UK Property Risk Premium narrowing in 2014

The previous post looked at yield compression in seven selected European cities, below paragraph explores further what this mean for the sector as an asset class.

Due to changes in the 10yr government bond (UK 10yr gilt) rate and further declining property yields, the risk premium for property has again narrowed to historically low levels in London.

CapG

In 2008 IPF sponsored a survey of 250 UK independent financial advisors asking “ what minimum threshold rate of return would their clients require above the risk free rate from their commercial property investments”

The figure that has come up and seems relatively stable over time is 330bps – 370bps (average 350bps).  What is surprising that this figure is stable throughout the GFC and previous economic cycles.  In comparison long the term risk premium for equities is 4.8%.

In Q3 2014 the risk premium for London City office property was down to 230bps and for West End property at 130bps.

UK risk premia

Source: PMA Net Prime Yields (reflect NOI and purchasing costs into account)

2014 changes in European office property markets

Market growth Capital growth is continuing in key markets with London leading the pack. This is especially supported by further declining vacancy rates across all seven markets. Madrid is has been the biggest mover over the period from capital value decline to a 19% growth y-o-y Q3 2014, despite still relatively high vacancy. Capital growth (Q3 2013 – Q3 2014) Financep Property yields vs interest rates All seven markets have started to display signs of yield compression. As a result of a further downward adjustment of 10yr government bond rates property yields remain at a healthy premium in most markets. Smallest premiums are achieved in Southern Eruoepan property markets such as Milan and Madrid, where property yields have started to decline more rapidly between Q3 2013 – Q3 2014.  Change in property yields (Q3 2014 – Q3 2014) Riskp Property leverage market health Although there is still a healthy gap between London property net yields and the 10yr UK gilt rate (due to extremely low gilt rates), property financing is becoming more expensive if property yields keep declining further in the West End or the City of London in 2015. Yield gap (Q3 2014) CapG In contrast available cheap lending margins in Germany allow for higher property income returns in Germany. (Data sources: Bloomberg, PMA)

H1 2014 European Real Estate Performance

What do the leading agents say?

Direct real estate market

The improving market from end 2013 has given investors confidence for a good start in H1 2014.

CBRE reported total commercial real estate investment in Europe reached €37.9 billion in Q1 2014 – a 18% increase on Q1 2013. The fastest year-on-year growth in Q1 2014 was seen in Austria (+183%), Ireland (+179%), Spain (+132%) and Finland (+103%). The core markets of Sweden (+68%), Germany (+47%) and France (+37%) also showed significant growth compared to Q1 2013. (CBRE research more details here)

While Spain or Ireland are favoured by overseas investors looking for value-add opportunities, UK, Sweden or Germany are considered for their core investment opportunities. However, the German market has seen considerably more activity with UK and US investors now starting to look at larger non-core portfolios with assets in secondary locations.

London recorded its highest-ever quarterly investment total in Q4 2013, exceeding peak levels of 2007, as a result  Q1 2014 as been quiet for London due to lack of available investments.Therefore  UK investors have started looking outside the London market into regional UK centres as well as into diversifying asset class from office to logistics, business parks and more alternative sectors such as healthcare and hotels. There are perhaps five or six major regional UK cities being targeted by investors, with Manchester and Edinburgh leading the pack. (CBRE UK)

CBRE reports investment into Europe:

 €m Q1 2014 Q1 2013
UK                                                      11,435                                                            11,802
Germany                                                        9,923                                                              6,731
France                                                        3,475                                                              2,531
Spain                                                          988                                                                  426
Italy                                                          720                                                                 619
Nordics                                                        4,634                                                              4,166
CEE                                                        2,078                                                              3,216
Other                                                        4,644                                                              2,643
Total                                                      37,897                                                            32,134

Yields and return

Prime yields have tightened across most of European markets with yield compression spreading to secondary assets in stronger markets, notably the UK where the debt market has improved significantly, followed by Germany.  Core markets such as Central London are forecast to generate total returns in the 6-8% range, as currently low prime yields give little scope for yield compression as well as producing a relatively low income return. Prime office yields in London’s West End are now as low as 3.5%-4.0% and City offices 4.5%. (Colliers Research)

CBRE expects cities located in CEE and Eurozone peripheral countries, such as Dublin, Madrid, Moscow, Barcelona and Budapest to be the top performing cities in terms of total return, with an annual average return ranging from 12% to 15% over the 5-year to mid-2019.

IPD UK monthly index shows 3.9% total return over the first three month Jan – March 2014 compared to -1.5% for Equities and 2.5% for bonds. The prime performer was real estate securities with 6.3%. The performance of direct real estate shows that most of the return can be attributed to capital growth driven by yield compression with rental growth filtering through much slower. (IPD Research)

EMEA rental markets

The JLL office-clock shows rental growth slowing down for German cities, but London rents still accelerating over the next  12months. Most other European cities including Milan, Brussels, Paris, Madrid are now at the end of the bottom cycle and rental growth is expected to accelerate later this year assuming the overall Economic climate in Europe keeps improving, with Paris already leading the pack with +3.5%. This is also reflected in Paris increased office demand which was up 19% in Q1 2014. (JLL Research)

Real Estate Securities

Listed real estate markets were the top performer Q1 2014 with EPRA NAREIT Dev’d Europe delivering a 5.8% return.

Developments in European regulation on securitisation

Since 20th June 2013 newly amended regulation has come into force expanding the scope and application of disclosure requirements for structured finance instruments.

The newly amended CRA3 demands that issuer, originator and sponsor of a structured finance instrument jointly publish information regarding the structured finance instrument on a website to be set up by the European Securities Markets Authority ESMA.

The information to be published is quite extensive and includes detailed credit information and performance of the underlying assets.

It further requires for any public or private structured finance transaction to be rated by two agencies. While this was fairly standard for the public transactions, this is entirely new for private deals.

Altogether this clearly represents another hurdle for securitisation in Europe, with the possible impact of falling even more behind US market growth.

CRE ETFs in investor asset allocation strategies

Pension, insurance funds and other investors are looking for alternative asset allocation methods to include real estate as an asset class. According to Consilia Capital and Property Funds Research in a study published by EPRA (European Public Real Estate Association, 2013) real estate securities funds have grown by 68% in AUM between 2007 and 2012 and by 39% in number of funds. This figure also includes CRE ETFs. One key advantage supporting this growth is the liquidity of real estate securities funds in general. This allows investors to react quickly to market changes.

But there are additional advantages choosing a CRE ETF instead of a real estate securities fund. While they offer the same return profiles and volatility, trading costs are significantly lower and liquidity is guaranteed through a registered stock exchange. They are even more liquid allowing for intra-day trading strategies being executed to gain access to very short term returns, for instance due to intra-day differences in trading price vs fund NAV.

CRE ETFs also provide investors with more flexibilities to adjust to market changes in the underlying real estate market by allowing to shorten a specific market. Just like individual shares, CRE ETFs can be sold short. For example an investor may choose a diversified portfolio of real estate stocks or a real estate private equity fund as their core real estate investment, but before they can exit, the market declines. The investor can now short his exposure in the segment using a CRE ETF as a hedge.

A similar strategy is possible for investors in specialist real estate private equity funds, by choosing a special CRE ETF tracking a specific benchmark such as UK industrials, although the hedge might not be as perfect. Options are limited in Europe through the limited amount of specialised real estate property companies. In addition the sector allocation through a basket of listed real estate securities might not be as purist as with a real direct property investment.

Trading CRE ETFs can also be a intermediate strategy for private pooled real estate funds to breach the gap until an appropriate property has been found. Investors will receive a real estate return with the same liquidity as a money market fund at a very low trading cost. There is also no minimum investment amount, because these products are essentially designed for retail investors.

Peak to trough – CRE ETFs during the crisis?

Peak to trough performance during the crisis

During the 2008/2009 liquidity crisis property values in developed markets around the world fell 40-50%.

Also CRE ETFs have been affected and comparing the five European listed funds the pricing index (Jan 2007 = 100) shows the EPRA US Property ETF falling to an index -42 by March 2009. The strongest fall was experienced for the EPRA UK Property ETF to an index value of -64 in August 2009.

EUR Performance

The first fund to react to the Lehman bankruptcy was the EPRA Developed market property ETF falling to -24 in Sept 2008, much earlier than any of the other property ETFs.  The European investment property ETF IPRP shows less decline (lowest index level of -3 in Sept 2009) than the UK fund. This observation is consistent with actual property price observations in Europe such as Germany and France compared to the UK.

The fund that has performed best during the crisis was the EPRA Asia Property ETF with the lowest index level of 19 in Jan 2009.

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