Rising interest, falling yields

The Stockholm skyline at sunset is one of the most beautiful sights one can see in Northern Europe. The sun, setting over the Mölaren, bounces off the new and old buildings in all directions. The landmark DN-huset office building on the water's edge, rising far above the surrounding properties, seems to grab more of the sun's rays than anything else. In fact it's impossible to miss it as you scan the horizon.

Perhaps it comes as little surprise that Niam, the Nordic region's largest private equity real estate firm, acquired the tower last year. After all, big firms like big properties, and Stockholm's big properties have been receiving their fair share of attention.

“I don't think that you'll find any country in Europe that's less bureaucratic than Sweden. It's very easy to do deals in both Sweden and Finland. The state guarantees that the property register is correct. If there was something wrong with the register, you will be paid by the Swedish or Finnish state—so there's much less consultant cost here than in many other countries.”

Sweden, the largest country in the Nordic region by population, size, GDP and property market, is just one part of a region whose successful economic past and rosy forecast for the future have been increasingly attracting the attention of international real estate funds eager to diversify their holdings. But though the macroeconomic factors are expected to remain strong, yields have been steadily decreasing as more and more investors check in to the region's two hottest areas for investment, Sweden and Finland.

It's not hard to see what has lured international funds to the Nordic real estate market: Its high liquidity and transparency, low frictional costs for transferring assets, good access to property financing and stable political and economic outlook make it an excellent target for investors who want to diversify their exposure without significant risk. It also has a well-established service industry in place, which makes the due diligence process relatively painless compared to other markets.

The real estate markets of Sweden and Finland have opened up significantly over the past several years, while their neighbors in Norway and Denmark have remained largely closed to foreign investors with a comparatively small number of investment opportunities.

One international firm investing in Sweden and Finland is ING Real Estate, which first bought itself into the Nordic property market in September 2005 and last September launched a €1 billion Nordic Property Fund focusing on core assets in the two countries.

“The shift of capital came from the fact that money is looking for higher yielding properties all the time,” says Peter Helfrich, ING Real Estate's Nordic managing director. “There were relatively higher yields in Sweden and Finland than there were in the UK and in Holland, and in other countries. Everybody wants to be able to diversify, and here you have less correlation with the European currency market, but the market is also easy to operate in. Clients are asking for it because they don't have a Nordic allocation, especially as the pension fund market is maturing and it's looking for diversification into new sectors and areas.”

As transparency goes you can't get much better than Sweden, market participants say, and Finland has made significant improvements over the past several years as well. Sweden has a property register going back 100 years and has always guaranteed the validity of these records.

“I don't think that you'll find any country in Europe that's less bureaucratic than Sweden,” says Lennart Sten, managing director at US investor GE Real Estate, which has invested €106 billion in Swedish real estate so far this year alone. “It's very easy to do deals in both Sweden and Finland. The state guarantees that the property register is correct. If there was something wrong with the register, you will be paid by the Swedish or Finnish state—so there's much less consultant cost here than in many other countries.”

Capital invasion
The real estate transaction volume in the region reached new heights in 2006 and 2007. The Swedish market alone had a record total transaction volume of €16.9 billion in 2006, up from the previous record of €13.9 billion in 2005, according to Swedish analyst Newsec. The total transaction volume in Finland more than doubled between 2005 and 2006, reaching €5.5 billion. International investors accounted for 43 percent of the deals in Sweden and more than half of the total in Finland.

Doughty Hanson is one of those foreign investors. The London-based firm's real estate arm was one of the earliest international entrants into the market through Doughty Hanson European Real Estate I, which closed in 1999. Over the past two years, the firm has been on a selling spree to realize investments from the fund.

“What's interesting is how dramatically the interest from international investors has increased over the past few years,” says Julian Gabriel of Doughty Hanson Real Estate. “It begs the question, why weren't more people interested in 2000 and 2001? The answer is that there's now more of a willingness for these investors to come into these markets. When we were here in the early days, local players mostly liked to do business with themselves. They were nervous about doing transactions with outsiders.”

Aberdeen Asset Management has also been active in the region for seven years through Stockholm-based subsidiary, Aberdeen Property Investors. The firm now has a dozen country-specific vehicles in the area as well as a pan-Nordic fund that invests in the whole region and the Baltics. Since then Blackstone, Goldman Sach's Whitehall Funds, Carlyle and Coller Capital have also joined the party.

Falling Yields
Investors like Doughty Hanson and Aberdeen certainly got in at the right time. In 2000, property prices were relatively low and yields were at a high. Today yields have bottomed out, and the fast-rising turnover in the property markets has forced both buyers and sellers to adjust to the higher demand.

“For a long time it was fairly easy to see, with all the interest gathering up, that that would push the yields down and enhance the property values up,” says Sten. “I think that became increasingly obvious in 2004' as, for the last three years, we've had this rapid cap rate expansion. For a long time cap rates in central Stockholm were around 6 [percent]. Today, I'd say they're probably less than 4 or 5 [percent]. With all the money coming, it almost had to happen because there's only so much property to buy.”

One macroeconomic factor also affecting yields in Stockholm was its turnaround in March 2004, as the market cycle turned up, vacancies stopped increasing and rental decline ended. Since then, both the Stockholm market and that of Gothenburg, Sweden's second-largest city, have been in recovery.

In Finland, the very high yields of just a few years ago have also dropped. “Finland is almost getting to where the Swedish levels are,” says Sten. “The problem is the yields compressed too quickly. We haven't done anything in Finland, but we probably should have two years ago.”

However Newsec's analysis predicts further yield compression in Finland this year, with a transaction volume of around €5 billion, meaning it may not be too late to get a good yield spread in the country. In Sweden, however, yields may not drop much further.

“We don't underwrite yields going any further down, but I can't really say they're coming up either,” says Niam's Bergman.

As the heady days of low prices in Sweden and Finland fade into the sunset, private equity real estate funds have adopted a variety of strategies to target the best areas for growth.

Follow the herd
Undeniably, the most popular play in the Nordic countries right now is in office space. In both Sweden and Finland, the labor market has drastically improved over the past several years, creating a strong need for new office stock in both main and secondary cities.

“In terms of performance outlook, the Nordic region is one of the few regions where we have a very good outlook for offices,” says Jon Lekander, recently appointed chief investment officer at Aberdeen Property Investors. “If you look at the four major office markets, there's a different story behind each one of those. Oslo has been doing well for some time on the rental side as well as the investment side. In Copenhagen, the demand is still robust, but the investment side is not as strong now as it was six months ago. The most similar markets in the Nordics would be Helsinki and Stockholm, where both economies have done very well in terms of GDP growth but the employment market has been lagging quite a bit. What we see coming out now is that employment is picking up quite significantly. The market in the past six months has improved, which means that office rents are also slowly ticking up.”

“What's interesting is how dramatically the interest from international investors has increased over the past few years. It begs the question, why weren't more people interested in 2000 and 2001? The answer is that there's now more of a willingness for these investors to come into these markets. When we were here in the early days, local players mostly liked to do business with themselves. They were nervous about doing transactions with outsiders.”

Another factor particular to the Nordic region making the office space an attractive target to some is the short-term lease structure found in these countries. Office leases in Sweden and Finland are typically three to five years, shorter than the European average. In Finland you frequently find contracts-at-will, where a tenant can get out of a lease with just a short notice period.

“The drawback is that your income side becomes more variable, but if you're in the market and you know how to handle it, it's manageable,” says Lekander. “The benefit is your depreciation tends to be lower, because once your lease contract runs out you do some tenant improvement in order to lease the office again. Our experience is it's more of a benefit than a drawback.”

Going to Norway and Denmark
In 2006, Norway had the second-largest total turnover after Sweden, with its transaction volume growing by almost €3 billion to reach an impressive €8 billion, according to Newsec. But those investments were largely from local players, including a number of high net worth individuals.

In many cases, foreign investors just can't compete with the money floating around in Europe's only oil economy. Still, the noteworthy success of the real estate market in Oslo is an attractive target for those with a local presence. Aberdeen's first entrance into the Nordic market was in Denmark and Norway with dedicated funds, investing in the central office markets of Oslo and Copenhagen. Because of this history the firm is able to get in on deals where other international investors could not. At press time the firm was close to acquiring Oslobased Norgani Hotels for Nkr3.5 billion ($612 million, €442 million) bid.

“The Norwegian market is a very domestic market on the transaction side; transactions are made much more quickly than in other countries in Europe,” says Lekander. “So it's difficult for a non-Norwegian to understand how the system works. But there are good opportunities there.”

In Denmark, a few big players in a small market with a lack of product have made for a big perceived barrier to entry for foreign firms. But some foreign investors have been able to crack the market. Carlyle recently made two acquisitions in Copenhagen, just a year after opening its Nordic real estate office. In July the firm made its fourth Danish acquisition, the purchase of a 49,100-square-meter office block in downtown Copenhagen from KTAS Pensionskasse, the pension fund of the Danish telecoms group.

“Historically, Denmark is more of a nation of traders,” says Thomas Lindstrom, the managing director for Carlyle's Nordic activities. “In Sweden it is more open and transparent, and the processes when you sell properties are very structured. In Denmark it's more open to negotiations: There's a little bit more wheeling and dealing, which I think it's a good thing. Some other investors are a little bit hesitant to go into these types of processes, because they think that the local competitors will have advantages. But I think this presents more possibilities and opportunities.”

Considering that vacancy rates in Denmark are now at an all-time low and rent levels rose in most market segments in 2006, finding ways around the perception of a closed market could be a wise strategy for international investors.

Buy from the state
Sweden's national election in 2006 resulted in a massive shift in government, with the center-right Alliance ending a 12-year run by the left-wing coalition. The result has been a steady program of tax cuts and privatization.

“The new government has said, ‘It's not our core business to be a real estate owner,’” says ING's Helfrich. “So they're selling off many government vehicles, which still hold a lot of real estate. Because they are government-owned, they have had the tendency to not be very well managed, so we can add value to these kinds of properties.”

There are several government disposal opportunities that have just been sold or are about to come onto the market. The city of Stockholm is selling all its shares in the retail company CentrumKompaniet, which owns a portfolio of ten shopping centers in the Stockholm area, to Boultbee in the UK for €1.2 billion. In September the Swedish government said its planned sale of six companies, the largest privatization plan in the history of the country at a windfall of Skr200 billion ($29.4 billion), is now entering a transaction phase.

Finland saw a similar sell-off recently with the sale of government-owned property investment company Kapiteeli to the Finnish-listed property company Sponda, the largest transaction in the history of Finnish real estate at an underlying value of €1.3 billion. Sponda then turned around and sold part of that portfolio to Goldman Sachs' Whitehall Funds.

Changes ahead
Though the lower yields may mean the purely cyclical game is over, private equity players in the Nordic region are saying there are still plenty of opportunities for active real estate managers.

For those investors that can structurally add value, it is still a promising area. And as for those foreign investors who have been in the market for a long time, they say there's still plenty of room for newcomers.

“It's more competitive now, but it's become a better market,” says Doughty's Nils Styf. “There are now different types of investors which are continuing to open up the markets and provide more liquidity. Four years ago, all the liquidity was in capital cities, but the liquidity today is high even in smaller local realty markets. We won't be seeing that interest stopping any time soon.”