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Norway’s $700 billion-plus sovereign wealth fund has recently been eclipsed in terms of total assets by its counterpart in China, but when you’re as large as the Norwegian Government Pension Fund, even a small shift in asset allocation makes a big difference. Witness its role in the recent €1.2 billion Deutsche Annington IPO, where it swallowed 12 million shares, 35% of the offering, effectively guaranteeing the success of the transaction. Norway’s colossal fund is one of a number of the world’s largest institutional investors to have developed a taste for real estate. It indicated recently that it plans to increase its allocation to the sector from 0.3% of its assets in September 2012 to 5% within the next few years, and it has already begun to deliver on its pledge. As well as absorbing a big chunk of Deutsche Annington’s equity, it has bought 25% of London’s Regent Street from the Crown Estate and a 50% stake in a European property portfolio from Prologis. More recently, it made its first acquisition in the US commercial real estate (CRE) market, picking up a quintet of offices in New York, Washington and Boston in a joint venture with the teachers’ pension fund, TIAA-CREF.
Sovereign wealth funds’ growing appetite for real estate is emblematic of a more general shift by institutional investors into the sector in a number of different ways. One of these is the acquisition by private equity funds and other investors of portfolios of CRE debt from European banks. Although they might sound like locations on a radio shipping forecast, Lundy, Forth and Pittlane are examples of a smattering of code names for projects that are illustrative of a transfer of ownership of CRE debt from traditional to non-traditional lenders in recent years. Each refers to the sale by Lloyds Banking Group of discounted portfolios of property. Among European banks under pressure to deleverage, Lloyds was one of the more active sellers of commercial real estate in 2012, offloading £6 billion ($9.4 billion) of property in the UK alone as part of a capital accretive non-core asset reduction programme worth over £42 billion last year.
Much of this unwanted exposure was bought last year by investors such as Lone Star, TPG, Oaktree Capital Management and Kennedy Wilson. Private equity funds such as these have been among the most conspicuous and aggressive buyers of commercial real estate in recent years, and have plenty more liquidity to put to work. Morgan Stanley puts their allocated firepower for commercial real estate at €25 billion, “with more funds expected to be raised as opportunities arise to invest and to lend”.
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| Rob Wilkinson, chief investment officer at AEW Europe |
A more recent example of this trend was the sale by Commerzbank of Eurohypo’s £4 billion UK CRE loan book to Wells Fargo and Lone Star, officially announced in July. Rob Wilkinson, chief investment officer at AEW Europe, which was one of the unsuccessful bidders on the Eurohypo portfolio, says that the sale was a landmark in the recent evolution of the market. “It was an interesting transaction because the larger share of the portfolio, which was sold to Wells Fargo, was the first major sale of a performing CRE book by a European bank,” he says. A third parallel trend that is underpinning a fundamental change in the financing of CRE is the emergence of non-traditional lenders – most notably, insurance companies – as direct lenders to the market. Among Europe’s leading insurers, Axa Real Estate Investment Management (Axa Reim) is one of the most active and longest-standing players in the CRE market. It now has about €7 billion invested in European CRE, chiefly in senior debt in the core UK, German and French markets, according to its head of European research and strategy, Alan Patterson. “Although we set up our team seven years ago, we did not do a great deal prior to the recession because our view was that property prices had risen too far and the risks to debt-holders were high,” says Patterson. “We’ve been much more active since the recession, because although interest rates have been low, margins have been exceptionally high.”
Insurance companies’ activity in the CRE debt market appears to have come in spite of, rather than because of, the Solvency II Directive on capital. “Solvency II is debt-friendly at the sovereign debt level,” says Patterson. “But it is much less so for debt secured by real estate, which is unrated. But we believe the high provisions we’ll be required to set against our CRE exposure will be offset by higher returns, and in any event Solvency II won’t come in until 2015 at the earliest.”
More broadly, there are a number of drivers behind this wholesale shift in the ownership of CRE in general and CRE debt in particular. The first and most conspicuous of these is continued deleveraging in the banking sector, which is creating opportunities for newcomers from within the banking industry and elsewhere to step into the market.
While bank deleveraging is driving supply of CRE, its credentials as an asset class relative to bonds and equities are underpinning a continuous rise in demand from investors.
“The key attraction of commercial real estate since the financial crisis has been the relative level of income from well-let real estate and the security of that income,” says Peter Damesick, chairman of EMEA research at CBRE in London. “With some variation by sector and market, prime assets across Europe are offering initial income yields of between 4% and 6%. It’s the differential on these yields versus those on top-rated government bonds, which sank to all-time lows of well below 2% earlier this year, that is driving institutional demand for commercial real estate.”
“Over and above these yields, the point about real estate is that if you pick the right property in the right country you have the potential for income growth over the medium to long term,” Damesick adds. “Relative to equities, the attraction is that real estate is inherently less volatile.”
AEW Europe’s Wilkinson says that there are other reasons why CRE is becoming increasingly appealing to institutional investors. “What has changed in the last five years is not just that there has been a much greater focus on the return profile and diversification benefits of alternatives such as real estate, private equity and infrastructure,” he says. “There has also been a recognition that commercial real estate provides investors with an asset class that more closely matches the duration of their liabilities and changing global demographic patterns.”
With bank deleveraging in Europe is coming a continued drift towards a market structure that is closer to the US model, where bank lending plays a more modest role in the financing of real estate than it traditionally has in Europe. This has also pushed pricing closer to US levels, which is another reason why the European CRE market has become more interesting to institutional investors. “One reason why the institutional market has been more prevalent in the US is because the margins they can charge on loans have been higher in absolute terms than in Europe”, says Wilkinson. “Pricing in the senior lending market in the US typically ranges from 400 basis points to 600bp.”
Those margins, says Wilkinson, still compare favourably with some European markets, but the pricing differential between the US and Europe is narrowing. “Pre-crisis, in the UK we were seeing margins of 100bp or lower on loans written by banks with significant capital from deposits,” he says. “Over the last three years, pricing has risen to around 300bp for plain-vanilla senior lending.” Unsurprisingly, in southern Europe it is considerably higher, with a recent report from AEW Europe putting margins on CRE loans in Italy and Spain at 500bp over three-month Libor. “Also,” the report adds, “financing for assets of more secondary nature in the UK (+350bp) or problematic assets in France (+400bp) still require higher margins.”
The inevitable trade-off for these returns, however, is the continued shortage of liquidity in the CRE debt market. “Anybody going into this market believing they can trade it is making a big mistake,” says Patterson at Axa Reim. “We always remind clients that this is a hold-to-maturity market.”
To date, Wilkinson adds, institutional participation in the European CRE loans market has been driven largely by UK and French investors. Those in Germany and the Nordic region, he says, are also becoming more active, although their preference has been to participate in the higher-yielding stretched senior or mezzanine markets. “This is because UK and French institutions tend to come from the fixed-income markets and therefore have fixed-income benchmarks,” says Wilkinson. “In Germany and the Nordics, their background is more often the equity side.”
The returns offered in the real estate market explain why rising institutional demand for CRE is a cross-border and an intercontinental phenomenon. It also explains initiatives such as the those recently announced by BNP Paribas Real Estate to set up platforms in Hong Kong, Singapore and Dubai with the aim of attracting more Asian and Middle Eastern investment into the European property markets. Etienne Prongué, director of international investment at BNP Paribas Real Estate in Paris, says that there has already been very strong demand from a number of Asian insurance companies, pension funds and sovereign wealth funds for bricks and mortar in the UK, France and Germany. Recent examples he points to include the investment by a South Korean consortium in the Galileo Building in Frankfurt, and by Korea’s National Pension Service in the Jacques Bingen Paris office building and the Paris Nord Two shopping mall.
The main attraction of European property for these investors, says Prongué, is the value offered by London, Paris and the top-four German cities relative to Asia. “The principal reason why we’re seeing so much Asian money looking to enter Europe is diversification away from the local market,” he says. “Insurance companies and pension funds are looking for yield, which in the top Asian cities such as Singapore, Hong Kong, Seoul and Taipei has fallen to 3% or 3.5%. That is well below Europe, which looks very interesting to Asian investors, especially on a leveraged basis.”
Another attraction of European property to Asian institutions, adds Prongué, is the fact that lease terms in most of the main Asian markets can be as short as one year. “That means investors don’t have the security of income that they have in the London market, say, where at best you would get a 25-year lease and, at worst, a five-year lease,” he explains.
The supply-demand dynamics that are fuelling far-reaching changes in the CRE market are likely to remain in place for a number of years, with bank deleveraging still very far from complete. In a comprehensive update published last November, Morgan Stanley calculated that European banks had completed 20% to 25% of their CRE deleveraging.
In the short term, PwC forecast at the start of 2013 that banks in Europe would be looking to offload loan portfolios worth about €15 billion this year. Whatever the precise figure, investors agree that there will be plentiful supply from the banks. “While a £4 billion transaction is a major deal in anybody’s book, it is probably the tip of the iceberg in terms of the portfolio sales we’ll see going forward,” says Wilkinson at AEW Europe, in reference to the sale of the Eurohypo portfolio.
On the demand side, meanwhile, market analysts see no sign that the flow of institutional money into CRE is likely to dry up in the foreseeable future. DTZ forecasts that new lending capacity from non-traditional lenders (insurance companies and funds) will reach $181 billion between 2013 and 2015. This will bring their share of the market to 15% in the UK, comfortably above Europe as a whole (7%) but still well below the North American average of more than 20%.
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| Alex Veroude, head of credit at Insight Investment in London |
These flows, however, are unlikely to be sufficient to meet the financing needs of the CRE sector, giving rise to what is known in the market as the funding gap. This gap is likely to fluctuate over the coming five years, reflecting the maturing of loans issued before the global financial crisis, according to Alex Veroude. He is head of credit at Insight Investment in London, which as of March had over €1 billion of CRE exposure in the form of CMBS and direct CRE loans, mostly in the UK, France and Germany. “Although figures vary, we estimate that there is about €2 trillion of CRE debt outstanding in Europe, most of which is still held by the banks,” he says. “Given that the music stopped in 2008, and that typical CRE loans are bullet facilities with maturities of between five and 10 years, it is clear that a lot of debt will fall due for refinancing in the next five years.” Some of these loans, says Veroude, will of course be refinanced. Some will be renegotiated by banks prepared to extend and amend. And some will be replaced by equity. But much of it will also need to be provided by new lenders, which is the dynamic that is opening up extensive opportunities for institutional investors such as Insight.
This process is welcomed by real estate consultants. “The creation of more channels of funding for debt into CRE has to be a good thing because it will make pricing more efficient and transparent,” says Hans Vrensen, global head of research at DTZ in London. “If institutional lenders had not come into this market we would have to wait until banks had freed up their lending capacity, which will take several years.”
It is also a dynamic that will have important ramifications for the CRE market across Europe as the nature of the relationship between lenders and borrowers undergoes substantial changes. Clearly, a private equity investor will have very different return targets, hold periods and exit strategies to a commercial bank. “As CRE lending was ultimately based on relationship banking”, says Veroude. “One of the things investors noticed when they began to acquire second-hand loans was that the banks cut the borrowers some very good deals on rates in exchange for ancillary products, some of which were neither wanted nor needed. As we’re not in the game of relationship banking, we’re not going to cut anyone a deal in exchange for an M&A fee or whatever. At the same time, we’re not going to push products to borrowers that they don’t need. We want to build lending relationships, but these will transaction-based.”
Views are mixed on the impact that the change in the ownership and funding of the global real estate market is having on underlying property values. In theory, investment demand should dovetail with underlying demand for occupancy, given that the two are driven by the same macroeconomic influences. In practice, it does not always do so. “A growing concern is the disconnect between leasing and investment demand, which is not necessarily driven by fundamentals,” says Jeremy Kelly, a director in the global research team at Jones Lang LaSalle in London. “The reality is that some cities with relatively subdued leasing markets, like London and New York, have seen very high levels of investment activity.”
One of the trends driving this disconnect since the global financial crisis has been an increased focus on liquidity. This has benefited markets such as London, Paris and the German quartet of Berlin, Frankfurt, Munich and Hamburg, which account for about 75% of European turnover, according to Prongué at BNP Paribas Real Estate.
“Back in 2006 or 2007 people priced each market relative to other markets based on the strength of properties and tenants,” says David Hutchings, head of research at Cushman & Wakefield. “Today, people are looking more closely at macro risk and liquidity, which has favoured the biggest centres. For example, London continued to trade more actively throughout the crisis than any other city. The market corrected, but if you had to sell, you could, whereas in smaller markets like Argentina or Vietnam liquidity dried up.”
Scarcity of liquidity, says Kelly at Jones Lang LaSalle, is an important caveat for investors attracted by some of the fastest-growing property markets in what he describes as the Mist bloc (as distinct from the Bric economies) encompassing Mexico, Indonesia, South Korea and Turkey. “Jakarta is arguably the hottest market in the world at the moment, with annual rental growth in excess of 30%,” he says. “But there is a disconnect between investment and leasing demand because of the transparency issues in markets like Indonesia. There are potentially huge dividends to be earned in a number of emerging markets if transparency standards can be improved.”
Liquidity – or lack of it – has contributed to a polarization of valuations within the global CRE market. As Morgan Stanley observes: “There is a huge quality mismatch in supply and demand, which means parts of the market will remain fine and potentially enjoy capital appreciation. But for the other, less desirable end of the spectrum, capital will be very scarce for potentially a long time, and therefore valuation markdowns could be very significant.”
Some market participants say that this is starting to change. “It is true that up to now new entrants to the market have been unwilling to lend on secondary properties in non-core regions because they were seen as posing too high a risk,” says Vrensen at DTZ. “That may not be the case going forward. The question is: as the recovery gathers pace, in the economy as well as in the property market, will investors want to go up the risk curve? We think the answer is yes, which will mean they start to look away from yields of 4% to 5% on London offices and towards some of the regions where they can earn 7% or 8%.”
The search for yield away from the most popular market has gathered pace recently, with consultants reporting an increased flow in enquiries about opportunities in bombed-out markets such as Italy and Spain. “Southern Europe has been characterized by very low levels of liquidity in the investment market,” says CBRE’s Damesick. “But this year we have started to see some changes in the climate for investment activity in the region, which is largely a reflection of receding concerns about the existential threat to the eurozone.”
Cushman & Wakefield’s Hutchings agrees. “At the moment annual trading volumes in some of the larger southern European cities are down to less than €500 million, compared with over €3 billion at the peak of the market, so we may see some of these centres coming back relatively quickly,” he says.
Non-European investors that are relative newcomers to the region say they are likely to stick to the most visible and best-known markets. Take the example of an investor such as Cornerstone Real Estate Advisers, a subsidiary of the Massachusetts Mutual Life Insurance Company (MassMutual), which has more than $40 billion of real estate assets under management worldwide. Cornerstone made its entry into the European CRE lending market in August 2012, with the completion of an £83 million refinancing for Derwent London, which was one of a number of real estate debt transactions worth $3.5 billion it undertook in 2012.
Cornerstone’s head of European research, Paul Stewart, says that its main focus will initially be on senior debt, although it will also monitor opportunities in stretched senior or mezzanine layers of the capital stack where returns can be as high as 10%. He adds that Cornerstone has to date been concentrating on central London offices where vacancy rates are low and occupier demand has been surprisingly resilient, but that it is also looking at the potential of hotel debt deals, which typically offer much higher margins than offices. “Investors generally shy away from hotels, where the risks are perceived to be driven more by the operating business than by the underlying real estate,” says Stewart. “But as Cornerstone manages an unlisted equity hotel fund in the US, we have considerable in-house expertise in that sector.”
The polarization between the best European cities and the rest is mirrored elsewhere in the world. Damesick at CBRE says that against the backdrop of an improving macroeconomic climate in North America, the seven Gateway cities are likely to continue to outperform in terms of volumes, investment activity and capital values.
The real estate markets in the leading Asian economies, say consultants, have generally been subject to more speculative activity – and hence to higher volatility – than those in most European and north American cities. This has also led to frothy markets in a handful of cities. “In the top-tier Chinese cities we’ve seen rents double,” says Kelly at JLL. “With rental rates now higher than in Tokyo, there has been an increasing reluctance to pay the prices now being asked in Beijing and Shanghai.”
