December 2009 / January 2010
The economic aftermath of the collapse of Lehman in September 2008 has been well documented and continues to unfold. Against a background of extreme uncertainty, investment decisions froze and most of the world's major economies entered recession. Unemployment has risen sharply across Europe and is still rising; stock markets, asset prices and business and consumer confidence tumbled, and even now the flow of credit to businesses remains patchy.
The main elements of policy response were near-zero interest rates and state intervention roughly equivalent to a sixth of GDP in Europe and the US. Not surprisingly, these have had some stabilising effect. Recent economic data are more varied and suggest that some economies are resuming a growth path, albeit a gradual one. While many economies and real estate markets will therefore enter the new year with prospects apparently looking brighter than seemed likely even a few months ago, this has been a challenging year to say the least.
- What sort of economic recovery will we see in 2010?
Estimates suggest that the major European economies will have shrunk by between 2% and 5% in 2009. There has clearly been some improvement since early 2009 when the Eurozone economy fell by over 1.5% in one quarter, and France and Germany proudly announced that their recessions ended in Q2, when the string of quarterly output falls was broken. We therefore appear to be past the low point in the economic cycle. While the risk of a "double-dip" remains real, a number of forecasters are now expecting a resumption of year-on-year growth early in 2010, and positive (if sub-trend) growth for most European economies in 2010 as a whole.
In addition, labour markets tend to lag changes in output and, with Euro area unemployment approaching 10% and still rising, this will act as a drag on recovery.
The role of government policy is difficult to exaggerate in the current environment. Specifically, the timing of withdrawal from the stimulus programmes introduced this year, and tightening of monetary policy, will be critical: too early and it risks stalling the recovery; too late and growth may already have become inflationary. The steepness of yield curves at present suggests at least some concerns about inflation potential.
- What has been happening to investment turnover?
In the first three quarters of 2009, we saw around €41 billion of investment activity in the European commercial real estate market. There has been a steady increase in activity each quarter since the low of €12 billion in Q1 2009, and we expect that this will continue, with Q4 seeing the highest level of activity for the year. Our expectation for the year as a whole is for a total of around €60 billion of investment transactions in Europe, which would be around half of 2008's total.
"The recent upturn in investment activity suggests that many investors believe the European market is approaching the bottom of the cycle; and in some cases, it may well be past that point. Whilst investment turnover has started to pick-up from lows of around €12 billion in both Q1 and Q2 this year, concerns remain about slow economic recovery and its lagging impact on the occupier market."
Michael Haddock, Director, EMEA Capital Markets Research, CB Richard Ellis
- Will this recovery continue into 2010?
While deal flow is likely to remain subdued for a while yet, we do expect that the steady improvement that has been seen throughout 2009 will continue in 2010. The final months of this year have started to see more opportunities coming to the market and this will translate into higher levels of activity during 2010.
However, a feature of the investment recovery so far is that, other than in the UK, it has been heavily concentrated on "defensive" investments: well-let, well-located, modern buildings, secured to good covenants on long leases. In other words, it has been focussed on quality and duration of income, and explicitly based on avoiding, or at least minimising, short-term exposure to the relatively weak occupational market.
In the UK, investors are showing more signs of being prepared to consider property that is further up the risk spectrum. This may be partly a reflection of the relatively wide yield spreads between prime and secondary, and the view of the UK market as something of a "safe haven", even if some economic fundamentals appear to be lagging. The risk is that it stems partly from shortages of prime stock forcing investors to widen their search criteria reluctantly.
Outside the UK, more secondary property, with potential exposure to the occupier market through vacancy, lease expiries or weak tenants, has yet to see a substantial increase in demand from investors.
So long as investor demand remains largely focussed on this prime segment of the market, the scale of growth in activity will be restricted. This is partly because investors' buying parameters will remain tight, and also because of the limited flow of new properties onto the market that meet the necessary criteria. It is unlikely that we will see much forced selling of prime property and, with no obvious motive to sell into a rising market, the vendor base may be confined to those who are looking to recycle capital.
CMBS/bank sales are key determinants of the recovery in volumes, as is the strength of economic recovery in giving confidence that occupier demand will improve. This could, in turn, tempt investors into secondary or riskier deals.
"The majority of investment interest is still heavily concentrated in the prime segment of the market. Some recently offered UK properties have attracted over 20 bids from a wide range of buyers, highlighting substantial build-up in competition for very good quality assets and putting increasing downward pressure on yields."
Michael Haddock, Director, EMEA Capital Markets Research, CB Richard Ellis
- What geographic and sectoral patterns should we expect in 2010?
The focus on prime assets has implications for the likely pattern of investment across different parts of the European market in 2010. Some of the most severe impacts on value and investment activity over the past two years have been felt in markets that have seen an unwinding of very sharp increases in property values in earlier years, such as Spain, Ireland and CEE. Some of these markets had seen very strong economic growth in the 2003-07 period (in some cases over 5% per year) which, combined with cheap debt, fuelled the expansion.
Current patterns of investor appetite reflect the legacy of this: a comparison of 2009 with 2008 shows the Nordics and CEE regions as having seen the biggest fall in investment activity (both over 80%). Risk-averse investors will continue to be cautious about markets that had seen risk premia fall well below historic norms, but which are not yet established as liquid, international real estate investment locations.
In absolute terms, we expect further increases in investment volumes in the UK market, even though, having seen significant growth in 2009, the growth rate may appear smaller in percentage terms than in some other European countries. Germany, which has seen strong growth in transactions over the last few months of 2009, could also figure as one of the fastest growing markets in 2010. Investor demand in France is undoubtedly strong, but growth in transactions is expected to be held back by the limited amount of available stock.
Markets such as Ireland and CEE, where 2009 activity has been very subdued, could easily see larger year-on-year increases in completed transactions in 2010 simply because of the low base they are starting from.
Sector trends are more complicated. In the first half of 2009, investment activity in the office sector declined most sharply, mainly as a result of the difficulty in financing large transactions and the uncertainty over the outlook for occupier demand, especially in financial services and associated business services.
The majority of large transactions in the first half of 2009 were for retail property. Not shopping centres, as might be expected, but portfolios of more specialist retail space such as high street bank branch outlets. Prominent examples include the disposal of a portfolio of 180 high street bank branches in Italy by Unicredit for €530 million; and Spanish bank BBVA completing a sale and leaseback of its Spanish real estate portfolio in September, comprising more than 900 bank branches and office buildings for €1.15 billion. In the second half of 2009, activity in the office sector picked up again. In recent months there have been a number of large office deals, including Blackstone's purchase of a share in Broadgate and the sale and leaseback of HSBC's tower and the sale of 5 Churchill Place, both in Canary Wharf, London.
Growing interest in the logistics sector has also been evident throughout the year, with increasing demand from German Open-ended Funds, who have historically avoided this sector.
The limited availability and stringent terms of debt finance (and the related fact that some lenders are still struggling to manage their existing debt books) means that, to a large extent, highly-leveraged investors and developer-traders are out of the market. At this stage of the cycle, with values having fallen steeply, we would have expected more activity from opportunistic "vulture funds" and value-add players looking to acquire sites or income management opportunities - but the combination of the limited number of vendors and uncertainty over the short-term economic outlook have restricted their scope.
As a result, the European real estate investment market is being dominated by equity buyers, mostly seeking well-let assets in core markets. German Open-ended Funds are very active and we are seeing growing activity from the Sovereign Wealth Funds. Institutional investors are also growing in importance, both directly and though indirect funds. Finally, the recovery in stock markets means that the listed property companies have switched from being net sellers to net buyers.
There is also some evidence that cross-border investors' appetite for real estate is still strong. The fact that in Central London, for example, around 80% of 2009 transactions have been to foreign buyers is a good illustration of this. It is also interesting to note that in contrast to 2006/07, when investment from outside Europe was mostly from the USA, current demand is global, with investors from all parts of the world active in the search for prime assets.
Across the sectors, capital value trends have been very highly synchronised in the downward phase of this cycle, reflecting the common drivers of reduced liquidity and increased risk aversion. The VIX index - which measures investors' expectations of future stock market volatility and is a good gauge of general investment market risk - rose to a 15-year high in November 2008 from which it has since eased, although still not back to the very low levels seen in 2006-07.
Year-on-year rates of decline in prime property values have moderated since the middle of 2009 as prime yields in some markets have begun to fall, after rising for the previous 18 months. In fact, CB Richard Ellis' measure of prime capital values (based on estimates of prime rents and yields in major markets) rose in the third quarter of 2009. As rental levels bottom in more markets across Europe and expectations of a resumption in rental growth take hold, prime yields in core markets should see further reductions across a wider range of markets next year.
However it is crucial to note that the paths of prime and secondary values are likely to remain divergent. Evidence from the UK shows prime / secondary yield spreads widening further in recent months, as prime yields have fallen sharply. With investor interest still predominantly focussed on well-let prime assets in good locations, secondary values are likely to remain weaker for longer. This is also, in part, because changing tenant preferences mean that rents on better quality buildings are likely to stabilise and then start to rise, earlier than is the case for inferior quality property.
In terms of the potential to see some positive movement in values, the UK looks likely to lead other markets as investors respond to the substantial pricing correction which has occurred, the nature and length of leases in the UK, and the current value of the pound. Indeed, this is already happening, with the CB Richard Ellis Monthly Index up by nearly 7% since July.
This is consistent with investment appetite focussing on core assets in mature markets where income security is high – attributes that the UK offers to an unparalleled extent. France is also likely to be among the early recovery markets, as it too has seen pricing correct relatively quickly.
"There is still some variation in the extent to which individual markets have repriced, but in general prime yields are showing clearer signs of levelling off. Indeed, in some highly liquid markets that have seen substantial repricing - notably London and Paris - the direction of yield movement is now downward. The rental market remains more difficult with economic conditions still weak, although even here the degree of decline seen in the third quarter is moderate by recent standards."
Nick Axford, Head of EMEA Research and Consulting, CB Richard Ellis
- Gradual recovery in occupier markets
So far, it is only really in the UK that investors have been prepared to consider property that is further up the risk spectrum. Elsewhere, more secondary property – with potential exposure to the occupier market through vacancy, lease expiries or weak tenants – has yet to see a substantial increase in demand from investors.
The extent to which investor appetite migrates up the risk spectrum depends on the speed of recovery in occupier markets, or at least the extent to which this can reasonably be anticipated by investors. The unusual nature of this downturn makes the use of historic relationships difficult, but generally the occupier market lags the economy, and the fact that rates of rental decline are easing in some places doesn't necessarily point to an immediate turnaround in occupational markets. In addition there is often a point in rent cycles where headline rents reach a floor, but any continued market weakness is reflected in high levels of tenant incentives rather than further falls in quoted headline rents.
Leasing activity in 2009 is likely to be around 30% down on 2008 levels, but will gradually recover as economic prospects improve, which we expect to see during the latter half of 2010. Most European markets should see stabilisation or slight improvement in take-up next year.
The extent to which individual markets follow this general pattern will vary widely: occupier demand for Central London offices, for example, already seems to be picking up, even ahead of the wider economy. We expect growing evidence of improvement in other core markets next year to encourage investors' appetite for riskier assets where performance is more explicitly linked to the strength of the underlying occupier market.
"Having entered the downturn earlier and more steeply than others, the UK in particular is now beginning to show signs of improvement ahead of other markets. From an occupier's perspective, there is a growing view that the market is unlikely to get much better than it is now - incentive packages and rental terms look set to tighten next year, creating less choice and a shrinking window of opportunity for occupiers."
Richard Holberton, Director, EMEA Research and Consulting, CB Richard Ellis
- Will occupiers still have the advantage in 2010?
For most of 2009, European markets have been characterised by falling rents and rising vacancy and, with landlords keen to avoid loss of income, occupiers were in a position to renegotiate lease terms in their own favour. A variety of mechanisms have been deployed by tenants looking to take advantage of market conditions. The ability to do this successfully will be reduced as tenant demand gradually recovers and values start to stabilise: occupiers' "window of opportunity" is likely to shrink over the course of 2010.
Office development pipelines have generally contracted as a number of schemes have been shelved or downscaled in response to rental declines, demand uncertainty, and lack of affordable development finance. Across the main Western European markets as a group, the overall scale of development expected over the period 2009-10 is now 5% lower than was expected at the end of 2008, and there will be a larger and more widespread reduction in supply additions in 2011. This will have the effect of constraining occupier choice in the office market, particularly for large new buildings.
"There is little evidence anywhere of new development starts taking place on a speculative basis and occupiers need to be aware of individual city pipelines to ensure they act whilst there is sufficient choice of space. Our research suggests that, from next year, we will see significant reductions in development completions across those markets that are most advanced in the development cycle, notably London and Paris, and from 2011 the rest of Europe should follow suit."
Richard Holberton, Director, EMEA Research and Consulting, CB Richard Ellis
- Impaired debt and sovereign debt
The expansion of bank lending and securitised debt markets in the middle of this decade, and the subsequent decline in values, have weakened capital structures and caused widespread breach of loan covenants.
While this has left a significant volume of debt to be managed out, the flow of distressed assets to the market has so far been less than expected. Although there are plenty of impaired debt situations where LTV covenants have been breached, banks have mostly been prepared to support these positions so long as interest on the debt is being serviced. This has been viewed as preferable to foreclosing and potentially bringing assets to the market and hence exposing negative price evidence or even depressing values further. The apparent improvement in investor sentiment is likely to act as a deterrent to sale where current owners do not need to realise value immediately, and opt to let a rising market repair the capital position.
The maturity profile of European real estate debt shows a high concentration of maturing loans in the next two years. Some of these will be difficult to refinance, not least because there are so few active lenders at present, or will result in foreclosures where the standing of the borrower is weak. This is unlikely to affect the prime market (where any assets brought to the market are likely to see healthy demand), but could have a profound impact on the secondary market. More broadly, the decisions and actions of banks towards their existing property loan books will be a key influence on the market next year.
Recent events in Dubai have served as a reminder that local aftershocks can persist for some time, and have also focussed attention on broader issues of sovereign credit risk. In markets where public finances are considered fragile (including Greece, Ireland, Hungary, Portugal and the Baltics), possible increases in the cost of debt to governments, and by extension to companies, could impair recovery.
We don't think so. While it is true that we are seeing increases in value ahead of any compelling evidence of an improvement in occupier markets, this increase is so far confined to a relatively narrow "prime" band of the property market. Equally importantly, many measures of yield and value are still in comfortable territory relative to long-run averages. For example, in a number of key markets including London, Paris and Madrid, prime office values are either below or in line with long-run averages.
This is not to say that there is no possibility of the rise in values stalling, or even reversing. For instance, a rise in inflation expectations and bond yields could be detrimental to values, as would any deterioration in investors' views on the likely strength of economic recovery. On the basis of currently available market information and trends, however, pricing does not appear inflated. Indeed, in some parts of the market, yield relativities against risk-free assets still look attractive.
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CB Richard Ellis Group, Inc. (NYSE:CBG), a Fortune 500 and S&P 500 company headquartered in Los Angeles, is the world's largest commercial real estate services firm (in terms of 2008 revenue). The Company has approximately 30,000 employees (excluding affiliates), and serves real estate owners, investors and occupiers through more than 300 offices (excluding affiliates) worldwide. CB Richard Ellis offers strategic advice and execution for property sales and leasing; corporate services; property, facilities and project management; mortgage banking; appraisal and valuation; development services; investment management; and research and consulting. CB Richard Ellis has been named a BusinessWeek 50 "best in class" company for three years in a row. Please visit our website at www.cbre.com.