Investors remain cautious in the wake of the US crisis, writes
The commercial property market started this year on a roll. In Europe, investment volumes and lending to real estate were reaching records as yields tumbled. Property shares hit record highs.
Globally, investors’ enthusiasm for real estate seemed unabated. Real estate funds proliferated and Morgan Stanley raised £8bn (€11bn) of equity for the largest opportunity fund. In the first half of the year, €127bn ($187bn) of European real estate traded hands, two thirds of it bought by cross-border investors.
The deals were big. Lehman Brothers paid €2.1bn for the Coeur Défense building in Paris while HSBC sold its tower in London’s Canary Wharf to Spanish property company Metrovacesa for £1.1bn, with a 20-year leaseback. However, the yields were small – 3.8% for the latter.
Small private investors were also entering commercial real estate. New Star’s open-ended international property fund took in £206m at its debut in June, making it the most successful UK retail fund launch. Private retail investors in the UK poured £6.2bn into them up to August. In Spain, booming property prices fueled a stock market frenzy, with real estate shares rising quickly.
However, this was the end to real estate’s bull run. In the UK, the Bank of England had been raising interest rates, squeezing returns. Even at the start of the year, five-year money was 118 basis points higher than prime property yields. Elsewhere on the continent, the funding gap was still positive, but narrow.
In their search for better returns, investors and developers started to turn to higher-yielding markets. Germany continued to attract substantial inflows, enabling some of the early opportunity fund entrants to sell on to other investors. Nordic real estate became fashionable. Others focused on central and eastern Europe, the more adventurous going to Romania and Moscow. The hot money headed for Asia: India and China.
Investors targeted higher-yielding specialist property sectors such as hotels, nursing homes and German motorway service stations. Billionaire property entrepreneur Sir Tom Hunter continued to collect UK garden centers.
However, while the direct real estate market was continuing to do well, the quoted sector was not. In the UK, the prices of tax-efficient real estate investment trusts and other listed companies started subsiding steadily.
In Spain the crack came in April, when worries about stock market star Astroc’s financial health triggered heavy selling of real estate and construction shares. European real estate shares are 21% down on the start of the year, according to the indices.
When property shares started trading at discounts to net assets, flotations faltered. In the UK, the £2.5bn Vector hotel reit did not get off the ground while in Germany the long-awaited rush onto the stock market failed to materialize.
There were other warning signs. In May, the Bank of England said it considered commercial property “potentially vulnerable” because of banks’ aggressive lending to the sector. The Swedish central bank also warned its domestic property market was overheating.
The European commercial mortgage-backed securities market also registered its first default in May, on the £530m Hoteloc securitisation. CMBS had been fuelling huge growth in the debt available for European real estate. In the first half of the year, €38.9bn of CMBS were issued, two thirds more than the same period the previous year.
No one foresaw the shock the US sub-prime crisis would inflict on real estate. As spreads rose and liquidity drained out of the capital markets, real estate deals, particularly those carrying larger price tags and more leverage, faltered. With investors shunning CMBS paper, securitisations were postponed. Lehman Brothers withdrew a €1.5bn issue secured against the Coeur Défense building.
The impact of the credit crunch has been particularly marked in the UK. Values are under pressure and it is unclear by how much, or at what level, yields will stabilise. The more optimistic are talking of a 50 basis points to 75 basis points rise for prime real estate, implying a 10%-15% fall in prices.
At the start of the year, data provider Investment Property Forum’s consensus forecast was anticipating total returns of 9%, mainly from rental growth. By October, returns to commercial real estate had dropped to a 10-year low of 1.9% and the latest IPF consensus forecast for the year has shrunk to 1.8%.
The slump in returns continues to worry retail investors, who have started withdrawing their money from commercial property funds. With flows turning negative, open-ended UK retail funds have started to impose exit charges and introduce notice periods on redemptions.
Debt in continental Europe is less easily available than earlier this year and its cost has risen but the shutdown does not seem to be as severe as in the UK. The deal flow, though diminished, still exists. Since yields have not been driven as far down as in the UK, investors are not expecting a dramatic rise, though lesser-quality property is expected to suffer.
Meanwhile, occupational demand for real estate in Europe remains robust. Most markets have a relatively healthy balance with supply of space, although the amount of development coming through in the City of London is causing concern.
If the credit crunch does not tip economies into recession, most experienced real estate investors – particularly those with plenty of equity – are preparing for a subdued 2008.
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