Investment paradox

It has been a year since the major European economies exited recession, and while I appreciate the many risks that may dampen the economic outlook, I am baffled by the many column inches dedicated to fears surrounding a so called ‘double-dip.’  The world economy has come along way in the last year, and although near term GDP growth across the core European countries may prove volatile, it is more relevant medium term growth prospects are positive, pushing 2.5 percent per annum over the next three years. In this environment, commercial property occupier markets should be close to their trough and we should see investors starting to deploy capital strategically in order to benefit from the new cycle emerging.

This is not, however, what we witness in Europe’s property investment markets where investors and lenders still operate in risk aversion mode, almost exclusively focusing on core assets. The most crucial investment mantra seems to be the long-leased secure asset that will outlive the short term uncertainty and volatility. Unfortunately, in the current risk-conscious climate, a high level of security does not come cheap. With prime yields recovering strongly, investors appear willing to pay substantial premiums for long-dated secure income. The prevailing investment approach implies investors do not really believe in a strong economic recovery any time soon and therefore still try to tunnel through a prolonged rough patch.

However, I don’t believe that avoiding risk at almost any cost is still the right move. Occupier markets lag economic indicators: Past recessions show that it can take 2-3 years from the low point of economic decline until rents find the bottom as well. This suggests that European property markets will begin to see rental growth at some time between mid 2011 and mid 2012. In this cycle, markets have been spared a construction boom which should help rental values to stabilise somewhat earlier. The very early bounce back of  prime rents in London, and to a lesser extent in Paris, in the first half of 2010, adds some support to this view. At least for prime assets, the rental recovery is in sight and should commence playing a role in investment appraisals.

Provided over renting is not a problem, leases expiring around 2014 and 2015 should potentially benefit from re-letting in a climate of accelerating rental growth. Additionally, periods of accelerating rental uplifts usually attract speculative investors that specifically target short unexpired terms or vacancies.

The capital values paid for prime stock at the peak of the market implied very strong rental growth or further inward yield shift to drive returns. Investors seem to have the most daring risk appetite when the economic cycle is near the peak. A past period of sustained rental growth, however, can be a innaccurate indicator for the timing of speculative investments, as it is most likely to be followed by further  slowdown or even an outright recession.

Typically, bidding is most prevalent at the peak of the rental cycle, when the market is ex-growth. Investors tend to look backwards at the growth trend and then extrapolate it into the future.

In contrast, by increasing ones appetite for risk ahead of the pack around the occupier market trough, investors can at least buy into the full rental recovery. Of course, there is the danger that the economic outlook deteriorates again and the occupier market recovery is delayed, but eventually the cyclical upturn in rents will come through. In particular, as we are experiencing in this cycle, the low levels of new supply support a technical rental value increase, even during what could be a slow growth environment.

Most importantly investors are rewarded with a sizeable risk premium for exposure outside the prime segment. With few investors prepared to take on risks, the price of risk has increased in favour of bolder investors. The exceptionally low trading volumes in secondary assets across Europe indicate that risk premiums have increased in a wide range of markets. So, if secondary offers an attractive risk premium, why are investors still not interested?

Admittedly, many investors who are convinced that the timing is right to move up the risk curve may not be able to act on it. The state of European banks and their problematic real estate balance sheets remain a stumbling block. The vast majority of European lenders are only willing to finance secure core assets. This means secondary assets are often stuck with the current owners, independent of investor appetite.

The most obvious reason for ongoing risk aversion is investors unease with the economic outlook. The spectre of a prolonged period of economic underperformance, possibly even a Japanese-style lost decade, still remains a possibility. A long phase of stagnation would depress the rental recovery which would particularly dent the performance of secondary assets. However, as this scenario would be accompanied by very low bond yields and interest rates, prime property could benefit from strong yield compression.

The sharp increase of bond prices, moving the German Bund 10-year benchmark yield to 2.3 percent in September 2010, suggests this view currently enjoys some support in the market. Property investors, however, using record low bond yields as a rationale for aggressive bidding on prime assets risk falling for a bond market bubble.

The group of investors who are really expecting a “lost decade” remain best positioned to focus on prime assets. In fact, if this scenario were to become reality today’s prime pricing would even look cheap in a couple of years.

However, based on current economic forecasts, which suggest that the recovery will continue and bond yields will soften, I recommend that property investors should place their bets on the current risk premium and play the next rental cycle ahead of the game.