SPONSORED ARTICLE: Don’t buy cheap, buy smart

In the wake of the global financial crisis, it has taken quite some time for Spain’s real estate market to heat up and 
become active once again. Now, more than four years later, the market is beginning to come alive as evidenced by a number of deals on the ground.

Prompting this activity is a number of positive indicators in the Spanish market, including improvement in the country’s economy and the actions of some institutions. According to the Bank of Spain, the first half of 2013 saw the country chalk up its first foreign surplus since 1997, bringing the economy to €5.25 billion in additional funding capacity in June. At the same time, the Association of Collective Investment Institutions and Pension Funds just published a paper putting the growth in assets under the management of collective investment institutions at 9 percent, which represents the first indication of growth for the sector since 2005. Finally, according to the Bank of Spain, there have been nearly €40 billion in net inflows of foreign capital during the first six months of this year.

Meanwhile, within the real estate industry, there has been a dramatic shift in the mindset of market players, especially financial institutions, in relation to the valuation of real estate assets. This is primarily motivated by Spain’s Royal Decrees last year, when the Spanish Council of Ministers approved new financial reforms to restructure financial institutions and set aside new provisions for real estate loans and properties on their books. It also created the legal framework for such firms to contribute assets to special purpose corporations for the restructuring of bank portfolios, following the creation of national ‘bad bank’ Sareb and banking asset funds (FABs) earlier this year.

Whether the level of existing distress in Spain translates into investment opportunities, however, will depend upon the continued improvement of the economic situation in the country, as well as Europe as a whole. Lastly, opportunities will depend upon the development of what is still quite an unsophisticated real estate market in terms of size and investable assets. 

Market opportunities

For a number of reasons, the commercial investments with the greatest potential seem to be the retail, hotel and logistics sectors. On the sell side, there is opportunity to acquire portfolios from banks and do so via more efficient vehicles. On the demand side, the embryonic increase in retail consumption, the continued allure of tourism leading to hotel occupancy increases in the year and the increase in exports within the trade balance speak for themselves.

That said, the key Spanish real estate sector based on its size is the housing market. It is believed that institutional capital should decide to increase their exposure to Spain if solvent workout plans can be implemented. At the end of the day, there is a massive amount of product available at substantial discounts and a total lack of quality products.

According to Deloitte, the Spanish housing market presents the largest offering within Europe in relative terms, at 570 units per 1,000 inhabitants, and it is the fifth largest market in absolute terms with 27 million units. The reason for that is the number of holiday units and massive variations between regions.

Meanwhile, the average selling price of residential in Spain is about €1,628 per square meter, representing a decrease of 34 percent compared to 2007 levels. While some sources are predicting a further decline, the average price convergence with European Union countries like France and Italy will support the future stability of the average level.

In late 2011, the unsold housing stock was 675,000 and the estimated absorption in 2012 was about 198,000 units (as in 318,000 sold and 120,000 newly built), so the current estimated balance is approximately 477,000 units. Given there is a high percentage of units with little or no demand, net absorption for new housing is expected to see a substantial increase from 2012 in certain areas that are supply constrained. 

Distress, but with a business plan 

When talking about Spain, many people use the word ”distress” and they often equate it to mean “opportunity.” However, that distress doesn’t necessarily equate to opportunity unless one has a workable business plan to apply to an investment. For this, it is essential to have the relevant real estate assets in line with market demand and, most of all, investment capital and market players aligned to undertake a more participatory role.

A number of fund managers are examining various investments. Often, such portfolios include land as well as existing property, which isn’t producing income and never will be saleable or leasable whatever the level of discount a buyer is getting. What such firms really need is not just a low entry price but a workout plan and a local independent platform that can provide relevant information and unbiased advice to add value.

Until now, the product those firms have been most focused upon are nonperforming loans. Very recently, however, they are beginning to look at properties rather than just loans. The property types that firms are looking at vary, but they have focused mainly on commercial property to date, even though it represents a limited source of investment.

One has to dip in very carefully, of course, as there are big differences between regions. In some areas, it might be more intelligent to start developing land where there is potential demand rather than trying to add value or lease up existing stock. 

Players in the current scenario

The real estate market in Spain currently is polarized between two groups. On one side, there are the ‘legacy’ operators, which include developers, construction and real estate firms with assets on their books. A lot of them used leverage and have a high debt exposure with financial institutions in Spain that need to conduct the workout of portfolios. Since the beginning of the global financial crisis, the majority of these groups have been forced to sell assets to deleverage, keeping their focus on financial stability but not their core business. That means these players are not active in the market and therefore leave a gap.

On the other side, there are players operating as service providers. This is the case of firms that are unexposed to assets and whose goal is to work for banks and other asset holders in advising them technically or commercially. A whole industry has sprung up, but none of these firms stand by the equity.

Therefore, more than ever, there is a need for a link between the capital and the assets. The problem is that none of the above players promote the investment market. In the case of the legacy operators, almost all have seen their capital evaporate and are immersed in complex refinancings, which consume their energies. Meanwhile, the service providers simply provide current and short-term solutions such as divestment of unsold assets for the forced management platforms at the banks. They do not provide the necessary alignment of interests with investors for further development of the investment market. 

Market developments 

Spanish real estate presents as a whole a product distribution very different from other countries, in terms of investment product and ‘development’ product. One can describe the market as having an investment side, meaning institutional-grade income-producing assets, which actually is very small. It also has a non-investment market characterized by the development companies trading their stock. 

Data on the market shows quite how undeveloped the Spanish market really is. According to the IPD Index Guide 2012, the estimated total size of the investment market in December 2011 was only €41 billion, with distribution by type of asset being 87 percent non-residential and only 13 percent residential (€35.7 billion and €5.4 billion, respectively). The market could be developed further by adding value to some distressed assets by implementing business plans that address current shortfalls. 

In contrast to the €41 billion institutional market, total real estate and construction sector lending was €307 billion, according to figures released by the Bank of Spain. This is the estimated debt exposure of real estate developers and construction groups. Perhaps two-thirds of this debt is nonperforming, which restricts further lending in the sector and the wider economy. We also estimate that 70 percent of the €307 billion debt pile is backed by residential, half of which is land. This contrast in figures is due to the weight of residential development that took place in Spain prior to the downturn. 

Consequently, residential property is expected to become a more institutional asset class in the future. Clues to that already can be seen from acquisitions being made by the likes of The Blackstone Group. There is a lot of stock and, while value will never be gained from a lot of it, one could realize value from some of it. Indeed, some of that massive debt exposure among financial institutions could be converted into income-producing assets.

At the same time, foreign investors should be aware that the institutional real estate market is very small, and growth through commercial real estate investing will remain restricted and very difficult without considering new land developments. According to data collected in the last annual report from Spain’s financial services  regulator, there  are only a total of six investment funds, with one being in liquidation, and eight real estate investment firms, with total assets under management equal to €4 billion as of June. 

Overall, the regulated domestic sector currently is a tiny portion of the €41 billion institutional real estate market, underlining how undeveloped the sector has been to date. Recent changes to the tax treatment of REITs – known in Spain as SOCIMIs – might stimulate the creation of new and reconversion of old regulated vehicles. This can only help the Spanish real estate sector, which ultimately should aid foreign investors as they finally begin to look at Spain as an investment market. 

About the Author:
Pepe Singla is a partner and head of investments at ADEQUA Real Estate. He and his team monitor the Spanish market and guide investment strategies for foreign investors. He can be reached at +34 93 240 55 25 or via email at psingla@adequare.es

About the Firm:
ADEQUA Real Estate is an independent asset management firm specializing in real estate. The Barcelona-based firm provides clients with contemporary real estate solutions within Spain and the Latin American region.