In the 19th century, Americans were told to go west to make their fortune. Investors are now being told to go east to make money from commercial property after the strong returns from Britian over the past few years. Investors may have already missed the best investment opportunities from continental Europe, however.
It is unsurprising that property funds are seeing massive inflows at the moment. According to the Investment Property Databank (IPD), British commercial property delivered a total return of 18.1% in 2006. The office sector alone returned 23%.
The strong returns have been marked by capital growth far outstripping income returns, which is the reverse of the long-term trend. This has seen substantial yield compression. Tony Horrell, head of European capital markets at Jones Lang LaSalle, says prime site offices in Britain have yields of 4.5% and below.
“It is difficult to finance commercial property purchases through borrowings given the rising cost of money,” says Horrell. “The common view is that there will be some yield increase in the UK and a fall in capital prices. This is especially the case outside London. “
A survey by Reita, the trade association for real estate investment trusts, shows that IFAs are still recommending Britain above any other commercial property market. This is despite the fact some fund managers have been advocating diversification to continental Europe to profit from better value.
But does continental Europe really offer greater value? Yields on German offices, for example, have fallen to 4.5% and less in some cases while offices in Paris have yields as low as 3.5%. Even in Warsaw, yields have dropped to 5.5%.
Horrell argues that continental Europe is further behind Britain on the investment cycle and therefore offers greater opportunities. But the “easy money” has already been made.
Key factors in determining prospects for the continental European property market are liquidity, sentiment and economic growth. Rob Burnett, manager of the Neptune European Opportunities fund, says the continental European market was driven higher in 2006 by liquidity and sentiment.
“With bond yields rising, property is becoming a less attractive investment,” says Burnett. “This may see some investors moving from property to bonds. Even if there are not redemptions, there may not be new investors and this will affect capital growth and adds a headwind for the market.
“Corporate profitability and economic growth in Germany and elsewhere in Europe supports the property market. But we believe these favourable fundamentals are already priced in.”
Horrell, however, is more optimistic about liquidity because he argues there is an “unprecedented” range of investors buying property in continental Europe. These include global and European funds, syndicates, private investors and sovereign funds. “The leveraged investors are affected by rises in interest rates,” says Horrell. “But cash investors, such as funds, are less impacted by interest rate movements and will continue to invest.
“There are record volumes of transactions in Germany and France. There is probably demand of about five euros for every one euro of supply in continental Europe.”
Nevertheless, Horrell says investors should expect a steady income from commercial property rather than substantial capital growth. “The days of buying a property in continental Europe and sitting on it for two years and enjoying capital growth are over. The only alternative is to conduct asset management by improving the property to increase yields and capital growth.”
Fund managers argue that you cannot generalise about the commercial property market. Stewart Webster, chief investment officer of New Star Property Asset Management, says his optimism is based on finding solid properties with rental income growth and capital appreciation.
He has been finding investment opportunities in Germany because of “economic growth and favourable demand and supply factors”, which leads to rental growth. There is a low supply of prime location good quality office space, says Webster.
He likes the Paris office market over the short and medium term because of an under-supply of good space. While yields have been compressed, Webster says the growing demand and lack of property have been pushing up rents.
Webster also likes Hamburg because it has several economic drivers. “There is a lot of interest so pricing has been aggressive but the demand will see rental growth.”
Julian Taylor, head of European property at Morley, argues that some markets like France, Ireland, Spain and Sweden have been highly correlated with Britain. “In contrast, Germany has been fairly negatively correlated.”
He is confident the German property market is improving. Taylor points to the fact that GDP growth was 3.5% year on year in the first quarter of 2007. Vacancy rates vary but Taylor says they are below 5% in key markets like Dusseldolf. “When vacancy rates get down to 7% or 8% they lead to rental growth.”
There was rental growth of about 6% in the German retail sector in 2006, which was double the rate in 2005. Taylor argues that with yields of between 5% and 6% in Warsaw and Prague, there are better investment opportunities in Germany.
Taylor says there has already been strong growth in prices in Ireland and Spain. “There are retail yields below 4% in Ireland and you have to be careful in Spain because of the amount of recent developments.”
With continental Europe following closely behind Britain on the investment cycle, some managers argue that investors should look to Asia for greater diversification. This is the view of Jack Foster, manager of the Franklin Global Reit fund. He is underweight America, Britain and continental Europe.
He says Asia, and particularly Singapore, offers better value than Europe and America. “Property values are rising in Asia but rental growth is strong, which means they are supporting prices. An important driving force is the strong economic growth in the region.”
Foster adds that land prices in Japan are growing for the first time in 15 years. “The office market in Tokyo is the largest in the world. It is a third larger than New York. There has been a pick-up in Japan and there is a differential of 200 basis points between rents and interest rates in Japan.
“In contrast, there are negative yields in the UK as rents are below interest rates,” says Foster.