After a prolonged period of strong performance in the domestic commercial property market, concerns about the potential for yield compression caused by the weight of demand is leading fund managers to look abroad for superior yields.
Pockets of value may remain in the UK but several fund houses have launched European and global property funds in the hope of finding lesser researched markets.
Scottish Widows Investment Partnership investment director of real estate Ian Hally says he is only finding value domestically in the London office market, which he believes will enjoy a further 12 months of rental income growth and remain attractive until at least the end of 2009. He believes continental European markets are now offering a better growth story for property investors.
Hally says: “France and Spain are particularly strong although, if you widen beyond those areas, there are also good stories in Germany, the Netherlands and Belgium.
“Some of the companies we are buying into are increasingly looking to buy into other central European countries, like the Baltic states and Russia. The rationale is that they believe the yield potential, particularly in the Baltic states, is higher than in the home market.”
Hally says the key difference between the UK and continental markets is the rent structure. There is less of a culture of upward-only rents in Europe but annual indexation of rents effectively provides the same effect. “The French government links inflation in the building industry to rental prices so the return is currently 7 per cent, making cities like Bordeaux, Toulouse and Lyon attractively priced compared with the UK,” he says.
Barings multi-manager property fund co-manager Sam Jeffries says the group is 70 per cent focused on the UK but can invest up to 30 per cent outside the UK.
He says the fund holds a number of core funds that invest in European property funds in Germany and Spain but the group is looking increasingly at Eastern European property fund managers. He believes opportunities will open up soon but wants the market to mature before he dips his toe in.
Jeffries says: “Our objective is to achieve capital growth in a low volatility environment and we believe the return profiles of most Eastern European markets are too risky so do not currently invest outside the mainstream market with the exception of Russia.”
New Star property manager Marcus Langland Pearse is concerned that investors might overlook risk in the hunt for yield in the emerging European markets. He says: “There is a risk that as yields tighten in more established European markets, investors are looking to increase yields elsewhere and ignoring the risk profile.”
Premier Asset Management pan-European fund manager Alex Ross is backing Western Europe over the East. He says the fund has shifted from a 75 per cent UK weighting at the start of the year down to 50 per cent, with France and Germany being the major beneficiaries.
Ross says: “Apart from the London office market, the UK is showing a negative yield gap of around 50 basis points while property yields in Europe are often over 6 per cent. The cost of borrowing there is around 4 per cent so it has a positive yield gap of around 200 basis points.
“We favour Western over Eastern Europe and have heavy weightings in prime retail sites in central Paris, Stockholm and Munich.”
Ross believes the core European markets have some way to go before they overheat. “The core markets are a bit behind the curve and we are just starting to see a cyclical recovery in rents which will trigger an increase in property values,” he says.
Some commentators believe the idea of mainstream and emerging European markets is an over-simplification.
Invista Real Estate Investment Management head of European real estate Tony Smedley says: “Europe is a huge geographic area and we are seeing yields tumbling in more traditional established Western markets but these countries are very big so there is still significant value in buying other opportunities there.”
Smedley believes many of the Eastern European property markets, such as Croatia, Poland, Bulgaria and the Czech Republic, are currently overpriced.
“People should not forget that these markets are not very liquid or deep and are generally very small so we believe there is better value buying into the more established and liquid markets like France and Germany,” he says.
Smedley says Invista has invested in property in Stockholm and Amsterdam but believes a lot of markets will continue to struggle with oversupply and lack of demand.
He says: “If there is oversupply, rentals remain weak unless you have long income streams. We were recently offered an office building in Warsaw at a 6.5 per cent yield but the depth of occupational demand there is questionable so we think buying in Lyon on the same yield is a better purchase.”
Rutley Capital Partners partner Nick Burnell says the domestic cost of debt is an important consideration. “You need to look at the amount of debt. If you can count the number of quality buildings on one hand, you have to be very careful,” says Burnell.