For the first time since the global financial crisis, we will start seeing winners and losers in the European value-added space. Or in Warren Buffett’s words, we will soon see who’s been swimming naked.
On the one hand, we are experiencing historically high yield spreads, making real estate in Europe an attractive investment class. On the other hand, yields in absolute terms are at historic lows, making real estate a seemingly risky affair.
Yield spreads between European government bonds and core real estate are substantially wider than the long-term average. In Germany, for example, the 10-year German Bund yields are only 30 basis points, while prime office in Munich is still above 300bps. Real estate has therefore attracted additional liquidity that previously would been allocated to other asset classes. BlackRock’s 2017 Global Institutional Rebalancing Survey – which covered 240 global institutional clients representing over $8 trillion in assets – showed a net 56 percent increase in investors seeking to boost their property allocations in continental Europe this year.
Europe’s liquid core markets provide strong exit potential for a value-added investor. Importantly, yield spreads between core and non-core real estate are also at historic highs, making impaired assets that can be transformed into core real estate through active asset management especially attractive. We like office, retail and student housing that we can reposition, rebuild and recapitalize.
Yields in absolute terms, however, are low, and in some markets between 2-2.5 standard deviations below the long-term average. This may mean that the real estate market is at an advanced stage in the cycle. At such a stage in the cycle and in the context of heightened geopolitical risks, we are focused on creating optionality through diversification, not least through vintage diversification, and through investments in liquid markets and short business plans, mostly in the range of two to three years.
Liquid markets for us value-added investors at BlackRock means predominantly the core European markets – UK, Germany, France and the Nordics. Bear in mind we don’t invest in countries, but cities: cities with strong macro, demographic and real estate fundamentals; cities such as Munich, Berlin, Frankfurt, Hamburg, Paris and the capitals of the Nordics.
We are distinctly resisting the temptation of following our peers into less liquid central and eastern European markets, where it is currently easy to buy well, but traditionally hard to sell well. Managing liquidity, more importantly, means buying the right lot size. Our research shows that the optimal asset size in Europe differs market by market and liquidity is much more closely correlated with lot size than with geography.
Finding the angle
But a value-added business plan is not enough; an opportunity is only an opportunity if the downside is protected and there is a unique angle to create outsize returns.
Even in the current context, it is possible to exceed our mid-teen base case net returns when, along with having a solid business plan, you can create value at entry by unlocking complex structures or acquiring assets located in markets with a supply/demand imbalance either on the occupier or capital market side.
Our high conviction value-added strategies today are UK student housing and office and retail in continental Europe. In December 2015, our research team modelled the impact of a potential Brexit on capital values in the UK across sectors. Low beta alternatives appeared the most resilient and we made a strategic choice to only pursue a student housing aggregation strategy in the UK and lately also Ireland. We also took a view ahead of the French presidential election that the perceived political risk in Europe outside of the UK was greater than the actual risk and went on to secure a number of impaired office buildings in Munich, Frankfurt, Hamburg and Paris.
I think such markets remain the best place for a Europe-focused value-add investor to be.