Back on the bull saddle: Prime property leads recovery

The recovery in European real estate began in 2009 with prime properties in the crucial markets of London and Paris. This recovery is now spreading out into other major western European cities, causing a ‘snap-back’ in prime yields.

This sharp compression of yields, typical of the initial phase of recovery, is not sustainable. A similar spike happened in 1994, in the recovery from the 1991-93 downturn. This produced a ‘W’ shaped recovery, which subsequently fed into a sustained bull market.

The current recovery is likely to take a similar shape with a strong initial spike in performance, giving way to a consolidation phase, before a recovery in the broader market.

The key themes for 2010
- Capital markets will remain a key driver: Improved risk appetite and the increased attraction of ‘real’ assets, as investors hedge their portfolios from the potential inflationary results of recent stimulus spending, will support investment.
- Market values to stabilise: Yields are expected to stabilise across major cities in northern and western Europe. Capital values should stabilise for most modern, well-let assets and increase sharply for some prime assets.
- Improving supply and demand fundamentals: The limited supply of new space will soften the extent of rental income declines.
- A different kind of recovery: We are seeing the beginnings of a horizontal recovery across markets rather than the traditional vertical model.

Historically, investors would invest in the prime and then, subsequently, the secondary areas of their own domestic real estate markets. Now, highly mobile investors are investing across borders to take advantage of prime opportunities in specific locations.

Where to invest?
Those countries more able to control their own economic destinies. The most attractive markets are the UK, France, Germany, Benelux and the Nordics with other areas remaining too risky until a suitably attractive premium is re-established to tempt institutional investors.

However, as the year progresses, highly opportunistic investors may begin to take advantage of ‘points of light’ such as in Ireland.

While now is the time to buy property risk, there is no need to take on unnecessary risk by investing in emerging European or Asian markets. Attractive returns are available in western European markets, which also benefit from higher levels of liquidity and transparency. Legal title can be quickly established and independent legal infrastructures are in place – something that many bondholders are more cognisant of in the aftermath of the Dubai debt crisis.

In terms of sectors, industrials will be the strongest performer, given the high yields that are available. Prime offices should deliver steady performance; the sector was oversold on the back of a bleak outlook for financial services, but fewer job losses than expected have subsequently occurred thankfully.

The retail sector however will be the weakest performer in 2010, before experiencing a strong recovery in 2011. However, in the short term, spending will remain subdued, particularly in the UK, as consumers focus on reducing their indebtedness.

Now that the large capital value corrections are through, the risk and return environment for property is very attractive. However, there is little need to take unnecessary risks in peripheral markets. Investors should retain a firm focus on income return, rather than get too carried away with short-term yield compression.

Research will become more important as investment becomes more granular and binary. The best performers will be those that make the right deals, supported by rigorous due diligence and effective management of income risk.