The case for Europe(3)

Mark Roberts, RREEF Real Estate's global head of research, and Simon Durkin, the firm's head of European research, met PERE in London to discuss the firm’s paper, The Case for European Opportunistic Investing.


In PERE’s Friday Letter “Equity Crunch”, a mention of RREEF Real Estate’s fresh paper on opportunistic investing sparked interest among readers keen to read it.

Here we present some of the findings of the document, which was introduced to PERE at a private briefing with Mark Roberts, global head of research, and Simon Durkin, the firm’s European research chief.

They said that history had shown that real estate cycles typically exhibited a similar pattern over long periods. The two men also said that with liquidity restrained, bankruptcies emerge, and bank capital ratios come under pressure. With debt capital less plentiful, landlords turn to equity investors to recapitalise their balance sheets. Further, with banks looking to recapitalise their own balance sheets, distress sales should begin to emerge.

“As such,” said Roberts, “opportunities to acquire non-performing loans and distressed property are usually the first to emerge in such settings. In these cases, investors typically buy assets at significant discounts to face value and total returns are more likely driven by increases in capital value as a result of rising liquidity.”

Of course, conditions for opportunistic investing have varied across the world, explained Roberts and Durkin. In response to the credit crisis in 2008, many fund managers in the US raised capital anticipating a distressed situation similar to that seen during the real estate crash of the 1990’s. However, ample amounts of liquidity from both the Federal Reserve and the US Treasury prevented a collapse in the market and the supply of opportunistic investments fell short of expectations. As a result, many fund managers have had difficulty sourcing investments that would achieve their desired return objectives.

However, in contrast, Roberts and Durkin said the situation appeared very different in Europe and the ability to implement an opportunistic strategy “may prove far greater as a result”. Unlike the US, Europe does not have a so-called ‘lender of last resort’” like the Federal Reserve. Instead, countries are more likely to develop local solutions to improve liquidity. To raise capital ratios, banks may need to sell assets more aggressively than their US counterparts. Also, to respond to drastic austerity measures, governments may need to sell assets too.

RREEF Real Estate has found that in Europe, total returns for European opportunistic strategies over an eight year period between 2002 and 2012 were 11.7 percent. The return for value added over the same time frame was 4.8 percent, and 2.8 percent for core. Meanwhile, returns for the EuroStoxx 600 were just 4 percent.

Durkin acknowledged that research is hindered by a lack of available data and time series. In Europe, the IPD produces geared fund level returns in its Pan European Pooled Property Funds Index. So, Durkin explained that to get the results above, RREEF organised those funds into three distinct groups: core funds as those having a target rate of return of 9 percent or less; value added funds with a target return of 9 – 15 percent with minimum gearing; and opportunistic funds that have a stated targeted return in excess of 15 percent and also a minimum gearing of at least 50 percent.

Turning to the US, RREEF analysed whether each style produced relative performance like that seen in Europe. It found that similar to the results seen in Europe, non-listed real estate in the US produced a comparable pattern of returns with each style outperforming equities over the one-year and 8-year periods. The report found that over longer periods reaching to 15 years, each real estate fund style outperformed equities and bonds.

However, an intriguing pattern emerged with respect to value-added investing. In both Europe and the United States, value-added strategies underperformed significantly in the five-year period.

While vintage year timing was a significant factor in generating outsized returns during the near-term, investors with “less perfect foresight” could still be generously rewarded through perseverance. Notably, value-added investing produced the lowest risk-reward trade-off.

Roberts said these results may be a function of sampling, survivorship bias and levels of leverage, or could be explained by the nature of the two investment styles. But it is the firm’s belief that value-added investing tended to rely more upon growth in net operating income to achieve its objectives while opportunistic investing tended to rely not only upon an improvement in fundamentals but also an improvement in liquidity

Turning to conditions in Europe today, Roberts and Durkin pointed out several important indicators which support the case for opportunistic investing.

The first of these is the property market cycle. During the first half of 2011, fundamentals in Europe were generally in recovery. However, more recent economic indicators suggest that this recovery has stalled across most markets.

Relative to the recovery in the US and Asia Pacific, the rate of growth in Europe remains weaker. At the same time, the threat of new construction is low. As such, this has created a bifurcated market. In certain instances, vacancy rates generally remain low and support core investing. Vacancy rates have reached peak levels in other markets. The heightened distress in these types of markets can provide opportunities to acquire high-quality assets or structures at significant discounts.”

That said, the firm pointed out that while the prospects for opportunistic investing appeared favorable in Europe, the ultimate outcome of the euro zone crisis remained unclear. Quoting from the report, Roberts said although a full break-up of the euro continued to have a low probability, it was no longer likely that the currency area would be able to “muddle through”.

Yet RREEF insists the euro zone crisis is creating opportunities for certain investors. “For example, should the immediate euro debt crisis be stabilised, the area will continue to require an extended period of both deficit and debt reduction. With real estate disposals proving one of the more politically palatable austerity measures, there will be opportunities to acquire government held properties through deficit reduction programmes,” the report argues.

Perhaps unsurprisingly, RREEF highlighted that the onset of the global financial crisis and downturn in real estate markets in 2007 has created a new cycle for opportunistic investing in Europe. The firm said there is a deeper level of distress in the market and that it has its own distinctive characteristics that make it a suitable region for opportunistic investing compared to other parts of the world.

Firstly, Europe is less efficient at pricing risk across its property markets. High quality properties trade aggressively, driving down cap rates while non-institutional quality properties attract less risk-capital. This is especially true now that the number of investors allocating risk-capital to the sector is lower,” says the report. “Secondly, Europe is more fragmented with a wide variation in levels of transparency from country to country, as evidenced by different responses to similar problems. Thirdly, due to the cultural and structural diversity of the region, there is no uniform approach to investing; therefore targeted, localized strategies become critical to success.

There is distress associated with both real estate bank debt and with real estate operating companies, argues RREEF. In the former case, there is an over-hang of European commercial real estate debt scheduled to mature over the next few years that has not, to date, been adequately addressed. A significant portion of this debt resides in assets for which financing was originated at the height of the market at aggressive loan to value ratios. As refinancing pressures increase as maturities approach, it is expected that many of these assets will inevitably be sold in distressed transactions.

Roberts and Durkin added that the sovereign debt crisis had become an equally serious political crisis that in quick succession saw new leadership installed in both Greece and Italy. Whatever the ultimate outcome of these crises, there is no “miracle pill” that will cure all ills, the firm said.

Still, assuming that markets will continue to ‘cycle’ in the future as they have in the past, Roberts said: “Our observations of the historical relationships between the key economic drivers of GDP growth, unemployment and the term structure of interest rates, combined with wide initial yield spreads, suggest that a window of opportunity across the risk spectrum could be opening.”