Take advantage in Europe with core real estate investment, says LaSalle

Warren Lewis
13th December 2012

Investment Strategy Annual 2013 released by LaSalle

Real estate investors will continue to encounter low interest rates, muted inflation and sluggish growth in most of the world’s major real estate markets for at least the next couple of years according to the 2013 LaSalle Investment Management (“LaSalle”) Investment Strategy Annual (“ISA”) - a comprehensive survey of, and outlook for, the global real estate markets over the next 12 months.

A multi-speed economy has seen low interest rates, low inflation and low growth in the developed world (Eurozone, UK, US and Japan) as opposed to higher inflation, high growth/urbanisation and rising interest rates in the developing world (Central and Eastern Europe, Latin America and Asia Pacific (ex-Japan)). However LaSalle believes there are more reasons to be optimistic in 2013 with steady improvement in the world’s three largest economies (US, China, and Germany). Highly accommodative monetary policies are bringing relief to capital-intensive industries like real estate. At the same time, the low cost of debt, along with changes in the regulatory treatment of different kinds of debt, introduce new uncertainties into the real estate investment equation.

LaSalle believes the uncertainties will include: distortions between unsecured and secured lending, uneven access to low-cost real estate credit between countries and within countries, exit uncertainty when unprecedented levels of support for credit markets are eventually withdrawn by central banks and timing/sequencing uncertainty, when monetary tightening occurs before a full recovery in the “real economy” has completely taken hold or is delayed.

Commenting on the report, Jacques Gordon, Global Strategist at LaSalle said:

“These uncertainties should result in the vast majority of capital markets remaining extremely risk-averse. This situation is exacerbated by the deep pools of capital that are entering the “drawdown” phase of their lifecycle. During this phase, investors will typically migrate from a long-term growth strategy to a more conservative income-generating one.

Even if some investors are in the drawdown phase, where income distributions matter more, extreme risk aversion is no longer warranted. In fact, this approach could create its own set of portfolio risks.

Investors should look beyond the most risk-averse positions that have built up in their portfolios since the global financial crisis. Ironically, these “ultra-core” positions may carry some of the biggest risks to portfolio performance in the years ahead, as the delayed economic recovery eventually takes hold. We continue to believe that the investment principles, which maintain portfolio diversification as well as ensure that risks are rewarded by appropriately higher returns, are the best way for investors to proceed in this challenging environment.”

In Europe, LaSalle thinks that debt restructuring still needs a lot of hard work. This deleveraging process, while painful in the short run, is absolutely critical for healthy economic growth in the years ahead. The region continues to be beset by the largely unresolved sovereign debt crisis and the real estate occupier markets remain vulnerable but with certain markets weathering the uncertainty better than others. Equity investors are as reluctant as ever to venture far from core assets, while debt investors remain constrained.  

Robin Goodchild commented:

“Confidence with regard to 2013 is low but comfortably above the depths of 2009. Despite economic growth expectations for 2013 being downgraded, they are uniformly better than for 2012. This conforms with the long-held view that Europe’s occupier markets will improve, but at a slow and steady rate over the medium term. In the near term, only the best vacant space will achieve lettings at target rents. With the exception of the strongest markets, rental growth will be weak and below inflation. Further rental falls are likely in Spain and Italy in 2013.”

Outside of Germany, France and the UK, LaSalle believes lot sizes over €80 million are often un-financeable by traditional means. Even development schemes with substantial prelets in undersupplied markets are being thwarted by the banks. Indeed the possibility of upward pressure on interest rates will impact real estate yields, further dampening the market. If inflation returns as a result of improving economic fundamentals, yields may remain unaffected.

Jacques Gordon:

“We expect fierce bidding to persist for scarce prime assets in London, Paris, and the leading German cities; as a result, their expected returns will be squeezed. Most of today’s capital is likely to remain reluctant to move up the risk curve, despite the higher pro forma returns on offer, due to uncertain leasing prospects and fragile income profiles.”
LaSalle cites mezzanine debt, prime assets, near-CBD submarkets and retail as the best opportunities in Europe.

•    Mezzanine Debt: With credit conditions set to remain tight well into 2013, mezzanine debt will provide the best risk-adjusted returns in a low growth Europe. In 2013, there should be a plethora of high-profile deals in this sector. Total returns secured on core assets in the order of 8% to 10% are achievable, with higher returns available higher up the risk curve

•    Prime Assets: With prime yields softening only at the margins even in the weaker markets, heavily discounted prime assets are unlikely to materialize. Across the entire continent there will be an abundance of fairly-priced, rarely-traded assets in core properties from the same vendors

•    Near-CBD Submarkets: The near-CBD submarkets will also offer distinct opportunities. Growth in the technology sector will continue to thrive going forward, focused on but not limited to a number of large household brands and their related companies. These tenants are more established than the start-up dotcom companies of the previous decade, and are expanding into mid-sized, good quality, flexible space in established submarkets.

•    Retail: Given its defensive characteristics, retail should remain the sector of choice for the risk averse core investor, despite weakening consumer demand. However, transactions in 2013 will be less numerous than in 2012 due to investors not wanting to sell. The focus should be on prime high street properties in major cities, or dominant fit-for-catchment units in secondary cities. In countries like France and Germany, shopping centres may offer the best opportunities. In the U.K., supermarkets or high-quality retail parks will be the more appealing prospects.

LaSalle also believes there are niche opportunities in European offices, hotels and data centres:

•    Office: The conversion of office space to an undersupplied residential use is attractive in certain markets. Parts of the U.K., Germany, and the Netherlands residential markets are particularly undersupplied, while the wider sector also offers opportunities in student housing and the healthcare sector

•    Hotel: Investors with higher risk appetites or a predilection for a niche strategy may opt for prime hotels in tourist locations, even in struggling countries such as Spain and Italy

•    Data Centres: Data centres have also emerged as a niche sector in recent years, while developing real estate linked to new infrastructure projects is an interesting strategy
Jacques Gordon concludes: “The breadth of the sovereign debt crisis in Europe means that many countries have downside risks to their outlook. Within core Europe, France seems vulnerable due to the paralysis of the private sector after President Hollande took office.  Extreme caution around Spain and Italy remains, despite progress in their bond markets and the promise of structural reform. Their real estate markets will present specific opportunities at an attractive price, although in general they may not represent fair value to the investor until late 2013 or beyond.
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