European investment sets a low base for recovery

Investment volumes in the first three months of 2009 fell 74% on the opening period of last year, registering a total of just €11.4bn across the region, with no market unscathed.  Unsurprisingly, prime yields rose further and the market was also hit by an acceleration in the decline of the occupational sector, with rents under pressure in most areas.  The combination of these factors left capital values across Europe down 18.5% over the year, according to global real estate adviser Cushman & Wakefield.

Trends within the market were similar to late 2008, with foreign investors pulling back faster than domestic buyers, taking just a 29% market share in the quarter, down from 43% last year.  Virtually all countries saw a similar pattern, with major markets such as Sweden, The Netherlands and Russia seeing no significant foreign buying at all.  The only exceptions were Italy, which saw an increase in foreign buying after a very weak fourth quarter, and the UK, where a steep fall in pricing and Sterling, as well as the increased availability of property as companies and institutions have needed to make sales, have combined to make the market a key focus for many of the international buyers who are in the market.  While domestic buying in the UK dropped by 41% - in line with wider European trends – foreign buying increased 147% on the final quarter of 2008.  Nonetheless, activity in the opening quarter from foreign players was still down on the same period of last year (by 54%).

Whilst domestic buying is down significantly on early 2008 levels, a  number of markets are reporting renewed interest from some domestic high net worth individuals and families, as well as local institutions.  These are often investors who have been out of the market for a number of years due to competition from foreign and debt backed buyers, but who now see attractive opportunities to invest, often for assets which may rarely come to the market, albeit often in smaller lot sizes

Offices remain the worst affected sector, seeing activity fall 57% on the last quarter to just 38% of all market activity, the sector’s lowest share since at least 2000.  By contrast retail activity fell 22% and industrial 42%.  Not all regions saw the same pattern, however, with office activity rising in Eastern Europe and industrial activity up in the Nordics and in Southern Europe – albeit in all cases from a low base in late 2008.

Performance Trends

Rents fell in virtually all areas in the opening quarter as the recession bit deeper.  On average, over the year to March, prime rents fell 4.1%, the first annual decline since 2003, but, in the first quarter alone, they fell at an annual rate of 14.5%.  Offices remain under most pressure with rents down 19.3% pa in the first quarter, versus a 12% drop for retail and 9.5% for industrial.  Emerging markets very much led the fall, with Eastern Europe seeing a fall over the quarter of 52% pa, versus 14.4% in Central Europe, 15.2% for the UK and 6.2% in the rest of Western Europe.  Aside from the UK, the most affected Western markets to date are Finland, Greece, Ireland, Norway and Spain.

Yields moved out sharply across the region but the pace of change was not quite as marked as in the final quarter of 2008.  Western European yields rose 18bp, compared to a 30bp rise in late 2008 – but much of this reflected a stabilisation in the UK.  Excluding the UK, Western yields rose 20 bp (versus a 25 bp rise in q4 08), with Finland, France, Ireland, the Netherlands and Portugal seeing the strongest increase.

Central & Eastern Europe saw a more marked increase once more, as investor risk-tolerance fell and tighter finance forced a further pricing correction.  Central Europe saw a 66 bp shift while further east, yields rose 88bp, with Bulgaria, Romania, Russia and the Ukraine all seeing an increase of over 100bp on the quarter.

The industrial sector saw the greater increase across Europe, followed by offices, although trends did differ by region.  In the West, retail saw a greater degree of stabilisation but industrial yield appreciation accelerated whilst in Central & Eastern Europe, even though there was still a major outward shift for industrial, the pace of change slackened from the previous quarter.

The Outlook

A sharp fall in activity and values comes as little surprise against the backdrop of such a severe contraction in economic activity.  Nonetheless, it is at least reassuring to note that the rate at which values are falling is no worse than in the previous quarter and, moreover, there is now a slow increase in buyer interest at today’s values.

“Looking at the wider capital markets, there has been an increase in risk tolerance among investors and alongside signs that we may soon be past the worst in the economy, this bodes well for increased activity in the property sector in the months ahead and for a peaking in prime yields in the second half of the year” said David Hutchings, head of European research at Cushman & Wakefield.  “However, while cheaper finance will help, there are few signs that the availability of debt is likely to escalate any time soon and property will have to compete hard if it is to bring in new buyers – hence any early signs of a stabilisation in yields must be treated cautiously until we have a firm handle on where rents are likely to bottom out.  We are forecasting a peak to trough decline in prime rents of around 15-20% across all sectors, with the market not hitting bottom until 2010.  However, much of this is already discounted in prime yields and it is secondary property which will bear the brunt of the slowdown from here.”

Moreover, a slow improvement in the balance of buyers and sellers is likely over the coming months and alongside a steady improvement in the underlying economy, this sets the scene for a modest upturn in investment activity.  The banks look likely to only slowly increase their sales in the near term, but listed companies, corporate owners and some institutions are being forced to sell.  Some larger institutions are also having to sell to re-balance their portfolios despite the recent rally in share prices.  At the same time, some new money is flowing into the market, be that from funds who are underweight or who have been out of the market for some time, or from private individuals and other long term players who see value in the market for prime property given where income returns are in other asset classes.

However, while volumes may stabilise in the months ahead, a return to stronger rates of activity is someway distant.  Roger Cooke, chairman of the European capital market board at Cushman & Wakefield, comments; “I think some people are over estimating the availability of equity for real estate.  Potentially there is quite a lot waiting on the sidelines but it is demanding in what it expects by way of a return whilst also being quite risk averse.  It wouldn’t surprise me to find in the not too distant future that we had situations where debt was available and affordable but there was a lack of equity at realistic pricing.”

Michael Rhydderch, head of the European cross border capital market group at Cushman & Wakefield, agrees and also suggests there are too many funds chasing either ultra-low risk core returns or ambitious opportunistic performance levels. “Some funds may be boxing themselves in with rigid return requirements.  Many core and opportunistic funds are finding good value-add opportunities on a risk-adjusted basis, but these assets do not match the return obligations they have made to their investors.  As a result good potential purchases are being overlooked.”

However, while an impasse between buyers and sellers may be set to slow the recovery, that recovery is still drawing nearer.   “Yields look to have further to rise in many parts of Europe before we can declare that the market offers great value, particularly for larger lots and most especially for secondary space”, commented Michael Rhydderch, “but with an acceleration in the rate at which rents are adjusting, we are certainly drawing nearer to that point more rapidly than is usual in a market downturn.  Moreover, for astute investors focussing on prime assets, it is increasingly clear that now is the right time to be looking because even though distress will be with us for some time, we are starting to see assets unlocked which rarely come to the market and in an environment in which cash is king, some great opportunities are emerging for well-funded investors.”