Global Real Estate Insights Into the Cyclical Downturn

Transcription

1 RREEF Research October 2007 Global Real Estate Insights Into the Cyclical Downturn Table of Contents 1. Introduction...1 Part I: Global Real Estate Markets 2. Recent trends and prospects 2 3. Global real estate insights: A framework 7 Part II: Regional Prospects 4. European real estate Americas real estate Asia Pacific real estate...52 Part III: Investment Implications 7. Cyclical and structural opportunities Investment strategies..66 Authors: Henry Chin +44 (0) henry.chin@rreef.com Ermina Topintzi +44 (0) ermina.topintzi@rreef.com Peter Hobbs +44 (0) peter.hobbs@rreef.com 1. Introduction The financial turmoil of the second half of 2007 seems to herald the end of what has been dubbed the Golden Years for real estate. Global real estate securities have posted a performance of 2% to the end of Q3 2007, after averaging 25% a year over the previous five years. The direct markets are also weakening and are set to fall to 5% in 2008 after averaging 13% over the previous five years. There are clearly variations with, for instance, the UK market to experience negative value growth during 2007 compared with Japan which continues to experience very strong performance. But the Golden Years are coming to an end and, although we remain cautiously optimistic over the impact of the financial market turmoil, there is a risk of a more significant correction in real estate performance. But, as predicted in last year s Global Insight report, this is a downturn that has been anticipated for some time and, more importantly, it is cyclical. Real estate remains an attractive asset class for a range of investors and the correction in its pricing could provide interesting opportunities for investors to increase their exposure. More fundamentally, real estate continues to provide a series of long term structural opportunities. These opportunities, which include the growth of emerging markets and the wave of sale and leasebacks in the more mature markets, will transcend the coming cyclical downturns. Although these opportunities exist, the slowing of performance and the wide variations across markets reinforces the need for systematic research into market prospects. It is within this context that we have prepared this edition of Global Insights. As usual, we provide a review of prospects across global markets, and draw out the implications for different types of investment strategy. This year, we have placed greater emphasis on a series of emerging markets, including those in Eastern Europe, Asia and Latin America. Tan Yen Keng yenkeng.tan@rreef.com Alan Billingsley alan.billingsley@rreef.com Sandra Naylor sandra.naylor@rreef.com IMPORTANT: PLEASE SEE IMPORTANT DISCLOSURES AND ANALYST CERTIFICATION IMMEDIATELY AT THE END OF THE TEXT OF THIS REPORT

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3 Part 1: Global Real Estate Markets 2. Recent Trends and Prospects 2.1 Financial Turmoil and Real Estate Markets Two scenarios - downside and cautiously optimistic The dimensions of the financial market turmoil have been well-articulated in our recent research report that explains the reasons for the turmoil as well as the implications for the broader economy and real estate markets 1. The paper outlined two scenarios. First, a downside scenario in which the credit crunch spills over into the real economy leading to a recession in the US that slows growth across global markets. Within this scenario, there could be general disaffection with real estate such that the sector experiences very weak performance over the remaining years of the decade. Although this downside remains a possibility, the more likely scenario is cautiously optimistic where growth slows but, due to the strength of the global economy and the reaction of central banks, a prolonged slow-down is avoided. Within this second scenario, cash-rich investors take the place of the highly levered investors who are squeezed out by the increased cost and reduced availability of finance. The continuing strong appetite for real estate and robust fundamentals mean that real estate performs relatively well over the medium term. Returns fall back from recent strong levels but represent a soft landing for real estate, and the asset class will continue to remain attractive to a broad range of investors. with the cautiously optimistic scenario being the most likely outcome. As the current edition of Global Real Estate Insights goes to print at the start of October, it remains too early to determine which of the scenarios will become a reality. There is increasing evidence of a slowing of the global economy and real estate markets but, at the same time, there are signs of some stabilisation. The weak economic data from the US and increasing concerns over growth in Europe and Japan mean growth is set to slow over coming months 2. The increased difficulty in gaining finance means a number of major high profile real estate transactions have failed to complete and performance has started to weaken. Despite this, the Asian economies, particularly China and India, continue to generate very strong growth, and the Fed s decision to cut interest rates by 50bp in September demonstrates their commitment to avoid a recession. On balance, the prospects for continued robust, if lower, global economic growth coupled with relatively sound real estate fundamentals means the cautiously optimistic scenario remains the most likely outcome. 1 RREEF Research (2007), Implications of the Financial Market Turmoil on Global Real Estate Markets, September 2 Deutsche Bank (2007), Global Economic Perspectives, 24 th September RREEF Research 2

4 2.2 Global Real Estate Outlook, Global economy is set to slow in H and Even before the financial turmoil of recent months, the global economy was set to slow in the second half of 2007 and into The tightening of monetary policy in many countries, as well as the slowing of the US economy meant that economic growth was expected to decline to 4.5% in 2008, down from 5.1% in 2007 and 5.4% in Economic growth in 2007 was expected to hold up strongly in parts of the world, including Asia and Europe but even here growth is expected to fall-off in This slowing of global growth is expected to increase the scope for interest rate cuts during 2008, certainly in the US and in Europe. The latest Deutsche Bank forecasts call for a further reduction in US rates from 4.75% in September to 4.5% by the end of This loosening of monetary policy is expected to support stronger growth in the latter years of the decade. Chart 1: Global Economic Growth f 2008f China India Eurozone Japan USA Note: As of 28th of September 2007; f= forecast Source: Deutsche Bank Global Markets Research Another good year for the performance of direct real estate in 2007 Within this economic context, it is likely that 2006 will come to be seen as the peak in the recent strong performance of real estate with global unlevered returns estimated to have achieved 15.5% during the year. Performance is set to remain robust in 2007 before falling off in The relatively good performance in 2007 is being driven by good fundamentals and the weight of capital. In terms of the fundamentals, the strong economic growth (ex-us) and limited new supply is leading to a spike in rental growth across many global markets (Chart 2). Investment activity remained, at least to mid-year, very strong, with record prices and transactions being recorded during the first half of the year (Chart 3). This high level of investment activity is set to fall off during the second half of the year, but the momentum behind the strong performance means that returns are likely to remain relatively strong for the year as a whole, at 11.4% for This performance means that real estate is set for another year of relatively strong performance, both in absolute terms and relative to other asset classes (Chart 4). 3 Deutsche Bank (2007), Global Economic Perspectives, 24 th September 4 Deutsche Bank (2007), Global Economic Perspectives, 24 th September RREEF Research 3

5 Chart 2: Office Rental Growth in Major Global Cities, Q to Q New York London Madrid Hong Kong Los Angeles Tokyo Paris Sydney Washington, D.C. Toronto 0% 5% 10% 15% 20% 25% 30% 35% 40% Source: RREEF Research, CBRE, JLL Chart 3: Investment Transaction Activity US$ bln 700 America Europe Asia Pacific H1 Source: RREEF Research, JLL, RCA, DTZ RREEF Research 4

6 Chart 4: Global Asset Class Total Returns, Direct RE RE Securities Equities Long-Term Govt Bonds 40% 30% 20% 10% 0% -10% -20% -30% Note: Global performance based on aggregate for US, Canada, Western Europe, Australia, Japan, South Korea, China, Hong Kong and Singapore weighted by market size Direct Real Estate figure is estimated, and for other asset classes it is year to date performance. Source: RREEF Research based on EPRA/NAREIT; IPD; MSCI; NCREIF; ICREIM; PCA; MTB IKOMA; JP Morgan Global Govt Bond Index. but marked variations across markets. Although real estate will likely continue to perform well at a global level, there are considerable variations in performance across the major markets. Most markets are set to experience a weaker 2007 than achieved last year, with particularly sharp reductions in the UK ( down from over 18% unlevered returns in 2006, to less than 5% in 2007). In contrast, the strong economic growth, and aggressive pricing mean that the second and third largest real estate markets of Germany and Japan are set to experience stronger performance in 2007 than last year 5. 5 It should be noted that while the IPD/NCREIF return series for the UK and the US are robust in effectively measuring market performance, this is not necessarily the case in Germany and Japan. IPD maintains a performance series for both countries, but the relatively small sample size and the valuation methodology cast doubt on the robustness of the performance series that are reported. For instance, in 2006 IPD reported All-Property Returns of 1.2% in Germany which is far lower than the reality of the market as a whole. RREEF Research 5

7 Chart 5: Estimated All-Property Total Returns for Major Global Direct Real Estate Markets, 2006 and 2007 Expected 2007 Returns (%) 26% 24% 22% 2007 Returns Higher Than 2006 Singapore 20% Japan 2007 Returns Lower Than % 16% 14% Australia Korea Hong Kong China 12% Germany Sweden Spain 10% 8% US Canada France Ireland 6% Netherlands UK Italy 4% 2% 2006 Annual 6% 8% 10% 12% 14% 16% 18% 20% 22% 24% 26% 28% 30% Returns (%) Note: Average annual unlevered market returns for Direct Real Estate. The size of bubble represents the size of real estate market Source: RREEF Research; IPD; PPR; NCREIF; BulwienGesa Unlevered global real estate returns to be relatively weak in 2008/9 Beyond 2007, performance is critically dependent on the way in which the current financial turmoil is resolved and impacts the broader global economy. On the basis of the cautiously optimistic scenario, unlevered returns will be relatively weak in 2008 and 2009 before starting to recover at the end of the decade. At a regional level, the weakest growth is expected in Europe where returns, averaging around 8% a year, were expected to be pulled down by very weak performance in the UK and Spain. This is expected to be weaker than the 11% a year for North America and 17.6% for Asia. Chart 6: Global Unlevered Total Returns, Annual return (%) 25% Western Europe North America Asia 20% 15% 10% 5% 0% -5% -10% f 2008f 2009f Note: Western European All-Property Total Returns is a weighted average of Germany, France, Spain, Ireland, Sweden, Italy, Netherlands and the UK. North American All-Property Total Returns is a weighted average of US, and Canada. Asian All-Property Total Returns is a weighted average of Australia, South Korea, China, Japan, Singapore, New Zealand, and Hong Kong. f = forecast Source: RREEF Research; PMA; IPD; NCREIF; BulwienGesa; MTB-IKOMA; Property Council of New Zealand RREEF Research 6

8 3. Global Real Estate Insights: A Framework Despite the weakening of performance, the enduring strengths of real estate Although real estate is set to experience a period of relative underperformance for the remaining years of the decade, it remains an important component of a multi-asset portfolio. On the one hand, it possesses a series of enduring strengths, including: Attractive long-term absolute and relative performance Relatively high income yield and low volatility Strong diversification potential against other asset classes. coupled with structural changes More fundamentally, real estate remains a relatively immature asset class, and the structural changes underway generate significant opportunities for investors over the medium and longer term. This is clearly demonstrated by the continuing growth of the global market which is set to expand by 40% to reach US$14 trillion by The growth rates are far stronger in the emerging markets of Asia, Eastern Europe and Latin America given the huge demand and limited supply (Chart 7) 6. Beyond the opportunities in emerging markets, many mature economies in Europe and Asia continue to undergo corporate restructuring and this generates significant opportunities (via sale-andleaseback and corporate investment) for real estate investors. Chart 7: Global Real Estate Market Size, Change (%) (RHS) 180% US$ trillion % 140% 120% 100% 80% 60% 40% 20% 0 North AmericaLatin America Western Europe Eastern Europe 0% Mature Asia Emerging Asia Source: RREEF Research create a series of structural and cyclical opportunities. It is these structural drivers that will come to add an increasingly important dimension to global investing. Despite this, real estate continues to be a highly cyclical industry with periods of undersupply tending to be followed by surges of new development. For this reason, investors need to assess the position of markets through their real estate cycles, both in terms of market fundamentals (demand, supply, vacancies and rents), and market pricing (performance). Given these drivers of performance, any assessment of market prospects needs to cover both cyclical and structural pressures for change (Chart 8). Beyond the structural and cyclical drivers of performance, investors need to understand the risks associated with investing in different markets and product types. On the one hand, these risks involve the volatility of market performance but, on the other, and more fundamentally, they relate to 6 RREEF (2007), The Future Size of the Global Real Estate Markets, July 2007 RREEF Research 7

9 more institutional risks. These institutional risks involve the economic and political maturity of countries, as well as more real estate-specific factors such as transparency, liquidity and income security. Chart 8: Schematic Representation of Real Estate Performance Drivers and Risks Determining Market Attractiveness Performance Drivers Market Attractiveness Real Estate Risks Structural Drivers Emerging Geographies Emerging Products Sale and Leaseback Opportunistic Value Added Demand, Supply, Rents Cap Rates & Performance Market Volatility Cyclical Drivers Market Fundamentals Performance & Pricing Core Country & Economic Liquidity, Transparency Structural Risks Source: RREEF Research Different types of market are suitable for different types of investment strategy. It is the combination of cyclical and structural risks and opportunities that need to be considered when investing across global real estate markets. The framework presented in Chart 8 demonstrates that different types of market and investment strategy are suitable for different risk/return requirements. Core/Core+ strategies are generally lower risk with a relatively high income return and a focus on more mature, transparent and liquid markets. Opportunistic strategies, in contrast, tend to have a higher proportion of return coming from value growth and, due to their higher leverage and focus on more volatile and emergent markets, tend to be riskier than more core-type strategies. Value added strategies tend to fall between the two extremes, in terms of return targets, leverage and appetite for risk. The issues captured in Chart 8 provide a useful framework for exploring the opportunities and risks across global markets. The remainder of this paper uses the framework to provide insights into investment strategy across six broadly distinct regions of the world, North America and Latin America, Western Europe and Eastern Europe, and Mature Asia and Emerging Asia. RREEF Research 8

10 Part II: Regional Prospects 4. European Real Estate There are marked variations in the maturity, property cycle, and the performance of real estate markets across Europe, most significantly between Eastern and Western Europe, but also within the two main regions 7. Within Western Europe, the UK, Irish, French, Dutch, German and Swedish markets are far more transparent than some of the Southern European markets including Italy, Spain, Portugal and Greece. In the Central European markets, the Czech Republic, Hungary, and Poland, are still maturing, and benefit from greater economic integration within the EU, political stability, and real estate market transparency. Further east, many countries are still emerging. Although very opaque, many of these Eastern European markets are growing and maturing fast, with rising personal income and growing interest from foreign investors. 4.1 Real Estate Performance in Europe Strong historic performance for European real estate Over the last ten years, real estate has delivered very strong absolute and relative performance, ahead of equities and government bonds, and at far lower volatility than the other major asset classes. Over this period, Western European real estate has generated around 9.4% annual total returns, compared with 10.6% for equities and 5.4% for bonds. The European securities market has outperformed all major markets in the same period with an average annual return of 16.6%. Chart 9: European Asset Class Total Returns 60% 50% 40% 30% 20% 10% 0% -10% -20% -30% Direct RE RE Securities Equities Govt Bonds -40% Direct RE Equities RE Securities Bonds Returns ( ) 9.5% 10.1% 19.0% 5.9% Risk 1.8% 21.4% 16.7% 4.7% Return / Risk Analysis Note: 2007 total return values are year to date Direct Real Estate figure is estimated, and for other asset classes it is 2007 performance to end of Q3. Western European All-Property Total Returns is a weighted average of Germany, France, Spain, Ireland, Sweden, Italy, Netherlands and the UK. Source: RREEF; IPD; MSCI; FTSE EPRA NAREIT; JP Morgan Govt Bond Index 7 Regional GDP levels and growth rates are from Global Insights (2007), and GDP growth rates are based on the period Real estate market performance prospects are based on RREEF Research estimates. Maturity of real estate markets is estimated by RREEF Research based on market transparency, liquidity, and investible ratios. RREEF Research 9

11 In 2006, strong cap rate compression and the recovery in rental markets meant that total unlevered returns were very strong across European markets. Western European total returns reached 12.3%, with the UK, France, and Ireland recording exceptional performance of 18%, 22%, and 27% respectively. In the same year, Spain, Denmark, Norway, and Sweden also saw their real estate markets performing strongly by over 15%. Much of this strong performance over the past two years has been due to capital value growth. Germany s performance also picked up with a surge of investment activity over the past 18 months (see footnote 5 on performance indices in Germany). Chart 10: Western European Direct Real Estate Performance, Country Index Annual Returns 5 year average Total Income Value United Kingdom IPD 9.6% 10.9% 18.3% 19.1% 18.1% 15.1% 6.1% 8.6% Ireland IPD 2.3% 12.7% 11.5% 24.3% 27.2% 15.2% 5.3% 9.4% Portugal IPD 13.8% 10.0% 10.6% 10.0% 12.0% 11.3% 6.9% 4.1% Spain IPD 8.3% 8.4% 11.4% 17.2% 17.4% 12.5% 6.0% 6.1% Denmark IPD 9.4% 7.3% 6.6% 18.0% 17.8% 11.7% 5.7% 2.6% France IPD 8.6% 8.0% 10.1% 15.2% 21.7% 12.6% 6.2% 6.2% Norway IPD 7.0% 7.6% 10.4% 15.2% 17.6% 11.5% 7.4% 3.8% Italy IPD 9.3% 11.0% 8.9% 9.0% 8.0% 9.2% 5.9% 3.0% Netherlands IPD 8.8% 7.1% 7.8% 10.2% 12.5% 9.2% 5.9% 3.2% Finland IPD/KTI 5.7% 5.9% 5.6% 7.5% 10.1% 6.9% 7.0% 0.0% Sweden IPD 2.4% 0.9% 5.8% 12.7% 16.2% 7.4% 5.7% 1.7% Germany IPD 3.9% 2.9% 1.1% 0.5% 1.3% 1.9% 4.8% -2.8% Switzerland IPD 5.6% 5.1% 5.1% 5.2% 5.9% 5.4% 5.0% 0.4% Western Europe IPD/RREEF 7.1% 7.1% 9.6% 11.8% 12.3% 9.6% NA NA Source: RREEF Research, IPD set to slow in 2007, driven by the weakness of the UK market. In 2007, real estate returns for Western Europe are expected to slow to around 8% for the year as a whole. This result is primarily driven by the UK s muted performance and the large scale of the market relative to the rest of Europe. Although rental growth in the market remains strong, investor sentiment has weakened on the back of pricing concerns and rising interest rates. As a result, the UK market saw valuation of properties revised downwards as cap rates started to move up after a prolonged period of strong performance. After posting an annualised return of 15.6% at the end of Q12007, returns fell to 12.4% by Q2 and to 9.9% in August suggesting that total returns for the year as a whole could fall close to zero. Market fundamentals remain stronger in the rest of Europe, with better growth prospects and less aggressive pricing. Overall performance for Western Europe ex-uk will weaken but should hold up at closer to 9.5%. RREEF Research 10

12 4.2 Western Europe Western European Economic Prospects Western European economic growth to slow to sub-2% in The Eurozone economy is expected to achieve 2.6% growth for 2007, up sharply from the 2% that had been expected at the start of the year. Despite this stronger-than-expected growth, the economy is set to slow during 2008 due to the weakness of the US, the strength of the Euro and the recent tightening of monetary policy. Based on these pressures, GDP growth in the Eurozone is expected to slow to around 1.7% 8 in Chart 11: Western European GDP Growth, (% per annum) Chart 12: Western European Interest Rate Outlook, (% per annum) Annual % f 2008f f 2008f World EuroZone UK and Nordics 0 UK Eurozone Sweden Source: Global Insight; DB Global Markets September 2007, f = forecast. The largest European economy, Germany, which in recent years has been one of the weakest Eurozone economies, has moved its way up to the European average. The VAT hike at the start of the year was more than compensated by stronger investment and public consumption, and growth is expected to approach 2.5% for 2007 before falling back to 2% next year. Germany s strong growth is complemented by good performance in other parts of Europe, including countries in the North (particularly Ireland, the UK, Sweden, and Norway), the South (Spain and Greece) and the East (particularly Russia, Slovakia, and Poland). Together with Portugal and France, the Italian economy is the weakest in the Eurozone area. Italy and Portugal have remained the region s slowest growth countries with GDP growth held to an estimated 1.8% in 2007 and 1.5% in 2008, due to serious problems in the public sector (i.e. fiscal deficit) and weaker growth in the private sector. In Italy, the Q2 growth was even weaker than expected. According to the latest results from the Italian National Statistical Institute, this weakening expansion was only supported by improving output from the service sector while manufacturing and agriculture weakened. Portugal follows the same story with eroding competitiveness feeding into weaker growth and deteriorating government finances. In France, GDP growth is expected to fall back to 1.8% due to the overall slowdown of the European economy, as well as the attempts by the government to tackle the structural challenges facing the economy. In Spain, GDP growth has not slowed as much as expected in 2007 (3.8%), due to strong domestic demand underpinned by healthy private consumption and labour markets. The risk of overheating still remains, as the construction sector represents a major share of 8 Deutsche Bank (2007), World Outlook, 28 th September RREEF Research 11

13 Spanish GDP, which also makes a significant contribution to employment. A potential slow down in this sector is a major threat to the Spanish economy. Tightening monetary policy and adjustments in the housing market also represent downside risks for the economic outlook. Outside the Eurozone, the UK, Sweden, and Norway are expected to outperform the Eurozone average in 2007 and The UK has enjoyed stable and strong growth for some time. This trend has not changed, with the economy now estimated to achieve growth of 2.9% in The robust picture for the UK economy has been supported by consumption and investment, but also by the healthy growth of the private service sector output. Although the Federal Reserve has cut the federal funds rate by 50 bps, the Bank of England is likely to sit through the current market volatility, holding interest rates for the reminder of the year at 5.75%. Because of the uncertain situation for the debt market (e.g. the emergency loan granted by the Bank and England to Northern Rock Bank), many banks have become more reluctant to lend to households in this environment. Any adjustment in the housing market may be accelerated in the near future such that the UK s economic growth is expected to fall to 1.8% in The Swedish economy remains favourable, with a 3.4% rate of GDP growth estimated for This growth is mainly supported by strong business investment activity. Despite the current financial market volatility, Riksbank, Sweden s Central Bank, is likely to continue raising the Repo rate in 25 bps increments to as high as 4% by the end of 2007 in order to control rising inflation. The Norwegian economy also has experienced sustainable growth for some time. However, rising concerns over a real estate bubble have caused the Norges Bank to increase rates, and these increases are set to continue towards the end of Market Fundamentals Office: Rent growth will be relatively strong in 2007/8. Some markets are close to peaking while others are in the growth phases of their cycle. Healthy economic growth in the first half of 2007 supports strong drivers for office demand in the majority of Western European markets. As a whole, the Western European markets are mostly at an attractive stage of their current cycle. Rental growth is set to remain positive across most Western European markets in 2007 and 2008, but the pipeline of new supply in several markets will dampen rental growth toward the end of the decade. London, Madrid and Barcelona are in the peak of the current cycle with strong rental growth in 2007 and potential risk of overheating. In London, rental growth is likely to be front loaded, with the wave of new supply 9 being set to hamper future growth from 2008 onwards. Madrid and Barcelona also experienced strong growth in the past three years. With speculative construction on the way from 2008 onward in both markets, rental growth is expected to be lower and might turn negative in With strong demand and limited supply, Stockholm and Paris are in the growth phase of their current cycles and this growth is anticipated to remain solid for the remainder of the decade. Even the formerly weak German markets are moving into various stages of recovery. Hamburg is transitioning from recovery to growth, with Munich following closely behind. With somewhat higher vacancies, Frankfurt and Berlin will stay in their recovery phases for a longer period. With a falling vacancy rate and revival of demand, Milan, Amsterdam and Vienna have moved out of contraction and into the recovery stage. 9 According to PMA s August 2007 Mid Year Progress Report on the European office market, speculative starts in the City of London in the year to July 2007 reached a record 3.2 million square feet the highest level in the past 38 years. RREEF Research 12

14 Compared to other parts of Western European markets, Lisbon is still in the contraction stage. With a weaker outlook for economic growth and the surge of new supply in the next 2 years, positive rental growth is only likely to resume towards the end of the decade. Chart 13: European Office Cycle Prague Warsaw Dublin/ Moscow Stockholm/ London/ West End Paris Madrid London/ City Bucharest/ Budapest Lisbon Munich Amsterdam Milan / / Frankfurt Berlin Note: Cities marked in green represent the Central and Eastern European markets Source: RREEF Research Retail: The outlook for retail remains strong with the UK being the major exception. With stronger-than-expected economic performance in the first half of 2007, Western European shopping centre markets continue to perform well. Strong demand from retailers and lack of good quality shopping centre space are the common features for the majority of the markets in Western Europe. The outlook for the Western European Shopping Centre market as a whole remains positive in the next three years with some exceptions, most particularly the UK and the Netherlands. In general, rising interest rates and the risk of a slowdown in house price growth, that have a negative impact on the wealth effect, are the major threats to the regional retail markets. The UK retail market is experiencing weakening consumer spending and an increase in new supply. Rental growth is set to slow sharply, probably to sub-inflationary levels over the next three years. The Dutch retail market is also wavering between re-adjustment and stability. With an ample amount of new supply and retail price deflation, sub-inflationary rental growth is also expected. Greece, Spain, Sweden and Ireland are at an attractive stage of their growth cycles. Ireland and Spain are benefiting from rapidly expanding economies in recent years. With the introduction and rapid expansion of foreign retailers, Greece and Sweden both have over 4% of rental growth in the next three years. A shortage of good quality of supply in France and the improving economic outlook in Germany have boosted the retail market performance in both countries. In the past six months, Italy s retail sales growth has gathered momentum and stimulated new demand from retailers. With a relatively tight supply, the outlook for Italy s retail sector remains positive, despite the weakness of the overall economy. RREEF Research 13

15 Hungary Chart 14 : European Retail Cycle France Spain Germany 3) Post Growth 4) Re-adjustment Poland / 2) Growth Czech Republic 1) Stable Netherlands Ireland Italy/ Russia / Greece/ Portugal Sweden UK Note: Cities marked in green represent the Central and Eastern European markets Source: RREEF Research Industrial: Industrial rent growth will be low, but positive, in most markets. The Continental European industrial markets are undergoing significant structural change, due to the rise of third-party logistics (3PL) operators and the shortage of good quality logistics space. Cost pressures mean that rental growth will be very low but it should be positive in cities including Madrid, Barcelona, Dublin, Amsterdam, Hamburg, Copenhagen, Stockholm, London and Helsinki. The fast-growing Spanish economy and geographic constraints on supply are the main drivers for Madrid and Barcelona s industrial markets. Both cities led Western Europe in rental growth in 2006 and should hold onto their lead through London and Paris also benefit from the balanced market fundamentals with an average 3% rental growth per annum over the next 3 years. Most of the Scandinavian cities are also experiencing relatively solid fundamentals with Stockholm in the lead, followed by Helsinki and Copenhagen. Despite the recovery of the German economy, the outlook for industrial rents in German cities remains weak owing to the poor quality of stocks. Chart 15: European Industrial Cycle Dublin Bucharest/ Budapest Amsterdam London / Paris Stockholm Munich / Madrid Prague / Moscow Warsaw / Lisbon Copenhagen Bratislava Berlin Frankfurt / Brussels/ Milan Note: Cities marked in green represent the Central and Eastern European markets Source: RREEF Researchh RREEF Research 14

16 4.2.3 Record levels of investment activity in H Capital Flows and Performance Prospects During the first half of 2007, investment activity reached a record level of US$140bn, up 5% on the same period last year. The level of cross-border investment has continued to increase in recent years from US$13 billion in 1997 to US$84 billion in 2006, a year in which activity rose by over 40%. In the first half of 2007, cross-border investment reached US$70 billion and was concentrated in Germany, the UK, and France. In the first half of 2007, Germany overtook the UK for the first time as the biggest cross-border investment destination. This is due to the revival of economic growth in Germany and the increased willingness of domestic investors to dispose of assets. Following record transaction volumes in the Nordic and Iberian markets in 2006, both regions show signs of slowing down in the first half of 2007, as investors became more cautious about rising interest rates and current yields. Chart 16: European Cross Border Real Estate Investment, 2001 to 2007 H1 Total Transactions: US$ 71 Billion (2007H1) Ireland 9% United Kingdom 25% Middle East 5% United States 48% Germany 13% Source: RREEF Research, DTZ The office sector continued to be the favourite sector in Western European markets, with volumes reaching around US$69 billion in the first half of the year, representing 47% of total activity. The retail sector remained the next most desirable sector for both domestic and international investors, accounting for around 19% of the total transactions, dropping from 24% in The amount of mixed portfolio deals has risen significantly in According to Jones Lang LaSalle, mixed portfolio deals in Germany reached more than US$10 billion in the first half of the 2007 and most of the deals were mixtures of both prime and secondary assets. The majority of cross-border investments in Europe are still dominated by intra-regional activities, with European investors from one country acquiring assets in another European country. Despite this, the American investors remain the single most active foreign investors in Europe, and have focused on Germany, France, and the UK. Within Europe, UK investors are the most active investors, and the bulk of their investments have been in France and Germany. Following significant sales activity by the German open-ended funds in 2006, German investors have again returned as active buyers within the European real estate market in RREEF Research Portfolio sales reached 36 billion in H according to the Jones Lang LaSalle. Jones Lang LaSalle (2007), European Capital Markets Bulletin H1 2007, August 15

17 likely to slow sharply in H2. Although during the first half of 2007 investment activity reached record levels, this is likely to slow sharply during the second half of the year. The reduced availability and increased cost of debt means many transactions have been cancelled or postponed. While debt markets, and equity investors, adjust to new levels of pricing, levels of investment activity are likely to remain low, and this is set to continue at least into the first half of Chart 17: European Cross-Border Real Estate Investment, US$ Billion US$ bln 90 Offices Retail Industrial Mixed Other H1 Source: RREEF Research, DTZ Cap rates set to rise in most markets. The strong weight of capital in the first half of the year led to further cap rate compression with certain markets, such as Paris, reaching record lows (3.5%) by mid-year (Chart 18). The low level of cap rates coupled with the increase in short-term and long-term financial cost means that the spread between cap rates and bond rates has narrowed significantly, and even turned negative in some markets. These low levels of cap rates coupled with an expected weakening of rent growth mean that cap rates are expected to rise over the medium term, especially in the more overheated markets such as the UK and Spanish office markets (Chart 20). There are exceptions, such as Germany where the better fundamentals and strong weight of capital provides support for current levels of pricing, but the recent financial turmoil means cap rate compression is unlikely to continue for the majority of the Western European office markets. Chart 18: Office Cap Rates in Key Western European Office Markets (%) Paris Milan Stockholm Munich Madrid London (WE) Q1 2002Q2 2002Q3 2002Q4 2003Q1 2003Q2 2003Q3 2003Q4 2004Q1 2004Q2 2004Q3 2004Q4 2005Q1 2005Q2 2005Q3 2005Q4 2006Q1 2006Q2 2006Q3 2006Q4 2007Q1 2007Q2 Source: RREEF; CB Richard Ellis RREEF Research 16

18 Chart 19: Cap Rate/Bond Rate Spreads for Key European Office Markets % Bond rate Spread with Cap Rate -3 Avg Q Avg Q Avg Q Avg Q Avg Q London City London West End Paris Frankfurt Stockholm Source: RREEF; CB Richard Ellis; Deutsche Bank Global Markets; OECD Chart 20: London City and Madrid Overheating Indicators Cap Rates London City Madrid Rent Grow th Cap-Bond Spread Volatility Note 1: Indicator of propensity of market to overheat based on four key indicators: (1) cap rates; (2) the spread between cap rates and government long-term bond yields; (3) future rental growth; and (4) historical rental volatility. The rhombus indicates the level of overheating. The closer to the centre, the higher the level of overheating. Note 2: Our analysis looks at how 2006 s value compares to a seven-year historical average of various indicators, except for rental growth, where instead we assess the level of future rental growth (2008 to 2010) against future expectations for inflation for the same period. Source: RREEF Research Returns are set to slow, with Germany being the major exception. The prospect of flat or rising cap rates and slowing rent growth means that returns are set to slow across most European markets. In general, the unlevered returns for most of the Western European markets are expected be lower over the period compared with the past decade, except for Germany (Chart 21). In Germany, due to a strong inflow of capital, sound market fundamentals and aggressive pricing, unlevered total returns are expected to increase to around 7% for the next five years. There are increasing concerns over pricing in the UK. Following the poor performance of the listed real estate sector in the first half of 2007, the prices of direct real estate have started to fall such that unlevered total returns are expected to drop from 18.1% in 2006 to sub-5% by the end of 2007 and might turn flat or negative by the end of The RREEF Research 17

19 Spanish market faces a similar challenge of increasing supply and rising cap rates, although it lags the UK by six to twelve months. Chart 21 : Average Total Returns for Key Western European Direct Real Estate Markets, and % Avg 97 Avg 07 Avg 97 Avg 07 Avg 97 Avg 07 Avg 97 Avg UK Germany France Italy Avg 97 Avg Spain Avg 97 Avg Sweden Avg 97 Avg Netherlands Source: RREEF Research, IPD, PMA Structural Changes The major structural opportunities in Western Europe relate to the scope for sale-andleaseback activity, or the transfer of real estate from the owner-occupied to the invested market. Sale and leaseback remains the most significant structural opportunity across Europe. In Western Europe, there are marked variations in the proportion of real estate that is owner-occupied. As a mature market, the UK has a relatively low owner-occupancy ratio at 40%. However, in less mature markets, such as Greece, levels are relatively high, at around 80%. This indicates greater opportunities in some less mature markets. In some of the biggest Western European markets, including France, Italy, and Spain, the amount of institutionally-held real estate remains low. Chart 22 : The Size of Western European Real Estate Markets, US$ Billion 1,200 Invested Investible 1, Germany United Kingdom France Italy Spain Netherlands Switzerland Sweden Greece Ireland Finland Portugal Source: RREEF Research, DTZ RREEF Research 18

20 In some Western European countries, the level of the government fiscal deficits has generated significant pressure to sell and leaseback their real estate. There has been more than US$25 billion of sale-and-leaseback activity in the UK so far this decade, followed by France (US$12 billion), Italy (US$10 billion), and Spain (US$6 billion) 12. Although these figures represent large sums of real estate, the actual share of the overall market remains low, even in the UK, at around 0.5% of the total market size. This relatively small share of the sale-and-leaseback activity shows that it will take many years for the level of owner-occupancy in Continental Europe to achieve the same level as the UK. Chart 23 : Sale-and-Leaseback Activity Relative to Market Size in Europe, % Sweden Italy France Germany Netherlands UK Spain Source: DTZ Research, RREEF Research European Real Estate Risks Western European markets benefit from relatively low institutional risks The level of structural risk across key European market is shown in Chart 24 in terms of their liquidity, economic status, transparency, political, and country risk. Clearly, the Western European average is lower than the global and Eastern European averages given the level of market maturity. Although much of Western Europe has relatively mature real estate markets, there continue to be wide variations, as illustrated by the rating of structural risks in Chart 24. The ratings clearly exhibit that London and, by implication, the UK, have the lowest structural risks. This rating is based on the low scores on a series of factors such as a well-established real estate investment market, high liquidity/transparency, low sovereign risk, and an investor-friendly leasing environment with long lease terms and upward-only rent reviews. A second group of markets is represented by Paris, Stockholm, Copenhagen, Brussels, and Amsterdam. They are similar to the UK on a number of criteria but have higher risks associated with transparency, tenancy/income, and liquidity due to the shorter lease lengths and other leasing characteristics. Many of the remaining Western European markets have slightly higher risks than those in France, Sweden, and Netherlands, and this includes those in Germany and Spain. These higher risks are partially based on lower liquidity and lease terms, but also due to the generally lower transparency of the real estate markets. 12 RREEF Research (2007), The Future Size of the Global Real Estate Market, July RREEF Research 19

21 although this does not mean the markets are necessarily less volatile. As structural risks tend not to change significantly from year to year, investors can filter their decisions further by weighing market-related risks such as the volatility of rental growth, cap rates, and total returns. Such market risks can be poorly correlated with structural risks, with mature markets such as the City of London, Dublin, and Stockholm being amongst the most volatile markets in the world. Chart 24: Risk Analysis for Key European Real Estate Markets 5 Transparency Liquidity Economic Risk Tenancy/Income Risk Political Risk Country Risk Brussels Copenhagen Paris: CBD Frankfurt Munich Milan Amsterdam Madrid Stockholm London: City Sofia Prague Budapest Warsaw Bukarest Moscow Istanbul Kiev Risk Score 1= The Lowest Risk CEE Average Global Average Western Europe Average Source: RREEF Research, 2007 RREEF Research 20

22 4.2.6 Opportunities Allocations across markets Allocations to European real estate over the next three years tend to call for high weightings to Germany, France and the UK. Based on the historic and forecast behaviour of the major European markets, a tactical portfolio allocation is shown in Chart 25. This allocation is constrained by market size such that the three largest markets, Germany, the UK and France, dominate the Western European portfolio, accounting for more than 60% of the optimal regional allocation. The three markets offer slightly different profiles. The UK weights in at the lower end of the risk spectrum due to its diversification potential compared with other European markets and the landlord-friendly leases that dampen market volatility. However, the allocation to the UK is significantly smaller compared with the allocations based on historical returns. The recent aggressive pricing of the market, the limited rental expectations for the next five years, and the weakening investor appetite in the last nine months have significantly dampened the UK s expected performance. France, on the other hand, has a larger allocation towards the higher risk spectrum due to the relatively strong performance that is expected over the remaining years of the decade. Germany s optimal allocation remains stable throughout the risk spectrum, because of the improved return outlook in the next five years, and the relatively low volatility compared with the rest of the Western European markets. German yields have compressed significantly in the first half of 2007 but remain higher than those in the UK and France, with spreads still being positive. Chart 25 : Indicative Western European Real Estate Portfolio Allocation 100% 90% Netherlands 80% 70% Spain Italy Sweden 60% 50% 40% Germany 30% 20% France 10% 0% UK Lower Risk Higher Risk Note: The portfolios are based on the historical risk and covariance for period and average expected returns for The average expected return is based on RREEF Research forecasts of unlevered market returns. Constraints based on minimum allocation to each country of 50% of market weight, and maximum allocation of two times market weight. Source: RREEF Research Emerging Investment Sectors Beyond the core real estate markets, Europe provides a fast growing set of alternative sectors. With real estate markets that are mature and well-defined, the dynamic Western European economies are generating demand for new product types and uses. There are a series of opportunities among these new emerging sectors, such as logistic facilities, student housing, medical offices, hospitality, retirement housing, health care, car parks, selfstorage facilities, marinas, and movie theatre complexes. RREEF Research 21

23 Changes in demographics (mainly ageing population), coupled with the wealth and maturity of the German, French, and UK economies means that there is considerable scope for the development of alternative real estate property sectors. These range from various forms of retailing such as big box/retail parks to sectors catering for the changing needs of the population such as medical offices, assisted living, senior housing, and nursing homes. A scarcity of quality residential stock and the trend toward second homes abroad together point toward increasing demand for residential developments in Southern European countries, especially Portugal, Spain, Greece, and France 13. Cyclical Plays Two types of cyclical opportunity, those relating to the upswing and those relating to market distress. Given the cyclicality of real estate markets there tends to be two types of cyclical opportunity, those relating to an upswing in market performance and those in a market trough. In term of a cyclical upswing, many markets are experiencing strong demand and relatively little supply and this supports the scope for development and redevelopment. In this respect, the German market provides interesting opportunities as it is transitioning from recovery to the early growth phase of its cycle. As such, there is an increasing need for quality office and retail space in both the largest cities and more affluent smaller cities. A similar situation also appears in the Italian market where repositioning and redevelopment continue to provide opportunities despite the weakness of the economy. In France, the market bottomed out in 2005 and has started to experience relatively strong rental growth in 2006 and Although the cap rates are now close to their historical lows, rental growth remains strong due to a lack of new supply. The combination of these factors supports strategies of development and repositioning. Beyond these opportunities there is an increasing likelihood that certain markets will fall into distress over the coming months. A number of markets such as those in the UK and Spain have experienced strong growth but, as the prospect of further growth recedes, cap rates might come to be seen to be too low. This weakness could give rise to the scope for opportunistic investments in distressed assets. 13 Savills Research (2007), Second Home Abroad, May RREEF Research 22

24 4.3 Central and Eastern Europe Central and Eastern Europe consists of over 30 countries with a population of 475 million Central and Eastern Europe consists of a significant number of countries (more than 30) varying in population levels but also in economic growth and maturity of real estate markets. Chart 26 demonstrates the scale of economy and population in Central and Eastern Europe. Russia dominates, accounting for 36% of the regional GDP of $2.7trillion and 30% of the population of 475 million, followed by a number of large countries. The top six economies (excluding Russia) account for 71% of regional GDP. The traditional three Central European countries, namely Poland, Czech Republic and Hungary, are included in the top six economies. For the purposes of this report, we have focused on 10 countries of Central and Eastern Europe, the first seven being the biggest economies of the region and the next three having already entered the European Union (Slovakia, Slovenia and Bulgaria), and as a result offer interesting investment opportunities. Chart 26 : Scale of Economy and Population in Central and Eastern Europe (2006) the largest six countries (excluding Russia) account for 71% of regional GDP. $bn 1000 Nominal GDP ($bn) (lhs) Population (m) (rhs) Russia Turkey Poland Czech Romania Hungary Ukraine Kazakhstan Slovakia Central European Countries - Mature CEE Countries in European Union Croatia Slovenia Belarus Bulgaria Lithuania Turkmenistan Serbia Azerbaijan Latvia Estonia Uzbekistan Bosnia & Herzegovina Albania Georgia Fyrom Armenia Moldova Kyrgyzstan Tajikistan Montenegro m Source: Global Insight, Q RREEF Research 23