Friday Letter Next stop where?

The main message from PERE’s second European Private Equity Real Estate Forum held in London in early June: Work very hard if you want to carry on making money in this asset class. The first half of the current decade will undoubtedly be remembered as a golden age of property investing, but will a 12 percent net annual return on an unlevered basis remain as readily available as it has been? Hardly, warned Matthew Ryall, a member of real estate research and strategy at Merrill Lynch Investment Managers in London who sat on the Forum’s concluding panel. Without active (and clever) asset management, performance will prove elusive. 

According to Ryall (who is by no means alone in holding this view), Europe’s property markets are emerging from one value creation paradigm without quite being ready to enter another: capital growth and yield compression are beginning to look like yesterday’s performance drivers, meaning the low-hanging fruit have all been picked. Rental growth, on the other hand, isn’t yet strong enough to take over, despite the fact that take-up levels in Europe’s leading cities have been on the rise.

Underpinning the current dynamic is the fact that there are no signs of liquidity drying up, even as interest rates head north. The consequence facing opportunity funds in particular is that they continue to find themselves bidding on assets against people whose cost of capital is significantly lower than their own. As a result, “deployment rates of private equity funds have been poor,” complained one conference delegate.

For limited partners pondering new fund commitments in a market this tricky and crowded, two issues deserve more attention than others: who are the managers that can deliver alpha, and where in Europe do you want them to deploy your capital?

To answer the first question, as ever in private equity, investors rely on art and gut feel at least as much as they do on science and track record analysis. Herd thinking plays a part as well of course, so it wasn’t a surprise that a number of speakers noted the growing influence of brand name bias in manager selection.

In terms of geography there was consensus, too. Go easy on the US or avoid it altogether. You’ll need a strategy for Asia. And in Europe, have the burgeoning countries of the former Soviet Bloc covered, where GDP growth is strong while quality real estate remains in short supply. In a poll of the audience, 91 percent professed an appetite for doing business in those Central and Eastern European countries that are already part of the European Union. A still respectable 64 percent said CEE countries outside the EU were equally of interest.

As they venture east of Vienna, practitioners will undoubtedly discover that the aforementioned need for hard work and active asset management is essential to make a satisfactory return. John Carrafiell, global co-head of Morgan Stanley Real Estate, predicted in a key note address that from hereon, his team would focus more on finding operating companies, rather than invest in buildings directly—a change of approach undoubtedly driven by a belief that if you are putting money into increasingly exotic grounds, there really is no better way than having local people in place to look after it and help with the heavy lifting.

Alongside CEE, Carrafiell singled out Germany as another mission-critical destination in Europe. There the market remains distressed, and so an opportunity exists to buy corporate assets in bulk and well below their replacement value. For the next three years, Morgan Stanley expects to place as much as 15 percent of its global capital output in Germany, which, given the firm’s heft as a real estate investor, equates to several billion euros worth of investment.

Making such a bet pay off won’t be straightforward, especially since Germany’s economic state remains precarious. Which brings us back to the point about hard work: next time you run into Carrafiell, expect him to have his sleeves rolled up.