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When Schroders held its annual Global Real Estate conference in early June, it was not simply the record attendance that was the most striking feature. Duncan Owen, Schroders’ head of global real estate, says that what was different to previous conferences was the sheer range of delegates. As well as the usual suspects from the UK and Europe, says Owen, there were attendees from countries ranging from Brazil to China. Owen adds that the participants at this year’s conference included more investment generalists than in previous gatherings. Perhaps more important, he says, was that the chief investment officers (CIOs) at the conference appeared to be more positive about real estate as an asset class than the property specialists. “This indicates to me that CIOs who are looking at relative value are increasingly concerned about valuations of other mainstream assets,” says Owen.
It is easy to grasp why. Simon Williams, head of investment at BNP Paribas Real Estate in London, runs through the comparative numbers. He says that the rise in the UK property market since 2009 of about 39% compares with 75% in equities and 30% in 10-year gilts, but that real estate in the UK now yields around 5%, compared with 3.8% for UK equities and 1.9% for 10-year gilts. “So it’s looking very much as though real estate has not accumulated in value to the same extent as other asset classes,” he says.
The geographical and professional diversity of the delegates at the Schroder conference is emblematic of the two most conspicuous trends in today’s global commercial real estate market. The first of these is that more cross-border investment is flowing into commercial real estate than ever before.
Much of this flow is travelling from Asia to Europe, which is a relatively recent phenomenon. Latest analysis from asset management company Catella says that Asian investors were “virtually absent from Europe’s real estate markets during the last economic upswing between 2004 and 2008”. They’re not absent any more. Catella says that Asian inflows into European real estate rose from a modest €3.2 billion in 2010 to €9.7 billion in 2014. This year, according to Catella’s forecasts, they will rise by 44% to €14 billion, and by 2019 they will reach €25 billion.
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It’s looking very much as though real estate has not accumulated in value to the same extent as other asset classes Simon Williams, BNP Paribas Real Estate |
The second trend reflected by the attendees at the Schroder event – the continued flow of institutional money into real estate – is by no means a new phenomenon. But one of the clearest signals that this trend is gathering unprecedented momentum came last year from the largest pension fund in Europe and the second largest in the world.
In 2014, the Norwegian Government Pension Fund invested more in real estate than in fixed income for the first time in its 48-year history. True, the Fund’s real estate exposure is growing from a low base, rising to just 2.2% at the end of 2014, compared with 61.3% in equities and 36.5% in bonds. But the $870 billion Norwegian Fund will not be stopping there. It has indicated that it intends to more than double its exposure to real estate to 5% over the next few years, with a corresponding decline in bonds.
When you’re as big as the Norwegian fund, that equates to a lot of money: a 2% increase in its allocation to real estate would suggest a $17 billion investment. To put that total into perspective, the largest shopping centre deal in the UK in the first quarter of 2015 was the £190 million purchase of a 50% share in the Bentalls complex in Kingston-upon-Thames by China’s Gingko Tree, suggesting a total value of about $600 million. In other words, another 27 Bentalls complexes would not be quite enough to meet the Norwegians’ real estate target.
Although the bulk of cross-border institutional flows are targeted at commercial real estate, there is also plenty of international liquidity looking for opportunities in the residential market. David Swan, head of real estate investment at Gatehouse Bank, the Shariah-compliant investment bank, says that many of the bank’s institutional and high net worth clients in the GCC and South-East Asia have been looking at private rented sector housing in areas of the UK like Merseyside and Greater Manchester.
Senior lending
Beyond bricks and mortar, institutional investors have been exploring plenty of other avenues for building their exposure to real estate, such as through CMBS, but with nowhere near the gusto they showed before the global financial crisis. Jerome Gatipon-Bachette, co-head of real estate structured finance at Société Générale Corporate & Investment Banking, says the relative volumes of CMBS issuance before and after the crisis may be a reflection of the shift among many institutions from CMBS to commercial real estate senior lending. “This may be a reason why the CMBS market in Europe has not reopened as strongly as it has in the US,” he says.
Dovetailing with rising institutional flows into real estate is a revival in banks’ appetite for senior lending to the property sector. “There are still some portfolios to be sold, especially in continental Europe,” says Adam Joseph, managing director of European real estate lending at Macquarie in London. “But in the UK in particular, we are nearer to the end of the deleveraging path than the beginning.”
This is also evident in some European markets. “In Italy and Spain, domestic lenders weren’t significantly active two or three years ago,” says Arnaud de Jaegere, co-head of real estate structured finance at SG CIB. “This has changed, with many of the banks’ deleveraging plans now having been implemented, and in some markets liquidity has returned much more quickly than expected.”
In the UK, this all amounts to a Goldilocks period for real estate, according to a recent blog from William Newsom, senior director at Savills, who notes that he has seen 150 new names enter the property finance market in the last three years.
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We’ve thought long and hard, and concluded that rising institutional demand for property is a long-term trend
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At a global level, meanwhile, these trends represent what PricewaterhouseCoopers (PwC) calls a new era. A survey it co-published with UBS last year forecast that the global stock of institutional grade real estate would expand by more than 55%, or from $29 trillion to over $45 trillion, by 2020. The same calculations say that by 2030 it could reach a dizzying $69 trillion, driven principally by investment flows in emerging markets.
Forecasts of this kind may not be enough to reassure some investors about the outlook for real estate valuations. “We have heard whispers from investors about concerns of a bubble in markets like London and New York, where prices are at all-time highs,” says Ernst & Young in its latest real estate Global Market Outlook.
Those whispers may soon become more audible. At Macquarie, Joseph says that in the UK, prime city of London office yields tracked by his team are now about 4.25%. “We track data going back to 1990, and yields have only been this low in two years out of 25, which were 2006 and 2007,” says Joseph. “We all know what happened immediately after that. You have to feel pretty bullish to believe that these yield levels are sustainable.”
In the bank market, a simple gauge of rising risk tolerance, Joseph adds, is the annual lending targets that banks appear to have set themselves, many of which are well up on last year’s. “There’s a finite stock of product available and if everyone has a higher lending target, competition is going to lead to increased risk or downward pressure on margins,” he says.
Joseph says there are signs that this is already happening. “Lenders are pushing up the risk curve and moving towards higher LTVs at a time when values are at historic highs in yield terms,” he says. “So are they making the same mistake again of lending at LTVs of 70% or 80% when values are 20% higher than their historical average, which would suggest that real LTVs are closer to 100%?”
It’s a good question, and one that Joseph is not alone in asking. While real estate valuations may be starting to appear decidedly toppy in a handful of prime locations, returns for lenders and investors are also beginning to look stretched relative to other asset classes.
As CBRE cautioned in an update on the UK market published in July: “There is no doubt that on an absolute basis we are approaching the limit of stated return premiums required by banks and other lenders for the commercial real estate market.” More specifically, CBRE forecasts that in the UK, average risk-adjusted returns to senior lending in the second quarter of this year were 3.7% a year. This might not look too shabby relative to returns in the government bond market, given that it equates to a premium to five-year gilts of 2.2%, which is above the long term average. But as this premium fell by 1% over the first six months of the year, the direction of travel is clear enough.
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Yields have only been this low in two years out of 25, Adam Joseph, Macquarie |
There are other reasons for lenders to be nervous about returns in the property sector, says CBRE. One is that as a relative value play against CMBS and corporate bonds, real estate lending is looking shaky. Triple-B rated CMBS now offers a premium to senior CRE debt of just 50bp, according to CBRE, while senior CRE debt’s premium to corporate debt fell from 1.7% to 1.4% in the second quarter.
Another concern, for senior bank lenders, is that returns are also under pressure measured by the yardstick of risk-weighted assets (RWA). CBRE says risk-adjusted return on risk-weighted assets (RoRWA) were in the range of 1.6% to 2.6% at the end of the second quarter, depending on their slotting treatment, compared with between 2.4% and 4% at the end of 2014. ‘Slotting’ refers to the regulatory capital banks are required to set against their CRE loans, which range from 50% to 250%, depending on whether they are categorised as strong, good, satisfactory or weak.
The result of declining RoRWA, says CBRE, is that so-called ‘strong’ loans, which qualify for the minimum RWA requirement, now offer comparable returns to those that were being delivered by ‘satisfactory’ loans six months ago. In other, rather more digestible words, the risk-reward dynamics of senior lending seem to be deteriorating apace.
“Real estate is seen as a bond proxy by an increasing number of investors, and there has been some fairly indiscriminate yield compression across the European commercial real estate market as a result,” says David Prescott, real estate equity analyst at Barclays in London. “So the question is, are we building up towards a bubble?”
Most lenders, investors, consultants and analysts (Prescott included) say that for the time being, the answer to this question is no. M&G Real Estate, for one, reckons that something more structural is happening in the world of real estate than a short-term response among institutional investors to low interest rates and miserly (or even negative) yields in bond markets.
“We’ve thought long and hard about this and concluded that rising institutional demand for property is a long-term trend,” says Martin Towns, who in March was appointed head of capital solutions at M&G Real Estate, which is one of the 25 largest real estate investors in the world. This is a new role created by M&G to build on its relationships with sovereign wealth funds and other large institutions looking to increase their exposure to real estate.
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Duncan Owen, head of global real estate at Schroders |
Towns says that institutions’ requirement for segregated accounts to manage their large and growing real estate portfolios is driven by several durable trends, none of which are likely to be derailed by short-term economic or monetary policy cycles. “Clients and prospective clients looking to up-weight their allocation to property are in many cases doing so from a low base, and targeting perhaps a 10% to 15% exposure,” he says. “Most describe this as a strategic as opposed to a tactical reallocation.”
Tactical shifts of this magnitude by large sovereign wealth funds and insurance companies, says Towns, will prompt a rethink about how investors manage their real estate portfolios. For institutions allocating these volumes, he says, investing through a traditional fund can be less appealing, because they may find themselves holding, say, 30% or 40% of an open-ended fund without exercising any control over it.
“For very large investors, it can make more sense for an institution to keep control of the investment strategy and mandate a manager to provide a best-in-class service for, say, UK offices, than to be a passive investor in a co-mingled fund,” he says.
Making that sort of commitment is quite different to buying a slug of CMBS. As Towns says, most sovereign wealth funds are banking on holding on to their property for a very long time. Pension funds and insurance companies, he says, may anticipate shorter hold periods. But for them, short-term probably means at least 10 years.
Investors and lenders appear to have plenty of reasons for sharing M&G’s enthusiasm. The first of these is that real estate need not have much to fear from the gentle rise in interest rates that most economists believe to be imminent in the UK. “I think we all agree that the cost of capital will be higher within the next three to four years, both in equity and debt,” says Schroders’ Owen. “That’s the negative.”
Cause for optimism
However, he says there is cause for optimism. “The positive is that we are seeing genuine improvements in the economic environment,” he adds. “Employment and productivity growth are both driving demand for new office space in industries ranging from financial services to TMT, which in turn will support rental growth and rental income.”
In the UK, says Owen, Schroders has identified a number of locations where this trend is most pronounced. He explains that in these so-called ‘clever towns’, such as Manchester and Cambridge, good infrastructure, coupled with rising investment and employment has not yet been reflected in strong rental growth.
Others agree that regardless of the outlook for monetary policy, there is plenty left in the tank for rental growth. Dominic Smith, head of real estate debt analytics at CBRE, says that with real rental levels still well below where they were 10 years ago, his firm is forecasting annual growth for the next five years of between 2% and 4%. “Except for in Central London, we have yet to see a significant recovery in rentals, but the signs are that is coming,” he says.
David Skinner, CIO of global real estate at Aviva Investors, echoes this view. “An important ingredient of total return is rental growth,” he says. “This has been strong in London but we expect it will spread through the rest of the UK market, offsetting the impact of rising interest rates,” he says.
This also holds true, think some analysts, in the residential market. If the conclusions reached in a recent Moody’s briefing are correct, UK mortgage borrowers now appear to be much better equipped to withstand an interest rate hike than they were at, or near the peak of previous property cycles. Moody’s reckons that a 1% rate in base rates would only leave 1% of non-conforming borrowers unable to meet their mortgage repayment commitments and living expenses. In the unlikely event of rates increasing by 3%, this would rise to a still-manageable 4%.
The muted impact that rising interest rates are likely to have on property valuations is also a by-product of an altogether healthier real estate finance sector than the over-heated and hubristic market that existed at the top of the last cycle. “Banks are still very cautious,” says de Jaegere at SG. “We’re seeing more professional money coming into the market for junior and mezzanine positions, with senior lenders not pushing for higher leverage as they were back in 2007.”
Others agree. “In London, which is the most liquid European real estate market, we haven’t seen a debt-fuelled growth in values,” says Prescott at Barclays. “It has been very much an equity-driven rally, which is why I’m less concerned about property valuations than many analysts.”
Another clear difference that bankers and investors identify between today’s real estate market and the extremes of previous cycles is that there is very little evidence, today, of the sort of speculative development activity that would be red flags to many lenders. “Even in London, there is only about 4 million square feet of office space under construction,” says Owen at Schroders. “That may sound a lot, but when I started my career in the City in 1989, more than 21 million had just been delivered.”
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Michael Kröger, |
Perhaps the most persuasive reason institutional investors have for adding to their real estate exposure, however, is the absence of other liquid asset classes with similarly appealing yield and duration features. Infrastructure, which has been presented for years as an attractive asset class for pension funds with long-dated liabilities, is perhaps the most obvious alternative. In many ways, it is also very similar.
“Both are real assets that generate above-average income growth,” says Owen at Schroders. “Airports, for example, are gigantic shopping centres these days with runways attached.”
Investors say, however, that there are also significant differences between the two asset classes, many of which continue to make real estate a more attractive proposition for institutional investors.
“In both asset classes you’re buying something tangible,” says Williams at BNP Paribas. “But property is more investable in the sense that it is a more liquid market and there is probably more professional investment advice available than there is in infrastructure. Additionally, more analysis of functional obsolescence is generally required in the infrastructure market.”
M&G’s Towns highlights other differences between the asset classes. “The majority of infrastructure deals are created with very long-dated bond-like income streams, typically with some kind of indexation,” he says. “There are a number of points on the risk spectrum in the real estate market, which means a similar prospective risk-return profile can be created, say, for example, a supermarket let on a 25-year lease with annual indexation.”
“But while most of the return in real estate is generated from income over the long-term, different strategies can be deployed to offer a spectrum of risk/return profiles within the asset class,” Towns adds. “In the vast majority of real estate investments there is also an equity-type component, where value can be created by physical improvement to the building, for example,” he adds. “So while infrastructure and real estate each have income qualities, property typically has more equity features with some capital upside.”
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Further reading |
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Bankers say that there is no shortage of real estate assets with upside potential underpinned by rehabilitating buildings that have been neglected since the financial crisis. “Especially in Southern Europe, very little money has been invested in commercial real estate over the last seven or eight years,” says Gatipon-Bachette at SG.
“This means that for investors focusing on relative value, there are still plenty of attractive assets in Southern Europe prime locations.” He says this may explain why there has been a notable increase in investment into the Spanish real estate market from US private equity funds.
Perhaps the most obvious difference between real estate and infrastructure, however, boils down to availability, which is far more plentiful in the property sector. “The attraction with infrastructure is the scarcity of product,” says CBRE’s Smith. “There has been a shortening of leases over the last 20 to 25 years in the commercial property market, so there is almost an argument that the infrastructure market today is similar to the real estate market two or three decades ago in terms of yield and scarcity.”
