The European commercial real estate market can be fertile ground for opportunities created by mispricing. To capitalize on this environment, we believe an investor needs a mindset, mandate and organization flexible enough to respond to market conditions in real time.
Sluggish deleveraging is picking up
The deleveraging challenges facing many European banks have been widely reported for years, but the pace of asset sales has been slower than many anticipated due to the fragile economic, political and regulatory environment across the continent. One real-world example of the deleveraging that hasn’t happened yet: European financial institutions had an estimated €2.4 trillion of commercial real estate (CRE) loans on their balance sheets as of November 2012 (according to Morgan Stanley), with sales from 2010 to 2012 amounting to just €93 billion. In addition, many real estate companies still needed to be recapitalized. While deleveraging in the U.S. is now in its middle stages, it is finally beginning to broaden and accelerate in Europe too.
Economic stabilization, the European Central Bank’s new role as euro area bank supervisor and the treatment of non-core real estate and real-estate-related assets have served as catalysts to deleveraging. In fact, most of the top 50 banks in Europe have now established dedicated non-core divisions, with four of the top 20 institutions creating these in the past year. However, the picture is not uniform across Europe. The approaches adopted in the UK, Ireland, Spain, Italy and Germany, for example, have and will continue to vary enormously in both focus and urgency. Nevertheless, the momentum is clear, as evidenced by the increase in the number and volume of transactions over the past two years. CRE loan transaction activity is expected to reach approximately €60 billion in 2013 versus €46 billion in 2012 and €36 billion in 2011, according to PwC.
The enormous quantity of non-core assets in need of new owners versus the estimated €40 billion in private capital that has been raised in this area does not automatically translate into attractive investment opportunities. Many financial institutions can afford to adopt a relatively controlled approach to sales, given the current low interest rates and exceptional liquidity provided by central banks. However, the complexity of the European CRE landscape, coupled with the pervasive effects of cognitive bias, capital rigidity and the unintended consequences of regulation, means mispricing can occur frequently.
Ongoing political and economic uncertainty in Europe has fueled fear and pessimism. As evidence mounts that seems to validate such a mindset, the rational assessment of risk can give rise to irrational or sweeping risk aversion.
For example, based on our observations, well-located, convenience-led shopping centers in the UK are still generally trading at substantial discounts to replacement cost of 30%–50% and at historically high net initial yields of 8.5%–10.0%. The Great Recession and a highly indebted consumer base, combined with the well-advertised failure of key retail tenants such as HMV and a sense that the UK had generally too much retail space, created an atmosphere of fear around non-prime UK retail. Many banks and other institutions consequently avoided or tried to exit this market, driving down prices even though we believe tenants were performing well and rents were sustainable, given the relatively low occupancy cost of retailers. To avoid behaving like the herd, investors should consider the rational combination of top-down macroeconomic analysis with bottom-up credit and real estate research.
Another recent example is the excessive aversion to new developments across Europe. In real estate, periods of economic expansion are often the catalyst for overbuilding, and consequently it is generally a bad idea to start new development projects before data show evidence that a sustainable economic recovery is underway. In addition, recessions bring spectacular stories of failed developments, with banks often experiencing significant increases in development loan default rates. As a result, the price of land and development loans often over-corrects. It was especially true in London and Paris during the past few years, where overbuilding did not occur during the previous cycle and tenant demand for new, well-located and environmentally sustainable buildings remained strong throughout the real estate cycle. Two powerful tendencies were in effect: anchoring, where too much reliance is placed on the first piece of information, and availability, where too much reliance is placed on information that is easiest to recall.
A final example is Poland, the only European country that did not experience a recession during 2008 and 2009. As a result, it became the “darling” of the real estate investment community. The benefits of a strong economy in neighboring Germany and a recent surge in immigration that fueled internal demand served to reinforce and magnify investor overconfidence. At the same time, negative news – such as a slowing housing market following the collapse in foreign currency loans being issued – was ignored. In our view, cognitive bias played a major role in driving prices above fundamental value in Polish retail and Warsaw office markets before giving way to the recent softening.
A well-known example of mispricing due to capital rigidity is when index-driven managers collectively are forced to sell a security solely because that security was removed from an index. The same concept can be applied to European CRE. For example, European banks, which prior to the financial crisis represented nearly 75% of CRE lending (according to Morgan Stanley), have since limited new underwriting to their own markets and/or to prime assets due to both increased regulation as well as continued balance sheet weakness. Even new entrants such as insurance companies or foreign banks remain narrowly focused on the core/prime end of the sector given its perceived safety, leaving a significant funding gap in many markets such as UK regional and southern Europe and alternative asset classes such as health care.
On the equity side, a significant amount of capital has been raised for the core/prime properties located in European capitals by both traditional institutions such as European pension funds and insurance companies as well as by sovereign wealth funds in bidding for such high quality assets. The result has been a sharp decline in net yields to pre-crisis levels.
Funds focused primarily on large portfolio deals have raised around €12 billion (according to JPMorgan), leading to a closely watched and highly competitive landscape in the non-performing loan space over the past six months. However, this situation may reverse rapidly if a larger number of portfolios are put up for sale across multiple regions within a short period of time.
Outside the above segments, Europe’s CRE markets remain starved of capital. This ensuing funding gap represents unprecedented refinancing opportunities. Furthermore, the inadequacy of the volume of capital raised is exacerbated by the typically narrow focus of that capital. For example, there is a particular paucity of capital for assets that need repositioning, yet as of September just eight funds have been raised totaling €4 billion, according to JPMorgan.
Unintended consequences of regulations
Regulation and legislative efforts, while often well intended, are almost always complex and, as such, are destined to have unintended consequences. Changes in U.S. tax legislation with respect to the savings and loan institutions in the late 1980s, and bank deregulation in the early 2000s, clearly played a part in distorting real estate markets in the lead-up to the financial crisis. With many new regulations, such as Basel III, Solvency II and Dodd-Frank, the potential for unintended consequences to affect real estate markets is high. For example, the recently suggested conversion of deferred tax assets into permanent tax credits for Spanish banks would de facto constitute a backdoor capital injection by the government into the banks of an estimated €20 billion to €30 billion, allowing Spanish banks to potentially further reduce their real estate exposure at a faster rate than currently anticipated.
Unlocking value in European CRE
The CRE market in Europe is characterized by a deficiency in the volume and type of capital, creating deep inefficiencies. To unlock such value requires an investment process that emphasizes a flexible approach to investing across the capital structure and the resources to source, underwrite, structure, service and operate commercial real estate assets. Investors must also learn to think big and small, as the best ideas are often found either in the most granular details where few others are looking or in abstract thinking about an alternative to the dominant paradigm. Ultimately, when attempting to capitalize on mispricings rooted in cognitive bias, capital rigidity and the unintended consequences of regulatory changes, investors need flexibility – in mindset, mandate and organizational capability – to respond to market conditions in real time.