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.

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.

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

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2014 Real Estate Calendar & Events

2014 Real Estate Calendar & Events.

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 20^th 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.

What about real estate ETF investment strategies?

There are a number of strategies used by ETFs that are not available to other real estate fund managers, which provide the ETF with more flexibility to react to market changes. ETF fund managers can follow a very passive strategy, these funds track an index, but funds can also be actively managed. There is no limit as to how actively they can manage the portfolio to focus on alpha strategies.

Figure: alpha-beta strategies road map

Source: Deutsche Bank, 2012
For example the majority of real estate ETFs are passive investments, meaning they track a benchmark index. Examples for passive beta strategies are:

• iShares FTSE EPRA/NAREIT Asia Property Yield Fund
• iShares FTSE EPRA/NAREIT Developed Markets Property Yield Fund
• iShares FTSE EPRA/NAREIT UK Property

Few funds use a different approach than market capitalisation, considered smart or adjusted beta such as

• BMO Equal Weight REITs Index ETF (ZRE-TSX)
• PowerShares KBW Premium Yield Equity REIT Portfolio

There is currently only one true active fund, which differs in the asset allocation approach:

• PowerShares Active U.S. Real Estate Fund

Invesco’s PowerShares Active US fund uses quantitative and statistical metrics to identify attractively priced securities and manage risk.
Physical ETFs can use the full spectrum of asset allocation tools for increasing or decreasing exposure to a specific style, sector or capitalisation

• Sector rotation strategies
• Arbitrage strategies
• Hedging and defensive strategies
• Stock-lending revenue strategies (from short sellers)
• Market neutral strategies
• Maintaining exposure during a manage transition
• Hedging tools for shorting
• Transition management

Being able to sell stocks shorts, provides the ETFs with downside protection in a crisis.

Synthetic ETFs

on the other hand are not based on stocks directly. They deliver the performance of the index they track via a swap contract. This technique allows them to have a smaller tracking error than conventional funds. The ETF manager builds a so-called “substitute basket” – sometimes also called “collateral basket” – these are assets of good credit quality delivering a low but risk-free return. In addition he enters into a swap contract with a counterparty – normally an investment bank – whereby it exchanges the performance of such a basket for that of the index.

Leverage

Not all ETF’s are based on stocks. Some are based on derivatives, such as options and futures. For example commodity ETFs use futures to replicate the performance. The use of derivatives allows leveraging to do a multiple of what the market index does. Leveraged ETF’s seek to make 2 or 3 times the return of their target index, while leveraged inverse ETF’s seek to earn a multiple when the target index declines.
While these types of ETFs are much more common for commodities, there are currently only a couple of real estate ETFs using leveraged performance. Two noteworthy examples are applying a beta multiplied strategy are:

1. Direxion Real Estate Bull 3X – Triple-Leveraged ETF
2. Direxion Real Estate Bear 3X – Triple-Leveraged ETF

These funds deliver 300% (3x) of a selected benchmark index. They create short positions by investing at least 80% of their assets in derivatives: such as futures contracts; options on securities, indices and futures contracts; equity caps, floors and collars; swap agreements; forward contracts; short positions; reverse repurchase agreements (REPO); exchange-traded funds (“ETFs”); and other financial instruments that, in combination, provide leveraged and unleveraged exposure to selected index. The remaining is typically invested in short-term debt instruments that have terms-to-maturity of less than 397 days and exhibit high quality credit profiles, including government securities and repurchase agreements.
Leveraged ETF’s are generally used for short-term trades — not as long-term investments, since markets go up and down, so gains and losses are both amplified.
The largest provider of physical real estate ETFs is Blackrock through it’s ishare brand. Main stock exchanges are NY, London and Canada.
Figure: Fund manager and number of funds

Source: Nicole Lux

Next week: AUM, how large is the investment universe, what about performance?

New European CMBS issuance rules 2.0

The April issue of Real Estate Capital confirms investor interest in reopening and reviving the European CMBS market.

Changes to the new style CMBS demanded by investors are around information disclosure, independence of advisers and most importantly control rights in events of default.

While some suggested changes are helpful such as the ability to sack property managers without cause after a loan default, with managers obliged to transfer information, selecting and negotiating with a new property manager can be a lengthy process and requires in-depth knowledge of what is needed to transform the assets into a performing loan.

Many requests address rights of the controlling class, noteholders should be aware though that where only a portion of the loan has been securitised this controlling party is often the B-noteholder or subordinate lender, who has different interests from the senior bond holders. In addition the senior noteholders are in most cases not real estate professionals.

Of course terms of engagement of rating agencies are not a secret and follow defined fee structures. It is up to investors to enquire.

http://www.crefc.org/Global/CMSA-Europe/Committees/European_CMBS_2_0_Committee/European_CMBS_2_0_Committee/