EUROPEAN ROUNDTABLE: Engineering precision in Europe

Widespread concern about sovereign debt and currency strength have not prevented real estate investors from making select investments throughout the Continent. PERE magazine, March 2011 issue.

In real estate investing, there are some things within the scope of risk management and some things that lie outside it. To those working in Europe, one of the elements that cannot be controlled is the future strength of the euro as a single currency. Such is the pressure on certain countries’ economies that the survival of the euro is not totally a foregone conclusion, which clearly has implications for global investors in Europe’s real estate markets as a whole.

It was against this background that five leading protagonists in European real estate met in London last month to discuss the major issues that concern them most. They participants included: Laurent Luccioni, chief executive officer for Europe at MGPA; Gianluca Muzzi, managing director and head of RREEF Europe (ex Germany, Austria and Switzerland); Peter Reilly, managing director and group head of real estate in Europe at JPMorgan Asset Management; Will Rowson, chief investment officer for ING Real Estate Investment Management (REIM) in Europe; and Harin Thaker, head of real estate finance international at Deutsche Pfandbriefbank.

What was learned was, while there clearly is sovereign risk attached to certain countries, on the whole no one would be able to carry on their business if they truly felt the euro would collapse. 

United we stand

“None of us can sit in investment committees and ask: ‘If the euro goes, will this investment work?’” said ING REIM’s Rowson. “If the euro goes, the game changes completely. If one is worried about that, one could sit here for the next two or three years and not do anything.”

For those gathered around the table, this is the first time there has been a major downturn in Europe since the single currency was introduced in the late 1990s, so everyone is  in unchartered territory. But the sense seemed to be that a collapse is a risk they have little choice but to live with.

JPMorgan’s Reilly said one has to believe major euro countries, like France and Germany, have a vested interest in keeping the euro together. That even goes for the UK, which is outside the Eurozone. “If you believe the euro will hold together, underwriting countries is more of a fundamental real estate issue,” he said. “But if you believe the euro is at risk, then you would have a hard time investing in Europe.”

RREEF’s investment committees have been taking into account the risk associated with the euro, but they believe that this is a macro risk that is unlikely to materialise. “What we are doing is hedging the exchange rate to protect the risk when we invest non-European capital into euro-denominated markets,” RREEF’s Muzzi said.

The fact is that all the firms represented around the table are pushing forward with their business plans despite uncertain times. As the discussion progressed, though, it quickly became apparent that differences existed in their attitude towards sovereign risk in some countries, such as Spain.

Pockets of risk

Seeing that some markets are more at risk than others requires firms to take a view on what the best geographic strategy should be. Deutsche Pfandbriefbank’s Thaker summed up the choice: “Do you chase all the opportunities or are there enough in the stable markets where one is more comfortable? That is the question.”

For MGPA’s Luccioni, the answer seems to be the latter. “I struggle with country risks such as those you find in Spain or Ireland,” he said. “I can manage certain risks like a tenant leaving, which you can do something about. But Spain leaving the euro, I can’t manage that.”

Luccioni recalled the Asian financial crisis of the late 1990s. “Indonesia will never go down, it was said, and a month later it did. Why would I put investment into a risky country when I can put it somewhere I can manage the risk?”

The answer to that, said Reilly, is when pricing differentials become interesting enough. He noted, however, it is questionable whether that has happened yet in Spain.

RREEF’s take on the Spanish market is that there are opportunities to get comfortable with. In September 2009, it led a consortium in acquiring two portfolios of bank branches sold by Spanish savings bank, BBVA. The first involved 944 bank branches and three offices, and the second included two landmark office assets and 153 bank branches. RREEF’s capital came from a value-added fund for the first deal. In the second one, it came not only from local capital but RREEF’s German funds as well.

Muzzi said: “Although the macro economics are difficult in Spain, a platform of native speakers with an extensive network of relationships has meant that we can still find good opportunities, like the sale-leaseback of the BBVA portfolio. If you underwrite properly, it doesn’t mean this is a market you shouldn’t touch.”
ING REIM has had mixed experiences investing in Spain. It manages a country-specific value-added fund, which has kept its powder dry during 2009 but started investing again last year. One of the existing investments is a prime national retail portfolio, whose assets are performing differently according to the part of the country they are located in. Those in the north, where the majority are located, are doing pretty well, while those in the south are not doing as well.

Rowson imparted this information to show how, macro risks aside, performance can be variable according to local GDP. He also related it to the question of how international investors perceive risk. “If you talk with investors in the Middle East about Spain, they have a long distance view and they tend to say, ‘No, I don’t think.’ But if you mention Spain to those that might know the country or region in some detail, they understand that if you buy the right asset in a wealthy part of that country the regional GDP can be dramatically different.”

Point of difference

Firms such as MGPA don’t need much convincing that there are selective investments to be had in Spain, but Luccioni’s point is that it is finding plenty of other attractive situations in more stable markets. In fact, one deal the firm completed in Germany last year has just been voted European Deal of the Year in the 2010 Global PERE Awards.  “Right now, we are seeing opportunities in other countries,” he said. “Maybe they are not as good, but they already are good enough.”

The deal MGPA won plaudits for was the acquisition of the so-called Aldi South value-added portfolio, containing approximately 140 properties in southern and western Germany. The idea, said Luccioni, was to combine the core parts – properties on 15-year sale-leaseback terms to value retailer Aldi that helped with the financing – with the value-added part of the deal comprising vacant stores and residual land. When assessing the discount it received and the spread between the cost of financing and the yield, as well as the value-added component of the deal, it should give investors in MGPA’s opportunistic European fund the returns they are seeking.

Aside from Spain, though, there are other key markets that seem to present too much of a risk for some, but where local knowledge is enough to offset potential macro concerns for others.

Italy is an example of a country that is not in Deutsche Pfandbriefbank’s strategic focus, yet the Munich-based bank recently provided a loan for a deal in Spain, where it will continue to look selectively. The problem with Italy, as Thaker explained, is that if a loan were to sour, it is a country where it so much harder to get hands on the collateral. This is in contrast to Spain, where it is “relatively easier”.

Here again, though, there is a divergence of opinion. RREEF’s Muzzi, an Italian, pointed out that, although both Italy and Spain are in deficit, the real estate markets are quite different. In Spain, there has been a lot of development in the last decade with limited demand. In Italy, however, there has been little development, yet Italians love to own real estate and it is a liquid market. These combined factors, along with an established local presence, add up to a market RREEF would get involved with.

Even in Ireland, it seems, there is room for interest despite the resignation of the last government in the wake of accepting an €85 billion bailout. Banks have been destroyed after years of real estate lending, and the country is set to enter a severe austerity drive. Yet ING REIM’s Rowson pointed out that some investors were taking on those risks, betting that the euro would remain because of the vested interest countries have in retaining the single currency.

“If one is willing to take a risk on the euro, some very strong shopping centres in Dublin look cheap on a long-term average yield basis,” Rowson argued. For example, if one could buy into a “rack-rented” centre – one where the rents are at current market levels – at a current market yield, it would look extremely cheap compared to 15 or 20 years ago, never mind five years ago, he noted.

On the flip side, even in stronger countries such as Poland, participants are mindful of risk. True, Poland was one of the very few countries, if not the only one, that didn’t see negative GDP growth at the height of the crisis, and signs continue to look good. However, one has to believe that the building blocks in Poland will remain intact as well as watch out for yields in certain sectors becoming sharper.

In fact, firms generally feel they are on safer ground in mature markets such as the UK, even if they are prepared to take development risks. MGPA, for instance, is working on two office developments projects in London. One is a joint venture with a bank, and the other is a shovel-ready site with building permits. Meanwhile, ING REIM has just put equity into a Nordic fund to buy a Helsinki office that is fully let but on short leases. “The minute the market knew we were going to do a refurbishment, a lot of the local firms were asking to come in to take floors as we complete them,” Rowson said.

Price points

Aside from assessing country and currency risk and the usual gripe that banks are not providing a large stream of sales, there are other operating issues that the roundtablers are grappling with in 2011. A fundamental one is pricing.

Underlining the point, Rowson explained how ING REIM recently bid on a shopping centre in Barcelona against two listed companies. Fundamentally, he said, the yield looked expensive at 6 percent, but in taking into account the size of the hypermarket the yield would have ended up over 7 percent. The market would now say Spain was at 6 percent for a core shopping centre, but in reality, on a euro-per-square-metre basis, that particular centre was “sensibly priced,” he added.

Rowson also mentioned a large portfolio of shopping centres being sold in Europe by a listed property company. Some of the assets were “challenging,” he said, yet they were being sold with a very core yield. “We backed away from bidding on a lot of the assets because we thought the pricing had become too hot for the risk,” he added.

In the recent past, more of the conversation might have been taken up by bank financing for deals rather than pricing of assets, but this demonstrates how lending has become less of an issue for many firms. MGPA’s Luccioni said: “The financing has not been the big issue. The big issue has been whether it is the right price for the assets.”

Part of the problem, noted Rowson, is the dearth of truly distressed sellers. Indeed, Thaker sees that banks are not keen to “maximize their losses” and, as a lender, he also has witnessed how much capital there is for prime core assets in Europe. This is helping to push yields down.

Reilly certainly agrees. “There is a lot of capital looking for low risk trophy assets in the top three markets throughout Europe,” he concurred.

JPMorgan Asset Management itself has been among the buyers of large prime assets. It bought the long leasehold interest in Bishops Square, London, for £557 million, representing a net initial yield of more than 6 percent. The 817,500-square-foot mixed-use property was acquired on behalf of two institutional property funds managed by the bank. It also purchased the OpernTurm office tower in Frankfurt, Germany, for a price thought to be between €500 million and €600 million. In that instance, it acquired the 42-story, 67,200-square-metre skyscraper in conjunction with GIC Real Estate, the real estate arm of the Government of Singapore Investment Corporation.

When mentioning core deals, Reilly doesn’t feel the pricing for those assets was expensive. “We spend a lot more time worrying about capital values than we do about yield,” he said. “In the core space, there are probably no bargains out there. But from a long-term cyclical view, even at these sharper yields, capital values still seem pretty attractive.”

Reilly explained it like this: if one looks at central London, capital values historically might trade at £500 to £1000 per square foot. Over time, if you are a very large institutional investor with a very long-term perspective on your investments, it is a very good time to be buying core when you can buy at £670 to £700 per square foot. Plus, there is not as much competition at the large asset level. There might be 25 bidders for a €100 million to €150 million asset, but the competition starts to thin out in the €500 million to €600 million bracket. 

Reilly is in a good position to assess pricing because the asset management part of the bank has been out buying across the risk spectrum. Generally, JPMorgan felt 2010 was a good time to buy as it invested in five deals with a total value of €1.3 billion. As well as the two core deals already mentioned, it invested in a mid-risk London office, Exchequer Court, and two vacant properties on rue de l’Amiral d’Estaing and rue de Logelbach in the central business district of Paris.

Speaking of the Paris deals, Reilly said leased versus unleased the yield differential was probably 150 basis points. Four years ago, it would have been less than 50 basis points. “There is risk, but I think it is priced right,” he added.

Rifle shot lending

This doesn’t necessarily mean that financing opportunistic deals is easy. While it has become less of a problem, it remains a challenge.

“I think the opportunistic space is now rifle shot. It is not big portfolios but select deals that make sense. No one is really doing this in volume,” Reilly explained, adding that lending banks are looking a lot harder at asset quality and borrowers’ business plans. 

JPMorgan landed financing of between 60 and 70 percent on a loan-to-cost basis for the two opportunistic deals in France. “They were small deals, and local banks most familiar with the Paris market stepped up to do it,” Reilly said.

Thaker of Deutsche Pfandbriefbank reckoned that large banks will on average take no more than €100 million of loans onto their balance sheets, and he didn’t think anyone would “stomach” more than €135 million. This is either because banks have shrunk or are in the process of shrinking as well as tidying up their capital ratios. That said, now that his bank has created a “core” bank following restructuring, it has a clear focus with a balance sheet positioned to concentrate on new business.

Deutsche Pfandbriefbank is prepared to finance transactions in the range of up to €100 million and, in certain circumstances, above that level for a well-diversified, cross-border portfolio. If one is talking about significantly above that level to €500 million, he said it was possible for banks to group together quite easily. There are very few banks left open with the competence and competitive advantage to do cross-border deals, he added.

As far as his bank is concerned, a 65 percent loan-to-value ratio is quite easy for it to lend against for the right asset. It will finance prime assets in secondary markets if the asset is “right” and the buyer is one with whom the bank has a track record of investing or has a highly experienced team. It would underwrite an opportunistic deal for the appropriate asset, including a pre-let, but he added: “We need to be very careful as to who we support.”

One example of a smaller loan the bank has made is a £31 million (€35.7 million) deal for a simultaneous recapitalisation and refinancing of an iconic London office building, No. 1 Croydon, for Wainbridge Capital’s value-added fund. That deal reflected a net initial yield of 9 percent. The bank also provided a £59.5 million facility to a special-purpose company owned by Catalyst European Property Fund for the purchase of the Stratford shopping centre in east London.

Investors’ call

As managers around the table do battle with a crowded field for core-like assets and assess pricing and country-specific risks, it is clear they do so for clients with very varying requirements. This goes to the whole debate about what investors want and, consequently, what a firm’s strategy should be in these times.

RREEF, for example, is being flexible because on the one hand it is seeing a lot of Asian investors looking towards Europe and, on the other hand, Europe investors looking towards Asia. Muzzi gives two specific examples. RREEF won a €500 million non-discretionary separate account mandate with a leading employee provident fund in Asia for the UK market. A couple of months ago, RREEF managed to close the first investment for the client. For the debut deal, it bought the headquarters of credit card giant Visa in London’s Paddington area for approximately €150 million. At the same time, a RREEF fund for German investors bought a shopping centre in Osaka, Japan – just one example of the €1.8 billion in assets around the world that RREEF acquired last year for its German clients.

“Clients are more willing to commit money to a specific investment manager that has a track record in a certain geographical area and product,” explained RREEF’s Muzzi. Some investors prefer separate accounts, which give them more control over investment decisions, but they can find it difficult if they lack the resource to originate and follow a deal. He thinks the trend is changing and they are becoming more open to commingled accounts, particularly as they may have limited resources and huge liquidity that needs to be deployed to the market.

As for higher-risk, higher-return vehicles, Muzzi believes there is still room for investors who are thinking about going up the risk spectrum to start allocating money again. “Going forward we would expect investors to re-allocate money to the high-yield side,” he said.

In dissecting the different groups, MGPA’s Luccioni said his firm can see the way clients have altered their outlook. Some wanted to focus on core European countries of France, the UK and Germany and also have their say in riskier investments such as development, where a separate account might be most appropriate. Some said they are happy to take the risk of investing in a commingled fund, but they don’t want operational risk. Instead, they want income. “That is more of a core-plus style,” he noted. 

Give ‘em what they want

It all boils down to providing clients with what they want, which is why MGPA is diversifying. “What I see is much more differentiation from the investors in terms of size, geographical location and needs. The last time we raised money in Europe was 2008, so we need to adapt to the world and be much more flexible in how we think about it. It is that transition that is going to be the challenge for us going forward.”
This is certainly an area where all can agree on – flexibility. The good news is that Europe is still in a high inflation, low interest period in which a lot of the very big investors are taking a small allocation away from fixed income and moving it into property.

ING’s Rowson said: “It is quite difficult for investment managers to plot where the capital is coming from next. You have to have your radar on all over the world. The challenge is watching where the capital is coming from, listening to what it wants and having the right products available.”

Secondary trading
Given the question of how opportunity funds are going to manage to make 20 percent-plus returns for investors, it is natural to only think about accessing distressed deals at bargain pricing with a reasonable amount of risk and leverage. But in the edited exchange below, two roundtablers point out that perhaps there is another way.

Will Rowson: The secondary market in 2009 was opportunistic because buying indirect shares in certain funds came with huge discounts, but now it is opportunistic for a different reason. Valuations eventually fell considerably and will rise again. So, another way of getting into the market is not just by buying direct deals or shares in new funds, but buying shares in existing funds that already have experienced the pain. You can ride the elevator back up.

Peter Reilly: I think that this is a real opportunity that a lot of investors may not be focusing on. You have a portfolio you can look at and underwrite that, by and large, has been marked to market. Because of these marks, there are high loan-to-value ratios, but the assets already have been through the process with the banks and the debt is stabilised.

Rowson: We have a regulated vehicle that invests, at arm’s length, in our own funds and sits on the other side of a Chinese wall. It is structured as a fund and currently has about €200 million of third-party equity. The vehicle is buying at the bottom in our own funds, and it is very sensible.

Risky business
Higher-risk investing has taken a bashing after the terrible performance of some portfolios, but there is a feeling that, with the number of firms operating in the space shrinking, appetite among investors might be returning. In the following exchange, three roundtable participants discuss the perceptions in the market. 

Peter Reilly: The opportunistic space is really going to shrink from its peak. Instead of giant players raising billions, we are moving towards smaller independent shops raising hundreds of millions. Meanwhile, the rest of the business has migrated back to core and core-plus management, which is probably the way the industry should be structured.

Gianluca Muzzi: We think there is room for investors who are thinking about going up the risk spectrum to start to allocate money again to the higher-return funds. These won’t be the mega-funds of the last cycle, but more region-specific funds.

Will Rowson: I recall being at a small MIPIM dinner two years ago when a large pension fund CEO reacted to a speech given by an opportunity fund manager. The person banged the dinner table and said: ‘I have had enough of listening to phrases like capital stack. All that my pension fund clients want is a 5 percent return every year. They don’t want the risk that you are giving them.’ Fundamentally, that is what underpins our business.

Muzzi: My feedback from pension funds is that they are targeting about 8 percent. In order to get to an 8 percent to 10 percent return on core, you need to increase the risk by looking at core properties outside primary locations and markets. In addition, we are seeing investors that previously have had a low allocation to opportunistic investing look to raise their allocation.

Rowson: We have a Dutch pension fund client, who I remember going to see in 2008 to present a core-plus product. Although the storm had hit London, everyone was denying the crisis in continental Europe. We were given such a cold reception because we weren’t from one of the American banks selling an opportunistic fund. We were seen as the dumb core guys rather than the sophisticated opportunistic guys. That pension fund put 75 percent of its investment in opportunistic, and you can imagine what has happened since. I walked away from that meeting thinking that is a very risky strategy with money at stake from people who want 5 percent to 8 percent.