Investing in European real estate: Opportunities and strategies

SENTIMENT towards European real estate remains upbeat and is further supported by the favourable macroeconomic outlook.

Given the recent turbulence in the global equity markets, investors are increasingly seeking comfort and stability in traditional bricks and mortar. However, many investors find themselves at a crossroads. They are already adequately exposed to their domestic market, but may be reluctant to venture further afield to other regions. Property investors can be forgiven for passing up the skyrocketing Hong Kong market and some pundits have declared the Australian party to be over.

So where does that leave investors? Instead of contemplating a European vacation, why not consider the European property market? The region's real estate market is expected to deliver both attractive rental and capital growth in the coming years.

ECONOMIC BACKDROP

Until recently, Asian investors have tended to overlook Europe. However, the macroeconomic environment for European property remains rather favourable. The overall economic recovery has continued to strengthen and the lingering political risks that characterised much of 2017 have now dissipated. Newly elected centrist parties in the Netherlands and France, may even lead to continued economic reforms.

It is important to note that the eurozone had its strongest growth in the last 10 years at 2.4 per cent in the past calendar year and is expected to accelerate to 2.6 per cent in 2018. The European Central Bank will likely refrain from raising interest rates in 2018 as core inflation remains tame at 1 per cent.

This vigorous economic growth coupled with an upswing in the labour market, has resulted in a boost for the region's real estate market. Unemployment in the eurozone continues to decline and this trend is expected to accelerate in 2018. In particular, Germany and the Netherlands are undergoing a categorical pick-up of economic growth, while Ireland and Spain continue to show similar signs of strength.

At this juncture it is important to point out that there is a distinct disequilibrium between supply and demand in Europe. The aftermath of the global financial crisis and the lingering effects of the European debt crisis has resulted in the fact that completion levels of new property space is likely to stay low for the foreseeable future.

Concurrently the continuing economic recovery is expected to lead to a demand overhang in rental markets. Declining vacancy rates in most office rental markets across Europe continues to persist. This has the additional knock-on effect that as supply becomes more limited, landlords will be in a position to negotiate higher rents.

WHY NOW?

Structural trends and social themes have gained importance in the context of Europe and provide yet another dimension to the opportunity set.

In contrast to the past, the focus of occupants and investors is the design of flexible work space that older office spaces cannot provide.

HOW TO PLAY IT

The choice of investment style is a key determinant for any real estate investment. Depending on their risk/return characteristics, real estate investments can be divided into core, core- plus, value-added and opportunistic.

Core represents properties in good locations and have a high standard of quality, alongside existing leases. As such, returns are mainly generated by the rental income component. The core-plus strategy deviates from traditional core in that properties are less centrally located and typically hold shorter-term leases.

Both income and value enhancement play a role in the value-added approach. In other words, value is enhanced through renovations, the negotiation of new leases and non-speculative project developments. The debt portion is also typically higher for value-add as loan to value ratios range between 40 per cent and 60 per cent. Lastly, opportunistic strategies have an even higher risk profile and contain a highly speculative element with loan to value ratios above 70 per cent.

CONSIDERATIONS & RISKS

Steeper and faster than anticipated pace of the ECB tightening combined with a softening in the economic momentum could undermine the growth prospects for the European property markets. Although numerous political hurdles were surmounted in 2017, the existence of further risks related to the EU exit negotiations with the UK as well as the Italian elections could have the potential to dampen the economic pace.

European real estate as an asset class provides a powerful value proposition when compared to other regional markets and can serve as a complement to a domestic portfolio. Investors seeking higher returns may wish to seek exposure to value-added strategies. A pan-European approach also benefits from the rental cycle differences between countries and sectors, thus creating another means of diversification.