The view from the top

High above London, four real estate bankers recently gathered to discuss the events of 2005, the key trends in today's market and whether the future holds boom or bust. By Jonn Elledge

The chaos and confusion of London's geography makes a good symbol for British life. While other countries have political systems, economies or even cultures that were consciously created, the UK just is, having grown organically through the centuries. So it is with London: gleaming 21st century skyscrapers abut 11th century castles, while on the south bank of the Thames a brutalist postwar power station now houses the UK's largest collection of contemporary art.

Grand redevelopment plans such as that developed by Christopher Wren after the great fire of 1666 have somehow never quite come off. Modern London is the result of a million different decisions by different developers, financiers and planners over the course of ten centuries, the majority of whom had less interest in creating a world class metropolis than in building something functional and (let's face it) turning a quick buck.

And so the upper levels of 30 St Mary Axe in the City of London would seem like an appropriate place for a discussion on the future of Europe's property market. Sir Norman Foster's gently curving glass tower, known locally as “the gherkin,” has quickly become a London icon, showing up in everything from the romantic comedy Love, Actually to the latest episode of long-running sci-fi series Doctor Who (which showed all the windows falling out due to a particularly nasty sonic wave). The private dining rooms on the 38th floor offer panoramic views of the urban sprawl—and of what can happen to a city when international real estate investors get involved.

Last year was, as few can have failed to notice, a big one for Europe's fledgling private equity real estate industry. Giant properties such as France's €2 billion Groupe Taittinger, the €7 billion Viterra German residential portfolio and the £1.3 billion Abbey UK portfolio all changed hands. More money hit the market than ever before, as groups including The Carlyle Group, Macquarie Global Property Advisors and The Blackstone Group all made significant allocations to the region. What's more, talk of REITs being introduced in Germany and the UK suggested that more capital was yet to come. So, from the bankers' point of view, what did such a busy year portend?

For real estate buyers the news, it seems, is not good. The wall of money crashing into the market (“we call it the tsunami,” one participant quipped) is finding comparatively few investment opportunities. As a result, Harin Thaker, the chief executive of Hypo Real Estate's European operations, argued, “Yield compression has been the issue that is impossible to ignore.”

While all the participants agreed that falling yields were a problem, there was some debate as to exactly how widespread it had become. Ralf Nöcker, for example, the managing director who co-heads the real estate principal investments group at Bear Stearns, suggested that there has been some form of polarization. “We're seeing increasing yield compression on properties with good strong cash flows,” he argued. “But we've also seen yields improving on assets with short leases or other problems. There are more opportunities for buyers to seek out the risk-reward combination that appeals to them.”

In contrast, Paul Rivlin, the joint chief executive of Eurohypo's European investment banking team in London, argued that the trend towards yield compression was universal—where individual markets differed was not in whether they were affected, but rather the degree to which they were. The reason for this trend is straightforward: simple pressure of money. “There are a lot of new investors coming to market with plenty of cash and little experience,” he said. “The number of preferred equity and mezzanine providers seems to grow every week.”

Nöcker sounded unconvinced by this line of argument. He cited the example of a recent deal he'd been involved with, during which he'd received calls from 18 unfamiliar hedge funds claiming they were interested in buying a chunk of the mezzanine funding. When it came to the finish line, however, not one of them went through with the deal; instead, the debt was sold to the usual buyers.

Upon hearing this story, Rivlin just smiled and shook his head. “I think you're hoping for something that isn't real there,” he replied. “When you're selling secondary tranches it's easy to sell BBB pieces at the moment, and there are an increasing number of traders down scale from there. Japanese institutions are coming in now, for example. The wall of money is in every category: equity, mezzanine and debt.”

One result of this yield compression has been investors edging up the risk-return spectrum. Rivlin cites the example of nursing homes: “They used to be regarded as an extremely risky play; now they're almost mainstream.” Yet he argues that investors should tread carefully. “You need to think pretty hard; the more yield compression goes on, the more the odds are stacked. There are signs of a bubble starting to develop.”

“Yield compression has been the issue that is impossible to ignore.”

The growing interest in European real estate from new providers of capital is causing some to worry about the market's stability. On the plus side, though, another traditional source of market instability—sudden interest rate shifts—seems to be worrying no one.

Richard Stockton, a managing director in Morgan Stanley's real estate department, argued that, “If interest rates go up by 200 basis points, yields are going to come out.” However, the consensus around the table was that such a big rate movement was extremely unlikely; based on the recent records of both the European Central Bank and the Bank of England, future change was expected to be in small increments, giving the market time to adapt.

“The ECB makes you confident that whatever is happening will happen gradually,” says Nöcker. “You can take comfort from the fact that you don't get one central bank moving 100 basis points at a time any more. This is a significant shift from five years ago, when individual central banks would make rapid interest rate movements with little notice.”

Another feature of 2005 cited by all four participants was the growing internationalization of the market. Thaker said that, “Last year, the Irish investors stopped flying into the UK and have begun moving into continental Europe.” Stockton concurred: “Crossborder activity is in its adolescence, and investors are looking at Europe as a whole a lot more than in the past.”

This trend has caused consternation in some quarters: witness the objections in Germany at the number of Anglo-Saxon “locust funds” buying up social housing from local authorities. Rivlin described such fears as a storm in a teacup. “Foreign investors picking a market up is not new—it happened in the UK in the early-nineties, when UK institutions had no interest in property whatsoever. The market is very heavily regulated, so the idea that people can pla

The emergence of Germany as a key market was, of course, another of the big stories of last year. Nöcker, a German national himself, noted that, “I've been involved in acquiring assets in Germany out of London for the past seven years, and it's never been so easy. Not only have decision-makers woken up, but local buyers have been on the retreat, allowing internationals to move in in a meaningful way.”

“The wall of money is in every category: equity, mezzanine and debt.”

He highlighted the early residential deals, such as the Gagfah portfolio, as being among those which had traded for a good price. Others round the table noted that it wasn't just the high profile deals that were fueling interest in Germany, but interesting under-theradar transactions such as the sale of Lidl and Aldi discount supermarket stores.

Germany isn't the only recently opened market that has been attracting attention. Countries which joined the European Union in 2004 and those still waiting on the doorstep have attracted significant capital from international real estate funds. Not all our roundtable participants, though, were convinced that returns available in Central European markets such as Poland and the Czech Republic included a decent risk premium.

“In Poland you can now buy class A real estate, which has been built in the last couple of years, and lease it to Western tenants,” noted Stockton. “But there is a country risk—of the government renationalizing assets, or of economic collapse.”

“I'm not concerned about that,” said Rivlin. “But local tenants in these markets are not so stable, and planning laws aren't so predictable. There's a risk of being undercut by what's going on elsewhere.” He cites the example of Warsaw, where there has been significant overbuilding of retail space.

Nöcker argued that the best way to avoid such overcrowding was to stick to smaller niche markets. He pointed to a recent office building in the Estonian capital of Tallin which was sold for a 12.5 percent yield: “Although Bear Stearns isn't active in these countries at the moment, I'd feel much more comfortable doing investments like that than I would large retail spaces on the outskirts of Warsaw.”

“But Estonia has a population about the size of Birmingham,” replied Rivlin. “And you still have to go through the whole process of getting to know the market. I'm not surprised there's no shortage of opportunities for those who'll put time and effort into them: it's a consequence of the wall of money. A lot of investors can't be bothered doing small transactions. What's the point of putting all that effort into a €10 million deal unless you can repeat it?”

Thaker demurred, arguing that, regardless of strategy or geography, there was no getting away from hands-on investing. “Given current liquidity levels, investors have no choice but to work the assets and add value.”

The panel's views on the prospects for more mainstream European markets were more varied. Nöcker suggested, “I think Spain's hit a bubble—lots of not so good shopping centers are trading at yields of around six percent and mixed-use is down to five percent.” Similarly, the participants agreed that the Stockholm office market, which has proved popular with international investors in recent years, has reached its peak.

“The question is, are REITs the lion that's not going to roar?”

When asked for markets on which he was more bullish, Thaker said, “Italy is beginning to look interesting, and Turkey, with 70 million people, is coming up now with lots of opportunities.” Nöcker added France to that list, arguing that, “The economic fundamentals are very stable. There's a bubble in long-lease properties in Paris, but outside that you can find very good value. The banking market has also become a lot more competitive; it used to be the most expensive market in Europe to borrow money, and now it's one of the cheapest.” On the UK, the panel was on the fence, arguing that the future depended on whether the recent economic slowdown persisted, and which way interest rates moved.

Rivlin argued that it was difficult to draw such broad conclusions. “I'm not sure we can talk about national markets,” he said. “We need to talk about city markets.” He noted that office vacancy rates were falling in Paris, making the market attractive despite its price; in contrast, Frankfurt may seem cheap, but it currently has a very high vacancy level. To illustrate the need to examine individual markets on this micro scale, he cited a pair of markets only two miles apart. “Agents are talking seriously about the £100 per-square-foot rent in [London's] West End. There's simply no prospect of that in the City: as banks have begun to move elsewhere, it's changed from having inbuilt scarcity to being just another London office market.”

As to what is widely expected to be one of the big stories in European real estate in 2006 and 2007—the introduction of REITs in Germany and the UK—the panel remained skeptical. When Rivlin noted that the arrival of France's version, the SIIC, had not had a huge impact on the French real estate market, Stockton laughed, replying, “Actually it's been so successful that it attracted all the Spanish investors in to buy up all the SIICs.” He suggested that the version currently under discussion in the UK looked to be better for syndicators such as Dawney Day than for real estate companies.

Nöcker was more cynical still: “Don't forget that a lot of the people who talk about introducing REITs in Europe at the moment are advisors who are paid to make more from them.” Stockton agreed, noting that the same could be said of the emerging real estate derivates: “People have definitely become more interested in trading options, but whether this constitutes an investment opportunity or simply a hedging strategy is far from clear at this point.”

“The question is, are REITs the lion that's not going to roar?” said Rivlin. “It reminds me of the way people at conferences three or four years ago were predicting $30 billion of assets sales a year by European governments and corporates. I don't think there has been even half that in any single year since. REITs could well be the same: a steady work in progress rather than a transformation.”

“Cross-border activity is in its adolescence, and investors are looking at Europe as a whole a lot more than in the past.”

So what's the outlook for 2006 and beyond? The two key points, according to the panelists, seem to be more yield compression and a correction.

“Yield compression is still the dominant story,” said Rivlin. And, he predicts, it'll be more dramatic than people think. “I think we'll see more in almost every European market—I wouldn't be surprised to see yields [50 basis points] lower by December '06 than they are today.” This does not make for a cheerful prognosis: “I'd be happy to take odds on a bust in 2008.”

Stockton, though, was more optimistic. “There is a boom—but that doesn't necessarily mean there'll be a bust.” If anything, he argued, there are still more players waiting to get in the game, such as the bloated Australian superannuation funds that cannot find ways to deploy all their capital at home. “A bust would have to be triggered by an event like a recession, and we're only two or three years into this economic expansion. I think a soft landing is much more likely.”

In the meantime, the substantial amount of available capital will not go away. Thaker argued that a correction was inevitable, despite the wall of money—and that the trigger could be an unexpected one. “There will be a correction,” he said. “But when and what will cause it—oil prices, the trade deficit or something else? I don't know.”

Whether the year ahead will spell boom or bust for the European real estate market is still unclear, but the opinions around the table suggest at least one thing: it definitely won't be boring.

Ralf Nöcker
Co-head of real estate principal investments group Bear Stearns

Nöcker, based in London, has been co-head of the real estate principal investments group at Bear Stearns since September. He focuses on the acquisition, structuring and financing of properties valued at more than €100 million located in Western Europe and the UK. He was previously a founding member of the asset finance group at Nomura International and, until December 2001, specialized in cash flow generating assets at niche private equity house Nikko Prinipal Investments. Nöcker holds a PhD from the University of Cologne and a Masters from the London School of Economics.

Paul Rivlin
Joint CEO of European investment banking Eurohypo

A barrister and accountant by training, Rivlin is now joint chief executive of Eurohypo's European Investment Banking team based in London. The team is responsible for providing a range of investment banking services and products to real estate investors, companies and institutions. In 2005 the group advised on deals including Starwood Capital's acquisition of Groupe Taittinger. It also issued approximately €5 billion of CMBS and underwrote $1.3 billion of mezzanine investments. In November 2005, Germany's Commerzbank announced that it had acquired a 98 percent stake in Eurohypo.

Richard Stockton
Managing Director, real estate investment banking Morgan Stanley

Stockton is responsible for advising Morgan Stanley's clients throughout the UK, Continental Europe and the Middle East on capital raising and other initiatives. He has executed a broad range of transactions, including public and private debt and equity financings and M&A assignments for real estate clients in the office, industrial, retail, lodging, property management and development sectors. He received an MBA from the Wharton School at the University of Pennsylvania in 1997 and a BS from the School of Hotel Administration at Cornell University in 1992.

Harin Thaker
Chief executive officer, Europe Hypo Real Estate Bank International

Thaker leads the European franchise of Hypo Real Estate Bank International, which encompasses the international real estate financing activities of Munich-based Hypo Real Estate Group (“HREG”), one of the largest European providers of commercial real estate financing, with 1250 employees and total financing of €123 billion. Thaker's group, which includes 170 personnel, provides real estate financing solutions across Western, Central and Eastern European countries, including Russia and Turkey. He has spent over 14 years at the bank.