Going, going, gone?

It has been a hugely turbulent time for European real estate, with few markets proving able to weather the financial led global recession. A collapse in investor confidence and massive deleveraging led to investment volumes plummeting, and significant valuation falls across all commercial property markets. Since the summer of 2009 though, unprecedented fiscal and monetary policy, sovereign debt risks, and low bond yields have stimulated the appetite of the real estate investment market once again.

It has been widely acknowledged that the vast majority of European markets have now reached a positive turning point in terms of pricing. However, this will not spark a uniform recovery in valuations and investment activity largely due to the variable gains and declines recorded prior to 2009 were heterogeneous. This volatility was shaped by a number of key market variables, including transparency and access to finance, all of which coupled with their macro-economic outlook, will ultimately determine the direction for the European property market.

During the bull market run-up to 2007, two errors magnified the subsequent collapse: largely under-estimated risk and over-stated returns. Buoyed by the health of the global economy and access to easy credit, European commercial property became more expensive. In the UK, this helped exacerbate the magnitude of the 44 percent fall recorded in values until a tipping point was reached in mid-2009, whereby alongside a sharp recovery in equity markets, property valuations were viewed to have over-corrected, and then perceived to be ‘cheap’.

The UK was one of the first markets to undergo a marked rebound in capital values and a significant valuation correction well ahead of continental Europe. This was due to buyer interest from a host of UK institutions and overseas investors seeking to benefit from the weakness of sterling. Additionally, the UK is one of the most open, transparent and liquid property markets in the world, with a mature domestic and international investor base. In Europe, where the fallout of the financial recession took longer to register and property markets are far more opaque, the initial boom and subsequent bust in valuation was less aggressive, tempering the rebound in investment demand and capital values.

Border battles
Cross-border investment activity has been crucial in driving transactions and valuations of European commercial property. In the fall-out of the credit squeeze, the risk-adverse nature of international investors led domestic players to determine pricing, and bring some stability to market conditions. As the market recovers and investment confidence continues to strengthen, cross-border activity will recuperate.

Although in late 2009, investments were clearly linked to the most liquid real estate markets, namely London and Paris hence they recorded the earliest and largest uplift in valuation. Furthermore, with the security of income fundamental, during a downturn, the UK is unique in Europe as being characterised by significantly longer lease terms, and it’s distinctive ‘upwards only’ rent review provisions generally occur every five years. The institutional market tends to be dominated by longer leases of 10 to 15 years, far in excess of Europe, while the use of alternatives (such as indexation, turnover rents) is still rare in the UK.

The broader, more stable European market however disguises significant regional, country and sector performance spreads. The European Valuation Monitor from CB Richard Ellis reported a 0.7 percent year-on-year rise in capital values in Q2 2010, but incorporates a 17.8 percent hike in the UK and that of a 6.8 percent fall in values across Central and Eastern Europe. In short, liquidity has returned, but it remains firmly focused on primiary sectors within key markets.

This implies that the projected recovery in Europe will be extremely polarised. Germany, France and the Nordics are being considered ‘safe havens’ in recent months of financial unrest, and will have benefited from an improvement in property’s relative pricing, whereas question marks surrounding true pricing across the southern economies still linger as bond yields remain inflated.

Clearly it is too soon to judge whether the more peripheral European economies are going to be able to successfully reduce their public deficits, but while risk-management and de-leveraging remain the cornerstone of investment management, yields will remain above their long-term equilibrium levels. Here, significant austerity packages will deliver weak occupational demand and severely rationed debt finance, therefore rental projections will not drive European capital value appreciation anytime soon.

Market outlook
Property values have generally increased across Europe in 2010 with the flow of money into property being fuelled by improving financing conditions and rising confidence that fair values have been reached. Our view is that pricing across core markets has stabilised after a substantial recovery in recent months; awaiting more promising economic news and an improvement in debt markets. Occupier demand across Europe is likely to remain subdued in 2010 and 2011, largely reflecting contracting employment levels and widespread austerity plans. This should prevent the investment market from getting over-heated, and deliver some much needed stability to the sector.

Property markets have performed very differently in the recession demonstrating the diversity within Europe. Going forward, Henderson believes that the large spread of regional economic growth forecasts will deliver a wide range of property returns across Europe. For the near term, given the precarious economic backdrop, investor activity is likely to remain centred on the most transparent and liquid markets such as the UK, where opportunities to acquire healthy returns still exist. Our risk adjusted return forecasts do not yet favour the more peripheral markets.

It is unlikely that the European property market will witness a marked recovery in investor demand towards better quality secondary and value-add assets. Given the re-emergence of risk management and a two-tier bond market across Europe that has emerged due to fears of contagion linked to the Greek sovereign debt crisis. Current investor intentions remain restricted to the core European markets and prime assets, and only if the supply of investment stock was to remain heavily curtailed will investors contemplate wider central European markets or riskier assets before 2011.

However, dismissing non-core markets and assets would not be wise. Unresolved challenges such as over-indebted asset managers, loan breaches, paralysed banks and corporate failures will leave opportunities for the shrewd investor to exploit. Downturns tend to produce insufficient differentiation. For example, entire countries such as Spain, Poland, Italy and Ireland can be discarded as “bad apples”, yet such generalisations often ignore good micro-location characteristics. Evidence of competitive bidding for prime assets in core markets could imply that the most attractive deals are more likely to be found in prime markets not yet in the investor arena or secondary and niche markets, currently overlooked by risk adverse mainstream investors.

The sheer weight of money currently poised to re-enter commercial property markets suggests asset prices across all sectors, as long as the income is long and secure, will be driven higher. As such, asset quality and covenant rather than country’s location may actually drive investor activity into 2011. By understanding individual country property market dynamics, leaves scope for careful market timing, sector choice and stock selection to construct well diversified portfolios. In summary commercial property will become increasingly determined on the ability to deliver income by protecting revenue, good asset management and therefore hopefully, some medium term rental growth.