Europe opens door to brighter offices

British commercial property shares tumbled but investors should seek more global exposure – especially in Germany, Italy and the Netherlands – where interest rates are not as harsh.

Last year saw several predictable developments in the commercial property market but equally some movements came as a complete surprise. It was obvious that the British market was going to slow down from the heady yield-compression driven returns of 15% a year during 2001-06, and sure enough it obliged, although the falls in capital values were higher than most had predicted.

Harder to foresee was the sheer scale of the reaction from retail investors to the change in sentiment. Having been the sector attracting by far the most capital for months on end in 2006, the sudden brake on British commercial property fund raising meant that most of the British authorised property unit trust fund managers – M&G, New Star, Norwich Union and Standard Life – were forced to apply exit charges in the form of bid pricing to help stem redemptions from their UK property funds.

The extreme volatility in property shares – real estate investment trusts (Reits) – was another unexpected response to the changed sentiment that has caught out several investors. They realised too late that a Reit was more akin to a stock rather than bricks and mortar commercial property and that when the market mood changed so did the market value of their property portfolio – downwards.

Some Reits moved from almost a 10% premium to net asset value (NAV) to more than 25% a discount almost overnight. Inevitably, the inclusion of property shares to provide liquidity to a property investment was shown up to be what it is – an unrealistic sop to investors who should have accepted that commercial property is fundamentally not a liquid asset class.

There are many advantages, not least its powerful diversification, inherent low volatility and real income features. But it is slow and expensive to transact and it is only a matter of time before investors are forced to realise this.

Investors do overreact to events and do so collectively and this is the likely reason that some European Reits have also suffered alongside their British brethren. The funds that are proving resilient are the pure bricks and mortar funds, which are net asset value priced and these are still showing positive returns and increased property asset valuations.

Many investors and fund of funds managers are seeing this as a buying opportunity and are picking up some bargain basement property funds. Investors across all segments have rebalanced their portfolios to internationalise their commercial property holdings, and Europe and Asia are regions to attract them as they offer inefficiencies for managers placed locally to add value.

For 2008 and beyond Germany, Scandinavia and some sectors in France and the Netherlands offering particularly good long-term value and, further afield, Japan and Vietnam are showing some attractively-priced opportunities in their rapidly-recovering economies.

The lessons to be learned from 2007 are twofold. First, commercial property should remain an important – and diversifying – component of their portfolios, but that the emphasis must change to both diversify that allocation away from purely a British one towards a more global exposure.

Secondly, an appreciation that the liquidity constraints of the asset class are such that bricks and mortar, rather than property shares, is the purest and least volatile way to get exposure to this newly-accepted entrant to the asset allocation ball.

Turning to the new year, the economic outlook for the eurozone countries continues to be good. The region will see a similar GDP growth forecast for the period 2008 to 2011 at 2% to the past 10 years with the exception of two countries.

The Spanish GDP will grow less while German GDP will grow more – differences that indicate the eurozone is converging. However, Britain and Scandinavia will remain stronger with a GDP growth rate at 2.5%.

In terms of rental growth of commercial properties, the outlook remains benign in the retail sector despite the credit crunch. With consumer spending on the up, countries such as Germany, Italy and the Netherlands offer the greatest new commercial property developments.

But France and Sweden are also good places to exploit this consumer spending trend. Within the industrial sector occupational demand is going to improve across all countries. In addition, the strong European economies offer better rental growth than was expected from the office sector, with a prime rent forecast at a rate of 3 to 6% a year from 2007 to 2011.

The economies in Europe will remain strong and are much less exposed to the American economy than in the past with long-run prospective returns at 6% a year ungeared.

The office sector has underperformed historically and rental growth needs to exceed growth rates to compensate for that. Yields are lower than the 20-year average and this in turn will lower returns.

However, more yield compression is still likely and individual property asset management remains the key source of investor value and return. The interest rate environment is more gentle in continental Europe than in Britain. Since the late 1990s the real estate rerating as an asset class has been associated with a fall in real interest rates but this process is largely complete and is at long term equilibrium levels.

To conclude, most markets in continental Europe will continue to outperform the British market with yields shifting, thanks to unexpected good growth within the office sector. Higher interest rates are hitting Britain more than continental Europe.

While European markets differ from Britain in lease terms, durations and cost norms, they offer good opportunities for property asset management to increase rental growth and property value.

Both institutional and private investors are going to seek direct exposure to pan-European property. This year is looking bright indeed for European commercial property investment with good prospective returns.