What a year! In 2015, property investors around the world put almost $700 billion into office buildings, retail space, hotels and logistics depots. While this corresponds to a slight decline of 3 percent year-on-year on a purely arithmetical basis, that is solely a result of the strong dollar says Hela Hinrichs, Director of European Research at the international real estate service provider Jones Lang LaSalle (JLL) in London. Factoring out the 2015 rally of the greenback against the euro and other currencies, instead of a minus, the end of the year would have seen an increase of more than 10 percent. The impact of the higher dollar rate was even stronger on total investments in Europe. On an equivalent basis, transaction volume was $253 billion, 9 percent lower than in 2014. However, in local currency investors across Europe committed 8 percent more to commercial real estate than in 2014. The major markets in continental Europe showed especially strong demand, most notably Germany and Scandinavia. Incredibly, transaction volumes in those two countries rose by just under 30 percent – outstanding growth that should actually give us every reason to celebrate.
The investors’ dilemma
But there is no trace of euphoria. “At the beginning of 2016, investors appear to be feeling more reserved,” is how David Green-Morgan, Capital Markets Research Director at JLL Global, describes the situation. And even if he won’t go as far as to speak of pessimism, the general mood is characterised at the very least by a level of caution, often punctuated by unconcealed worry. There are several reasons for this, explains Reinhard Kutscher, Chairman of the Management Board at Union Investment Real Estate GmbH. “There are a large number of challenges on the global real estate market – with both internal and external causes – that investors will have to meet in the near future.” For the head of the Hamburg-based property investment management company, the external risks include geopolitical crises and persistently very low interest rates on the global capital markets. That fuels demand for real estate investments and aggravates the intrinsic market risks: already low property yields remain under pressure, and the ongoing competition for first-class properties will intensify, with the risk of a trend towards overheating.
Unlike the Fed, the European Central Bank is not expected to increase interest rates for the time being.
Alarm bells ringing?
Timothy Horrocks, Head of Europe at the international investment firm TH Real Estate, also clearly sees the dilemma: “In 2015 the European real estate market experienced a greater inflow of capital from around the world than ever before,” he says. But this has a flip side: “This is making the market for core and core-plus real estate more and more competitive, and demand significantly exceeds supply.” However, against this backdrop one factor is giving many observers food for thought. As Horrocks says in a nutshell: “Transaction volumes and prices have already reached the values of the last market high in 2007.” A fact that may cause alarm bells to ring for many a market observer. Eight years after the disastrous collapse of the global real estate markets as a result of the worldwide crisis in the financial markets, while the shock may have been overcome, the memory has in no way faded. And so the instinctive question is: are the markets facing a cyclical downturn once again? And if so, will the downward trend have the same sort of painful consequences for real estate investors as before? “As I see it, forecasting the future of the real estate market has never been as difficult as it is today,” says Jochen Schenk, Management Board member at Real I.S., the Munich-based asset management company. Bearing in mind the geopolitical hot spots and the fact that the global economy is still vulnerable, he too is inclined to err on the side of caution. There is so much going on in the world that the direction is difficult to predict. “In our view, the only option is to refer to base trends,” concludes the property asset manager.
And those look surprisingly positive, according to the vast majority of experts. “First, the situation today is different than in 2007 when real estate was bought up very quickly,” says Andreas Wende, Chief Executive Officer and Head of Investment Germany at Savills, the real estate services provider. “Buyers are examining their investments far more closely simply because the financing banks demand it.” As a result, significantly more equity is being committed than before the financial crisis, adds Andreas Quint from the international real estate service provider BNP Paribas Real Estate. “While we regularly saw debt capital ratios of more than 90 percent back then, today we are at 60 percent, maybe in rare individual cases at 70 percent,” says financial consultant Quint. “In 2006 and 2007 – that is before the financial crisis – investors were interested in highly speculative deals,” confirms Marcus Cieleback, Head of Research at the German real estate company Patrizia. “Investors today look very closely through safety-oriented glasses,” he says. Investors are therefore aware that the price level on most international markets is already very high – which means that the yields are correspondingly low. This applies in particular to office investments. The average top yields calculated by JLL for 21 global markets declined by almost 200 basis points, from just under 7 percent in 2009 to less than 5 percent now. Fundamentally very few experts see that as a problem: unlike during the pre-crisis years of 2006 and 2007, property yields are a good 300 basis points above the yields from comparable secure government bonds. A risk buffer that most observers consider absolutely sufficient.
Income is moving to the forefront
In addition, professional buyers know that at the current price level the business plan is key, says Cieleback. These plans have to be fine-tuned to suit the individual investment strategy and the property in question. “In the current market phase, sustainable long-term income is decisive,” he believes. In this respect as well the fundamentals are overwhelming positive. “We are seeing internationally stable, in part even dynamic rental markets again,” says Reinhard Kutscher at Union Investment. Office markets for example: “We have noticed demand for office space increasing in a number of sectors, and letting activities have again risen significantly worldwide,” states JLL researcher Hela Hinrichs. But this is not yet reflected in peak rents: the year-on-year increase in 25 global markets for 2015 was a moderate 3 percent. “However, the increase will rise to 4 percent this year,” forecasts the expert. Because the rental markets in Southern Europe have made a visible recovery. “For example, in Madrid and Barcelona price hikes in the top range are quite reasonable,” says Frank Billand, Member of the Management Board at Union Investment Real Estate GmbH and responsible for Investment Management Europe. The reason: there are comparatively few suitable properties. “For core assets, demand is significantly higher than supply.” As a result, maximum prices are being paid again, not least by domestic investors.
For example, last year the real estate investment firm of Inditex founder Amancio Ortega Gaona, one of the world’s richest men, acquired what may be the best-known building on the Gran Vía in Madrid: the retail and office building at number 32, which was opened in 1924 and designed to resemble a Paris department store. Pontegadea paid €400 million to the Canadian owners, Longshore and Drago Capital. The rental markets in Germany, the Nordic countries and London also remain strong, says JLL researcher Hela Hinrichs. Her assessment of the office letting markets in the British capital should calm many investors. 2015 was certainly another very successful year for the real estate market in the United Kingdom – for the third time in a row, growth rates of capital values were in the double-digit range, reports fund manager Guy Glover of BMO Real Estate Partners in London, the property asset manager for the Canadian BMO Financial Group. “But this naturally raises the question of how long this positive mood will continue,” adds the London expert. His answer is optimistic: “Although there are certainly risks and potential headwinds, our outlook for 2016 is positive.”
The market environment calls for discipline and forward-looking risk management
Why yields may bottom out
Andreas Schultz, Managing Director Transaction Management International at Warburg-HIH Invest Real Estate, agrees: “Yields on the London commercial real estate market have fallen to an all-time low.” There has recently been some lateral movement. “But it is still too early to conclude that yields have already bottomed out.” A clear yield difference can still be seen between core real estate in good to very good locations and secure long-term cash flow and other properties. BMO fund manager Glover expects that the decline in property yields in London may slow down in 2016 or even come to a stop. “That is why investors may focus more on the amount and quality of income, and – even more importantly – on the possibility of increasing that income.” Observers also agree that the greatest risk for the London market would be a Brexit – a British withdrawal from the European Union.
According to surveys, the electorate will most likely vote to remain in the EU, but only with a narrow majority. “We assume that both domestic and overseas investors will act more cautiously and refrain from making new investments the closer we get to the date of the vote,” explains Guy Glover, basing his assumption on the fact that a vote to leave the EU could have unforeseeable effects. “In any event, such a decision would most likely impact the market for commercial real estate investments in the short term, with the office market in central London being hit especially hard,” he says. Over the long term, however, the consequences may be less severe as London will remain an international centre for companies and institutions in the financial, legal and business sectors.
USA offers major opportunities
Investors have also given a largely positive assessment of the US market – in 2015 it attracted the largest share of global real estate capital. “There are almost no dark clouds on the horizon there,” says Marcus Cieleback. The country’s economic fundamentals are promising, which in particular reflects the interest rate rise initiated by the US Federal Reserve (Fed) in December. Union Investment also considers the US real estate market to be on the upswing. In December 2015, the Hamburg firm expanded the portfolio of its real estate fund in Seattle by acquiring the Amazon Phase VI office property for its UniImmo: Europa open-ended retail real estate fund at a price of $299 million. “As one of the fastest-growing US cities that is also highly attractive for young, well-educated workers, Seattle offers conditions that are perfect for our strengthened international commitment,” explains Martin Brühl, Member of the Management Board at Union Investment Real Estate GmbH and responsible for Investment Management International. Union Investment’s real estate specialists are looking for opportunities not just in US office properties, but also in the country’s hotel property markets.
It also recently invested about $180 million in The Godfrey Boston, a boutique hotel with 242 rooms, for the UniImmo: Europa as well. For Reinhard Kutscher, capturing new markets – such as Australia – and entering markets on a cyclical upturn – such as the USA – is a strategic decision and one of the best ways of hedging against a possible change in the domestic European markets. However, he expects this to happen at the earliest in 2018. “This year will provide similar opportunities to 2015 for real estate investors. However, the market environment calls for careful judgement when selecting markets and properties, a disciplined investment programme, and forward-looking risk management,” says Kutscher. Because, and here all the experts agree for once, the reversal of the international real estate investment markets will come at some point. As soon as the European Central Bank increases interest rates, thus raising bond yields, investors will shift their attention to other asset classes.
We are not there yet
However, Wolfgang Kubatzki, Head of Real Estate at the Bad Homburg-based rating agency Feri Eurorating Services, does not believe that interest rate levels will rise even slightly in the next 18 months. Steffen Sebastian, an expert in real estate financing at the International Real Estate Business School of the University of Regensburg, is also certain and states: “Unlike the Fed, the European Central Bank is not expected to increase interest rates for the time being.” What that means is obvious: returns on investments remain low and real estate prices remain high. But looking at his own country, the professor warns that this also means that “in the German real estate market, the trend toward excess will continue.”