of 200 apartments/townhouses per transaction. All of the units are for rent and there are no owner-occupiers in the complex. The typical renter profile in multi-family apartments includes police officers, teachers and nurses, etc. That is, the renter profile helps to ensure that the flow of rents is very stable and suffers from a low level of defaults, which in turn helps to ensure very stable returns.
Now, it might sound strange that we like multi-family when it appears that the overall US residential market is in trouble. However, the cause of the residential markets problems, namely, higher mortgage payments is a key factor supporting multi-family.
At the moment, monthly mortgage payments are 30% higher than monthly rental payments. Furthermore, underpinned by strong demographics and employment growth, we believe that US multifamily will produce strong and stable returns over the coming years.
Asian Dragon Continues to RoarWe are also big fans of Asian commercial property markets due to the ongoing structural and cyclical upswing in their local economies. Last year, Asian property markets in general produced another year of stellar returns. Looking at the prime office markets across Asia, some produced amazing returns, such as the Tokyo CBD market which was up 72.7% in year-on-year terms to the third quarter of 2006 (capital terms only). The Indian markets of Mumbai and Delhi produced capital returns of 61.5% and 48.7% respectively. Other markets of note include Singapore with capital returns of 35% and 16.2% in Seoul. All of the above numbers are sourced from Jones Lang LaSalle up to Q3’06. Rents have also shot higher in these markets and therefore, despite the outsized capital gains, yields still look reasonably attractive.
Fundamentals Still AttractiveAsian commercial property markets are very cyclical and thus the risks of investing in these markets increase in tandem with returns. Nevertheless, we believe that the underlying economic buoyancy combined with the very positive property market fundamentals suggest that there is still more upside to the regional commercial property markets.
Other Target Sectors
We will also be looking at opportunities in the hotel sector in order to take advantage of the demographic trends in Europe and the US. Infrastructure is another asset class that we will be focusing on, and we believe that there are significant opportunities in this sector across the globe.
To ConcludeLast year was another year of great returns for global commercial property markets. We are not unduly concerned about the sustainability of global commercial property markets at these levels for the foreseeable future, given what we believe are key structural changes not only in the commercial real estate markets but in the global economy at large. These structural changes include greater transparency in global property markets, a lower interest rate environment than what prevailed in previous decades and an increased allocation to property as an asset class by global pension funds and institutions. However, we do have concerns about the pricing in some individual markets from a cyclical perspective and we would expect yields to widen a little over the next couple of years. Fortunately, however, most markets are currently experiencing a strong recovery in occupier demand and this should see vacancy rates fall further and rents continue to grow.
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