PREI European Quarterly October 2010 Market Perspective Executive Summary The pace of European economic recovery has exceeded expectations, but markets are nervous of a faltering outlook for 2011 with little room for policymakers to maneuver. There are signs of life in the credit markets, but the recovery is still expected to be long and drawn out in most markets. Ireland and parts of southern Europe will lag the rest of the continent. Banks are gradually working down their real estate debt exposure through liquidations and by originating fewer loans. They remain reluctant to offer new loans on anything outside of core markets of Western Europe. Credit committees remain vigilant and origination teams remain small. Investor demand is strong for stable assets in prime locations, but there are signs that sentiment is waning. Transaction activity is dominated by cash-rich investors. Finding deals is difficult amid growing concern that prime markets look expensive given the rental growth outlook, although tight supply pipelines are an upside risk. The public markets rallied in the third quarter of 2010. Real estate outperformed the wider equity markets, including the financial sector, off the back of strong economic data. As with private markets, though, raising equity remains difficult. Space market fundamentals are slowly improving, although how much varies by sector and geography. With tenants focused on consolidating operations to cut costs, demand for space is largely driven by lease expirations and not corporate expansions. Economic Environment Prudential Real Estate Investors 8 Campus Drive Parsippany, NJ 07054 USA Tel +1 973.683.1745 Fax +1 973.734.1319 Web www.prei.com Europe exceeded expectations with strong economic numbers in the second quarter, although the good news was largely driven by factors that are set to unwind, such as inventory restocking and government stimulus. Markets have reacted favorably to bank stress tests and the sovereign debt initiative by the International Monetary Fund/European Union (IMF/EU). Non-food retail sales and industrial production are holding up despite worries of a slowdown in global activity. Credit markets are also slowly showing signs of life. Banks have started to rely less on the European Central Bank s unlimited lending facility. The recovery varies by geography, though. Countries with a higher debt burden, including Ireland and some Mediterranean nations, remain fragile. Nonetheless, the outlook is considerably better than it was three months ago. The consensus as of September is that Europe will grow by 1.6% in 2010, up from the 1.1% forecast in the second quarter.
Beyond 2010, however, the outlook is less bullish. Slow economic growth globally and the recent strengthening of the euro are a drag on export volume. Credit for households and businesses remains a trouble point (Exhibit 1). Corporations in need of debt have turned to the bond market because banks have been reluctant to lend since 2008. Talk of a currency war appears overdone, but policymakers are in a tough spot, with public protests against government policies on the rise. Financial markets are demanding austerity measures across much of Europe, particularly in the more indebted nations where long-term bond yields are high. Further monetary measures are hard to justify when demand for credit is so thin. The bottom line is that uncertainty remains heightened, and there is a growing worry that policymakers have few options if the recovery were to falter. Exhibit 1: Lower Rates Could Portend Growth in Consumer Credit Euro Zone Annual Consumer Credit Growth and Interest Rate on New Loans 12% 6.0% 10% 6.5% 8% 6% 7.0% 4% 7.5% 2% 8.0% 0% -2% -4% Annual Consumer Credit Growth (l) Average Interest Rate, Consumer Loans, 12-Month Forward (r, inverted) 8.5% 9.0% Jan-04 Apr-04 Jul-04 Oct-04 Jan-05 Apr-05 Jul-05 Oct-05 Jan-06 Apr-06 Jul-06 Oct-06 Jan-07 Apr-07 Jul-07 Oct-07 Jan-08 Apr-08 Jul-08 Oct-08 Jan-09 Apr-09 Jul-09 Oct-09 Jan-10 Apr-10 Jul-10 Oct-10 Jan-11 Apr-11 Jul-11 European Central Bank, Prudential Real Estate Investors Research Debt Markets The European banking system is not quite out of the woods. Additional government support given recently to Anglo-Irish Bank and to Deutsche Pfandbriefbank (former Hypo Real Estate) serve as a reminder of the problems banks still face. According to the IMF, European banks must write down about 208 billion ($290 billion) in bad debts in the second half of 2010, which would bring to 860 billion ($1.2 trillion) the total losses taken by European banks since the start of the global financial crisis. A big part of the problem is commercial real estate, whose share of banks corporate loan books remains far above long-term averages. Banks have been slow to reduce their real estate loan books due to government support, low debt-service levels and the desire to avoid realizing losses. The process could be speeded up in wake of Basel III regulations, which implement more stringent capital reserve requirements on banks, making it more costly to hold problem loans. As a result, banks are growing more eager to refinance loans as opposed to rolling them over. The recovery in property values has alleviated some of the problem with the funding gap. There are a large number of underwater loans that can t be refinanced without an equity injection or write-down by the lender. As property values rise, though, some loans that were overleveraged can be refinanced with less remedial 2
PREI action taken by borrowers or lenders. Loans that are in default or are severely overleveraged will continue to be a problem. This is most evident in the UK, where lenders were among the most aggressive during the property boom and where values have recovered the most. Should values fall again, or if interest rates rise quickly, banks exposure to real estate would be exacerbated. Banks are also reducing exposure to real estate by writing fewer loans, as they remain reluctant to offer credit on anything outside of high-quality properties in the core markets of Western Europe. German banks are the most active, as their access to low-cost financing via the covered bond (or pfandbrief) market enables them to outbid competitors on margins. According to Savills, German banks represent nine of the 12 banks currently lending in the UK. Underwriting standards have been tough all year, although spreads have softened of late to about 150 bps over interbank rates. Loans are mostly limited to less than 100 million at 65% of property value with a five-year term. Portfolio deals remain largely off the table, and development finance is still difficult to secure. Development loans for the most part carry margins of 350 bps over Euribor, along with terms that require pre-letting and financial guarantees. Investment Markets With less debt available, and property sellers reluctant to wait for the uncertain lending process, cash-rich investors are dominating the transactions market. The situation also provides an opening for investors who can weave together complex capital structures that involve layers of senior and mezzanine debt and equity. Investors largely are focusing on the prime segment of core Western European markets and cities with relatively small development pipelines buying into an expected real rental growth recovery. According to CBRE, in the first half of 2010 about 25% of office transactions in Europe took place in Central London, Paris, Berlin and Stockholm, where supply is tight. Deals outside of core space are being done by a number of smaller value-add/opportunistic funds, which have carried cash from before the financial crisis and have financing from regional banks that do not have the legacy loans on their books. These banks are willing to do sub 10 million loans with easier terms and conditions than larger banks demand. Exhibit 2: Sign of a Pause in Investment Market Recovery? Quarterly Investment Transaction Volume, Private Markets, (bil) 100 90 80 70 60 50 Rest of Europe Spain Germany France United Kingdom 10 Year Average 40 30 20 10 0 1Q07 2Q07 3Q07 4Q07 1Q08 2Q08 3Q08 4Q08 1Q09 2Q09 3Q09 4Q09 1Q10 2Q 10 3Q 10 CBRE, DTZ, Prudential Real Estate Investors Research 3
Transaction volume fell slightly in the third quarter, according to CBRE and DTZ, reflecting the lack of product put up for sale and investor concerns that markets are fast becoming pricey. Prime yields across most markets are below historical averages, making it difficult for investors to find value without clearer signs of strong rental growth beyond 2010 (Exhibit 3). Returns for real estate funds were positive for the second quarter in a row in 2Q10, largely driven by declining yields, according to indexes of European property funds produced by INREV and IPD. One key investment strategy involves focusing on cities with a lack of development activity, particularly offices. Development pipelines were weak in the peak of the cycle and they continue to fall. As a result, even minimal absorption could produce strong rental growth. Exhibit 3: Yield Impact Continues to Drive Returns Contributions to Notional Prime Office Market Returns, Selected Cities 40% 30% 20% 10% 0% -10% -20% -30% Yield Impact ERV Growth Income Return Total returns 1Q 94 3Q 94 1Q 95 3Q 95 1Q 96 3Q 96 1Q 97 3Q 97 1Q 98 3Q 98 1Q 99 3Q 99 1Q 00 3Q 00 1Q 01 3Q 01 1Q 02 3Q 02 1Q 03 3Q 03 1Q 04 3Q 04 1Q 05 3Q 05 1Q 06 3Q 06 1Q 07 3Q 07 1Q 08 3Q 08 1Q 09 3Q 09 1Q 10 3Q 10 Cushman & Wakefield, CBRE, Prudential Real Estate Investors Research There are signs that investor sentiment in the UK is starting to wane. Surveys by both the Lloyds Banking Group and by Property Market Analysis (PMA) find investors less than bullish on the outlook for the UK property market over the coming year. CBRE s 3Q10 flash estimates for prime office yields in UK secondary cities drifted higher, suggesting that yield compression got ahead of itself. Over the past few months, there has been less money flowing into UK real estate funds, according to the UK s Association of Real Estate Funds and the Investment Managers Association. Outside of the UK, however, according to PMA, investor sentiment remains strong. Inflows to German Open End Funds were strong through July, although there was a reported net outflow of 152 million in August, most likely due to proposed changes in German law that would potentially penalize institutional investors. Investor sentiment is likely to remain fragile due to the uncertain economic outlook, ongoing problems faced by banks and lingering concerns over the impact of possible regulatory changes. Still, real estate remains an attractive option due to the wide margin between government bonds and property returns (Exhibit 4). This is particularly true given signs that inflation expectations are picking up. 4
PREI Exhibit 4: Property Returns Are High Relative to Government Debt Europe ex UK All Property Prime Initial Yield and 10-Year Euro Area Government Bond Yield 12% 10% Series2 Series1 8% 6% 4% 2% 0% 3Q 90 3Q 91 3Q 92 3Q 93 3Q 94 3Q 95 3Q 96 3Q 97 3Q 98 3Q 99 3Q 00 3Q 01 3Q 02 3Q 03 3Q 04 3Q 05 3Q 06 3Q 07 3Q 08 3Q 09 3Q 10 Organization for Economic Cooperation and Development, Cushman & Wakefield, Prudential Real Estate Investors Research Public Markets The public real estate markets rallied in the third quarter, outperforming the wider equity markets and financial stocks. The rally resulted from the strengthening of the euro as investors began to price in another round of monetary easing by the U.S. Federal Reserve, and the fact that investors are comfortable with the valuations of listed companies. The dollar-denominated S&P BMI European Property price index rose 28.4% in 3Q10, while the euro-denominated EPRA index returned 14.6%. Sentiment was also boosted by a sharp drop in volatility. The S&P index s volatility fell 50% in 3Q10 compared with the prior quarter (Exhibit 5). Exhibit 5: Public Property Index Volatility Has Eased Dramatically S&P BMI European Property Index Volatility 80 70 60 S&P BMI European Property Total Return 60d Historic Volatility S&P BMI European Property Total Return 30d Historic Volatility 50 40 30 20 10 0 Jan-04 Apr-04 Jul-04 Oct-04 Jan-05 Apr-05 Jul-05 Oct-05 Jan-06 Apr-06 Jul-06 Oct-06 Jan-07 Apr-07 Jul-07 Oct-07 Jan-08 Apr-08 Jul-08 Oct-08 Jan-09 Apr-09 Jul-09 Oct-09 Jan-10 Apr-10 Jul-10 Oct-10 Bloomberg, Prudential Real Estate Investors Research 5
Despite the positive returns, raising fresh capital remains difficult, especially compared with other regions of the world. To date this year, public firms have raised only 3.8 billion of new equity. A significant quantity of fresh investment into the sector has come from quick and dirty book builds, where companies issue new stock amounting to less than 10% of their equity capital, thus not requiring existing shareholder approval. By contrast, listed firms have been active in issuing low-cost corporate debt and using the proceeds to retire existing bank debt. Space Markets Occupiers are continuing to consolidate operations as they try to cut costs in wake of the global financial crisis. Demand is largely driven by lease expirations. Rental growth is limited for the most part to the supply-challenged office segment and prime high street retail, in which international retailers compete over the small amount of space that comes to market. Vacancy rates largely have peaked but remain elevated, particularly in the logistics sector where the excess capacity in European economies is most keenly felt. As usual in the early stages of a recovery, there is a prime secondary split in rental performance as tenants gravitate to modern, well-located properties. Office: Headline rents have been positive in some cities this year, but the prospects in most markets are dim due to weak job growth. Surveys of employers point to an increase in job growth in coming months, but the market has to deal with the large amount of vacant space, hoarding of labor, and the likely decline in public sector employment. Despite overall weak demand, rental growth across Europe might exceed expectations over the next year due to the lack of new supply. Cities with positive rent growth this year include Paris, Berlin, Stockholm and London City. CBRE reports that headline rents in London City have grown by 25% in British pounds since 3Q09. Those cities have had positive absorption, although the limited demand for space will wane if the employment market does not improve. Retail: Retail sales held up better than expected in Europe throughout the global financial crisis, largely due to government stimulus packages that are slowly being phased out. Although few markets are reporting positive rental growth, rents have held up better in prime high street locations as national and international retail chains fight over the limited amount of available prime retail space. As with offices, performance is related to geography. Rents are falling fastest across most of south Europe due to household deleveraging, weak wage growth, fiscal consolidation and high unemployment. The exception is Italy, which avoided the worst excesses of the global liquidity bubble. The Italian economy has been surprisingly resilient throughout the global financial crisis and into the recovery. By segment, discounters and non-discretionary occupiers report relatively strong trading numbers. Vacancy rates are low in established dominant/regional shopping centers particularly in core markets in the UK, France, Germany and Spain although tenant incentives remain elevated. Retail warehouse rents also are dropping, in part due to weak demand for housing-related big box goods in countries such as Spain and the UK, but also because of the influx of supply in markets including Germany, Sweden and parts of Central and East Europe. Logistics: The logistics market continues to struggle with the legacy of the excess capacity in Europe. Development has stopped but vacancy rates are high in most markets, particularly across much of Central and East Europe. The glut of space puts pressure on headline rents, even in the most modern stock, as 6
PREI tenants are able to negotiate healthy incentives and short leases. Tenants that are looking at keeping a lid on costs are attracted to older stock with lower asking rents. The switch to older properties might continue to be a theme over the coming quarters as a lot of second-hand space hits the market. Closing Thoughts The recovery from the global financial crisis was always likely to be a long and drawn-out affair. And markets are understandably nervous about the outlook for GDP growth beyond 2010, when government austerity plans kick in. So it is no surprise that in wake of uncertainty about economic growth, investor sentiment toward private real estate in recent months appears to have waned, especially in the UK, where property values have recovered the most. Despite the fact that property yields are at near-record highs in relation to government bonds, it now is clear that the rally in commercial real estate values in late 2009 and early 2010 was based on investors expectations of a strong growth recovery that now appears to be unlikely. With bank lending still hard to find and few property owners putting assets up for sale, transaction volume is likely to remain below historical averages. It is fair to say that most investors are focusing on chasing income across prime markets, but there continues to be opportunities outside of core markets where sophisticated investors can fill a need for capital in niche segments. 7
The Investment Research Department of PREI publishes reports on a range of topics of interest to institutional real estate investors. Individual reports are available by e-mail or via the Web at www.prei.com. Reports may also be purchased in quantity for use in conferences and classes. To receive our reports, change your contact information, or to be removed from our distribution list, please e-mail us at prei.reports@prudential.com, or telephone our New Jersey office at 973.683.1745. Important Disclosures These materials represent the views, opinions and recommendations of the author(s) regarding the economic conditions, asset classes, securities, issuers or financial instruments referenced herein. Distribution of this information to any person other than the person to whom it was originally delivered and to such person s advisers is unauthorized, and any reproduction of these materials, in whole or in part, or the divulgence of any of the contents hereof, without prior consent of Prudential Real Estate Investors is prohibited. Certain information contained herein has been obtained from sources that PREI believes to be reliable as of the date presented; however, PREI cannot guarantee the accuracy of such information, assure its completeness, or warrant such information will not be changed. The information contained herein is current as of the date of issuance (or such earlier date as referenced herein) and is subject to change without notice. PREI has no obligation to update any or all of such information; nor do we make any express or implied warranties or representations as to the completeness or accuracy or accept responsibility for errors. These materials are not intended as an offer or solicitation with respect to the purchase or sale of any security or other financial instrument or any investment management services and should not be used as the basis for any investment decision. Past performance may not be indicative of future results. No liability whatsoever is accepted for any loss (whether direct, indirect, or consequential) that may arise from any use of the information contained in or derived from this report. PREI and its affiliates may make investment decisions that are inconsistent with the recommendations or views expressed herein, including for proprietary accounts of PREI or its affiliates. The opinions and recommendations herein do not take into account individual client circumstances, objectives, or needs and are not intended as recommendations of particular securities, financial instruments or strategies to particular clients or prospects. No determination has been made regarding the suitability of any securities, financial instruments or strategies for particular clients or prospects. For any securities or financial instruments mentioned herein, the recipient(s) of this report must make its own independent decisions. Conflicts of Interest: Key research team staff may be participating voting members of certain PREI fund and/or product investment committees with respect to decisions made on underlying investments or transactions. In addition, research personnel may receive incentive compensation based upon the overall performance of the organization itself and certain investment funds or products. At the date of issue, PREI and/or affiliates may be buying, selling, or holding significant positions in real estate, including publicly traded real estate securities. PREI affiliates may develop and publish research that is independent of, and different than, the recommendations contained herein. PREI personnel other than the author(s), such as sales, marketing and trading personnel, may provide oral or written market commentary or ideas to PREI s clients or prospects or proprietary investment ideas that differ from the views expressed herein. Additional information regarding actual and potential conflicts of interest is available in Part II of PIM s Form ADV. PREI is a business unit of Prudential Investment Management, Inc. (PIM), an indirect wholly-owned subsidiary of Prudential Financial, Inc. Prudential Real Estate Investors 8 Campus Drive Parsippany, NJ 07054 USA Tel 973.683.1745 Fax 973.734.1319 Web www.prei.com E-mail prei.reports@prudential.com Copyright 2010