Commercial property has been the darling of investors over the past few years.
They have not only fallen in love with an asset class that has provided both income and growth normally associated only with equities and a relative security comparable with bonds but have also seen their property investments comfortably outperform both.
Until recently, UK investors have needed to look no further than their own backyard for investment opportunities as UK returns marched ahead of those in continental Europe, but with many commentators calling an end to the superlative performance enjoyed over the last few years in the UK, the question arises whether investors should start to set their sights further afield, particularly when hunting for income.
Seven Dials Consulting senior research analyst Kieran Farrelly says: “This strong performance in the UK has been primarily due to strong capital-growth-driven by falling property yields.
“However, until recently, European commercial property yields have seen less downward pressure than those in the UK, although they are low by historical standards. A big driver of this yield compression has been the lower interest rates globally that have occurred since the mid-1990s, which left property looking cheap relative to bonds in both the UK and Europe. Recent yield falls in the UK have reduced this relative valuation gap whereas European yields have fallen much less.”
Invista Real Estate director of European strategy Tim Francis says: “Yield compression across continental Europe has changed the dynamics of the real estate investment markets to the extent that we now favour the more established markets – underpinned by the bigger economies, such as France and Germany.”
The collapse of the dotcom bubble led investors to flee to the perceived safety of bricks and mortar, an asset class previously used almost exclusively by institutional investors.
Farrelly says: “Private investors suddenly discovered the attractions of commercial property, such as its ability to reduce a portfolio’s risk, its historical track record of delivering real returns and its low volatility.
“This wider awareness fuelled a re-rating of property as an asset class and this has now become a key component in asset allocation frameworks, with allocations of 10-25 per cent becoming widespread.
“This has meant that both the UK and Europe have seen their property risk premiums reduced by investors, helping to drive yields down further”
Seven Dials believes European commercial property is poised to benefit from possible further re-rating, particularly in some more developing markets, while the UK has less scope to do this now.
“Core European economies have certainly been lacklustre whereas the UK has seen both strong and stable economic conditions since the mid-1990s,” says Farrelly.
“Recently, European economies have improved, and investors have started to become more confident over prospects in Europe, particularly Germany, and they are now assuming continued robust growth. Europe has far more potential upside on the growth side than in the UK.”
Farrelly says to take advantage of conditions in Europe, UK investors will need to be selective in terms of markets and sectors. They also need to remember that careful stock selection is far more critical than is the case with equities.
Invista head of European funds Tony Smedley says the diverse nature of regions, property types and value propositions means there are a number of different markets within each country. He says: “It is difficult to compare the European market with the UK. It is a huge geographical area, with each bit moving at different speeds.”
Farrelly says: “At a sector level, Seven Dials currently prefers retail and industrial over the office sector, as they are better placed to benefit from domestic demand and aren’t as keenly priced.
“These sectors also offer the best diversification benefits, being less marketcyclical. The office markets in the key cities tend to be the most liquid and transparent markets and thus have attracted the weight of the capital flows going into European property.
“Seven Dials also thinks that some office markets potentially have too much growth priced into them, though in the short-term strong performance is likely.”
Geographical areas favoured by Seven Dials are the Nordic region and the Netherlands, where robust domestically driven growth can be expected and which offer attractive pricing on a relative basis and thus good prospective total returns.
Invista Real Estate favours much the same areas, believing Sweden, France, Germany, Netherlands, Belgium and Spain offer a compelling balance of risk, diversification, transparency, liquidity and pricing and excellent opportunities for investors to benefit from cyclical improvements in continental European real estate leasing markets.
Specialists remain unsure about Eastern Europe. Smedley says: “We are wary of parts of Central and Eastern Europe, where prime yields are now close to those in the west. In our view, these yields no longer reflect the additional market risk of investing there.”
Patrick Sumner, who manages the Horizon pan-European property equities fund for Henderson Global Investors, with euro 2.3 billion under management, is particularly bullish about Germany, where a Reit regime similar to the UK’s is just being introduced.
He says: “Germany has the biggest property stock in Europe but it is under-represented in the listed arena and the introduction of the G-Reit should encourage the creation of a significant listed German property sector. It is taking place at an interesting time in the property cycle, with consumers growing in confidence as employment starts to grow again, and key office markets, such as Hamburg and Munich, are showing early signs of recovery.”
Standard Life Investments investment director of mutual funds Barry MacLennan is also a fan of Germany. He says that now is “absolutely the right time” for investors to be looking to Europe in terms of the market cycle.
“Reits have hit the right time in the cycle for Germany, as the market enters a period of recovery and very few property investments are already securitised” he says. “It is great timing for the German market.”
Seven Dials, which has just reopened its European property fund of funds after a successful first tranche at the beginning of the year, believes that to outperform the market, stock selection – that is, individual property assets – is the key driver.
Farrelly says: “Property investing is less landlord-friendly on the continent than it is in the UK and requires greater property asset management. Selecting the right teams to invest with is crucial.”
On risk, he says: “Following a number of highly correlated years between UK equities and property, European property now offers significantly better comparable risk-reduction benefits. With greater scope for further yield re-ratings, there is a strong case for believing that Europe also has better upside growth potential than the UK. With lower downside risk as well, this offers an appealing combination.”
Smedley says: “Continental European real estate offers investors a number of opportunities, including the potential for strong performance, with continental properties offering relatively high levels of income yields relative to interest rates and the potential for capital appreciation through rental growth and further yield compression.”