Asset differential provides opportunities for European property investors

The very low level of European interest rates has been the main driver of recovery in European real estate over the last few years, as income-hungry investors substitute higher yielding prime real estate investments for low-yielding bonds.

This has driven up the prices of these assets to such an extent that prime yields in a number of markets are at record lows. However, prime assets are only a small proportion of the total real estate market. While their value has risen quickly, the rest of the market has seen a much slower recovery, creating a significant dichotomy in the market.

This combination of persistently strong, but polarised investor demand and the lack of prime space to let has resulted in a larger than average spread between prime and secondary rents and yields. This points to potential opportunities to pursue value-add strategies that reposition secondary real estate assets as prime properties.

The rising price of prime property assets in Europe may have pushed rental yields down to levels not seen since the peak of the market, yet it still delivers a historically large yield premium versus long-term government bonds.

As insurers and pension funds are finding it difficult to meet their liabilities, many have invested in prime European property in an attempt to access stable long-term cash flows that have provided higher returns than those on offer from bonds.

The European market has also been boosted by the emergence of sovereign wealth funds (SWF) and rising wealth and savings in Asia. According to Real Capital Analytics, SWFs have invested €45 billion(HK$384 billion) in European real estate over the last five years. Due to their size, SWFs are increasingly dominant in transactions for large assets and in global gateway cities, particularly London.

The main source of prime real estate investment is the development of new buildings. The global financial crisis resulted in a collapse in development activity, the impact of which was prolonged by banks restructuring their balance sheets.

Over the last eight years the supply of available new assets has dwindled, causing shortages of prime space. European office development activity in 2014 was at its weakest level for 20 years. As occupiers move to new premises, the owners of the buildings they leave behind have struggled to attract new tenants without refurbishment.

Vacancies are increasingly concentrated in that growing supply of older secondary properties. This has resulted in the price of older buildings falling below their replacement cost. This imbalance in the supply is leading to upward pressure on the rent commanded by prime buildings, but little or no pressure on the rents for the significant supply of older assets.

Investors have a choice between investing in core market tracking investments or value-add investments whereby additional performance is delivered by repositioning, rebuilding, or recapitalising the corporate structure in which assets are held.

As the gap between the prices commanded and rents achieved by prime and secondary properties has widened, the opportunity to deliver profits from transforming secondary into prime becomes greater. Furthermore, the inherent value of such strategies is underpinned by continued low interest rates and enduring strength of appetite for the prime real estate assets being created.

The attraction of value-add strategies is also enhanced by Europe’s cities having clearly defined centres with good communications infrastructure. This trend has been reinforced by the growing preference of both tenants and their staff to live in dynamic urban environments.

European countries remain very distinct. This means that there is no “one size fits all” strategy. In some locations the full or partial conversion of older office or industrial buildings into other uses can deliver a substantial uplift in value.

However, in other locations this strategy may not offer the best risk-adjusted returns, especially for investment where a lengthy and uncertain planning process is required to obtain this change of use.

Refurbishment of existing buildings can also be highly attractive especially when the margin between the prime and the secondary rents is higher than its long-term average. Careful analysis is required as the costs of transforming different buildings will vary considerably, as will the length of time taken to complete the works and to find suitable tenants.

As different markets are at different stages in their recovery, a key question for value-add investors will be, “is this the right time for this strategy in this market?”, with a particular focus on liquidity at exit. The UK has led other European markets and the recovery, which started in London, is now broader based with the majority of markets seeing rising rents. In the short term, there is considerable further potential for rental growth.

However, a rising development pipeline and the threat of higher interest rates suggest that the most appropriate strategies are those that can be executed quickly.

In continental Europe interest rates are much lower and unlikely to rise in the short term. These markets offer less scope for broad-based rental growth but there are more opportunities for arbitrage in rents and yields between secondary and prime property. They also provide scope for longer-term opportunities as the enduring low level of interest rates underpins the stability of exit yields.

Across the different European markets, investors also need to have an eye on the liquidity of the markets in which they invest. Longer-term investment plans in markets with lower liquidity or a greater variance in liquidity over time will carry greater risk than markets with higher or more consistent liquidity.

The European real estate market is diverse and the range of opportunities within it large, particularly in the current environment where countries and regional markets are recovering at different speeds.

A legacy of underinvestment in the existing stock combined with the widening differential between prime assets and the rest of the market creates opportunities for investors to enjoy enhanced returns from value-add strategies.

Thomas Mueller and Mark Long are the portfolio manager and head of research, respectively, for BlackRock Real Estate, EMEA.