By no means was it a “black swan”. That is what the financial world – using a term popularised by the statistician and trader Nassim Nicholas Taleb – calls a completely unexpected and highly improbable event, which has extensive consequences for the capital markets for precisely those reasons. Investors had plenty of time to prepare in advance for one of the most important dates of 2016: the referendum by British voters on leaving the European Union (EU). However, when it became known on 24 June that a majority of Britons had voted in favour of the so-called Brexit – one of only two possible outcomes and therefore rather probable – it rocked the global capital markets.
Following in the wake of the FTSE, exchange prices around the globe suddenly tumbled. It was even worse for the British pound: after the victory of the EU opponents in the country, the currency sank by a good 13 percent to its lowest level in more than 30 years; foreign exchange traders were paying about $1.31 for each British pound – $0.20 less than the day before.
Speculation will continue for months on the medium and long-term consequences of the British referendum on the economy of the UK and the EU, on the global economy, and not least on the globally networked capital markets. But one thing is certain: the European and US central banks will do everything that they consider necessary to support the markets. In other words, they will continue to keep the money gates wide open for the foreseeable future. Immediately after the results of the referendum were declared, the British central bank announced it would make an additional £250 billion available to the banks in order to prevent bottlenecks in the money supply. The Governor of the Bank of England, Mark Carney, stated that monetary policy incentives would probably be necessary in the course of the summer because the economic outlook had worsened. The UK’s Chancellor of the Exchequer, George Osborne, also promised relief for the countries’ businesses – primarily by reducing corporate taxes from 20 to 15 percent.
billion euros net flowed into German open-ended real estate funds between January and May 2016. In contrast, equity funds lost
That would be significantly less than the continental European governments demand from businesses. And in the United States, the additional increase in interest rates – expected prior to the Brexit vote – will likely be postponed. The majority of observers assume at a minimum that the US Federal Reserve will forgo any additional interest rate hikes until 2018. However it is clear that despite – or perhaps because of – these measures, investors’ uncertainty will continue. All observers expect that the fluctuations in the equities and currency markets will remain high and investors will attempt to evade them by switching to safer investment forms that are largely resistant to risk.
billion euros net during the same period.
That sounds rather good to managers of large commercial property assets. They can largely ignore currency and equity market fluctuations. And because investing in office buildings and shopping centres, hotels and logistics depots is considered comparatively safe, there is hardly a risk that the interest in real estate investment will suddenly drop off – with corresponding negative effects on their value. On the contrary: “The current phase of uncertainty could stimulate investments in “Betongold” (concrete gold) slightly again,” says Martin Steininger, Chief Economist at Bulwiengesa, the Berlin-based real estate analysis firm. Frank Pörschke, CEO Germany of the international real estate consultants JLL, has similar expectations: “As a result of Brexit, market actors will probably look increasingly to Germany as the nation with the strongest economy in Europe”.
Clear market distortions
However, the turbulence in the equities and currency markets, the continuing strong demand for safe real estate and, above all, the sustained very high liquidity in the markets may bring about mixed feelings among risk managers at the large investment management companies specialising in real estate. Because when evaluating the opportunities and risks associated with both new and existing investments, risk managers in no way look solely at real estate-specific factors such as economic growth, the labour market, demographic trends, property condition, occupancy rate, quality of the micro and macro-location, or the position of the location in the current market cycle. “They also look at the opportunities and risks in the capital market,” explains Christoph Holzmann, Member of the Executive Board at Beos, the Berlin-based project developer and asset management company. As far as property risk strategists are concerned, the weight of the capital market here has increased significantly recently – with serious consequences: “We live in times of considerable market distortions,” states Martin Brühl, Member of the Management Board at Union Investment Real Estate GmbH.
This is due primarily to the glut of capital as a result of the loose monetary policy of the European Central Bank (ECB), caused by the record low interest rates and the bond purchasing programme that the central bankers around ECB President Mario Draghi expanded yet again in March 2016. The ECB reduced the key interest rate for money that the eurozone banks borrow from the central bank from 0.05 to 0 percent. On top of this, the banks must also pay a penalty interest charge of 0.4 percent for short-term deposits at the central bank. In April 2016, the ECB also expanded the bond purchasing programme it has been running since March 2015 from €60 billion to €80 billion per month. And as if that were not enough, the central bankers are also buying corporate bonds in the eurozone for the first time.
The ugly flip side of new capital
The bundle of monetary policy measures is flooding the markets with capital and driving the yields of many sovereign debt issues below zero: European government bonds valued at more than €3 trillion are currently earning their buyers no interest. In Germany, about 80 percent of all government securities are actually yielding negative interest. The continuing interest of institutional investors such as insurance companies, and private and public pension funds in real estate investments is therefore more than understandable. Any investor losing money in government bonds will gladly buy a first-class office property in a high-demand European metropolitan centre – even if the initial return on equity is below 4 percent. German insurance companies, for instance, have increased the share of real estate in 2016 to a record high of 9.3 percent of their investments (2015: 7.6 percent), according to a recent survey of 30 insurance companies by the advisory firm EY Real Estate. On average, each of them holds real estate assets of around €3.5 billion. And that share has not yet reached its final mark, says Dietmar Fischer, Partner at EY Real Estate. “German insurers will be placing even more real estate in their investment portfolio in the future in order to be able to keep their promises of guaranteed interest.”
What is right for the insurance companies is simply cheap for private investors. They are also seeking salvation in real estate investments – and not only in the residential markets in German cities. Indirect investment in open-ended retail real estate funds is also enjoying greater popularity. According to information from BVI, the German Investment and Asset Management Association, between January and May 2016, German open-ended real estate funds gained new capital of approximately €3.9 billion net – that is after deducting shares redeemed by customers. That is almost three times as much as during the same period in the previous year, when an already generous €1.3 billion flowed into the funds. Investors are apparently restructuring their assets: equity funds reported net redemptions amounting to €1.8 billion.
That presents the managers of open-ended real estate funds with a dilemma. Because the new capital has an ugly flip side: it is difficult to invest with appropriate speed in property that corresponds to the yield-risk profile of the fund strategists. The reason is well known: competition for properties is continuing to grow. Real estate investors will develop alternative strategies and, for good or bad, all experts agree they will also have to accept higher risks in order to generate appropriate yields. “It will be all the more important, in the interest of the investors, to maintain the balance between the risk tolerance necessary in a zero-interest world on the one hand, and the prudence required in view of the large number of existing risks on the other,” says Union Investment Manager Martin Brühl.
The liquidity wave is now the main determining factor for real estate professionals.
Union Investment has already demonstrated its prudent risk tolerance in recent years. Based on a risk management process that is continually enhanced from a strategic, conceptual and technical standpoint, the Hamburg-based investment managers exploited new regional markets – such as Brisbane in Australia and Boston in the United States – and further expanded their exposure in familiar markets such as Mexico; they invested in hotly contested metropolitan centres and in medium-sized cities; they significantly expanded their hotel investment segment, and were one of the first in the industry to dare to invest in development projects together with selected partners. All of these measures underscored their interest in increasing the number of candidate investments with lucrative yields through smartly calculated risk tolerance. Around €2.1 billion was invested in new properties in the first half of 2016, just under 40 percent of this in America. For example, in April $315 million went into the purchase of the LondonHouse in Chicago for UniImmo: Europa. The architecturally striking hotel on the corner of Wacker Drive and North Michigan Avenue is leased long-term to Oxford Hotels and Resorts Group LLC. The acquisition of the office property at 101 Seaport Boulevard in Boston cost $452 million. The global headquarters of Converse in Boston was also purchased for around $150 million.
Liquidity-related risks increase
But the risk managers at the major investment management companies are no longer looking simply at the investment side – with good reason. The “wave of liquidity is now the central determining factor for real estate professionals,” says Tobias Just, Professor at the International Real Estate Business School at Regensburg University. The results of the most recent semi-annual real estate investment climate survey by Union Investment, for which a representative sample of 161 professional property investors in Germany, France and the United Kingdom were surveyed (see page 24), clearly supported this conclusion. Over the last three years, the importance of liquidity management has risen sharply for 42 percent of those surveyed. During the same period, the significance of liquidity-related risks increased by 25 percent compared to other risk types.
The risk management process of an open-ended real estate fund begins with liquidity management.
At the German open-ended real estate funds, the run on real estate has significantly increased their cash on hand – and that is causing quite the headache for the fund strategists. Many of them – including Union Investment – therefore resolved in early summer to stop taking new customer deposits for the time being. “We believe the risk management process of an open-ended real estate fund begins with liquidity management of the incoming capital,” says Union Investment expert Martin Brühl. Cash must be invested – in connection with statutory requirements totalling at least 5 percent as a liquidity reserve and up to a maximum of 49 percent of the fund assets – and here property asset managers face exactly the same challenge as their colleagues in insurance companies or pension funds: clearly cash does not produce income.
As the Scope rating firm determined, more than 22 percent of the available funds of all German open-ended real estate funds are currently in cash reserves. The worry about earning negative yields is therefore quite real. At UniImmo: Deutschland, for example, the yield from liquid funds in the financial year 2015/2016 was 0.4 percent – still positive, but also only half as much as in the preceding financial year. And this was the case even though the vast majority of the cash reserves are held in special securities funds instead of money market accounts.
The effect on fund performance is still the smallest problem; it is considered manageable. From the risk strategists’ perspective, the greater risk from the increasing liquidity is that the already major investment pressure on the real estate markets will rise further and, in return, limit the latitude for rational disposals for adjusting the portfolio. The obvious result: a greater risk of a misallocation of capital. Looking at the risks on the globalised capital markets, which are certainly not decreasing, this means that iron discipline is needed to prevent such a misallocation, all the more so in the event that the financial markets should yet again be beset by a veritable “black swan”.