finding value late in the cycle - lasalle investment management · 2019-03-08 · lasalle...

LaSalle Investment Management | Finding Value Late In The Cycle | 1

Finding Value Late in the CycleLASALLE’S GUIDE TO EUROPEAN REAL ESTATE INVESTING IN 2019

Feb 2019


Mounting evidence suggests that many developed economies are in the later stages of expansion, characterised by gradual global interest rate normalisation, greater volatility, and lower expected benchmark returns for nearly all asset classes.

Currently, real estate investors in many parts of the world face the challenge of whether to accept lower core returns or pursue higher-return strategies that are more dependant on continued economic growth and real estate fundamentals. If a slowdown materialises, these strategies could be derailed. Investors’ return and risk objectives should be cycle-sensitive, by over- and under-weighting different strategies depending on economic, capital market, and property market cycle stages.

In Europe, these considerations are compounded by the ongoing Brexit process – the outcome of which remains unpredictable. In this uncertain environment, our base case scenario continues to feature a long transition period leading to an eventual free trade area in goods and services, with the City of London retaining some form of financial services passporting rights with the EU. However, under the extreme scenario of a no-deal Brexit, the UK would revert to World Trade Organization (WTO) rules with the EU. This would drive up inflation due to the weak value of the pound and generate higher trade tariffs and non-tariff costs, and therefore represents the main risk to the UK property market.

Executive Summary


In Continental Europe, our assessment of the risk factors and investment opportunities in the late-cycle environment is as follows:

• Market overview: Headwinds are easing in Germany but exporters remain exposed to assertive US trade stance; both Germany and France will benefit from fiscal stimuli. Interest rates will remain very low in the Eurozone and significant normalisation of monetary policy is required before a meaningful repricing of prime real estate will happen.

• Office: Investors seeking defensive assets should focus on centrally located office submarkets, including well-connected central districts outside of the CBD, with German offices looking particularly well suited here.

• Industrial & Logistics: Rental growth strongest in France, Italy, and Spain, but muted compared to UK & US.

• Residential: Secular trend of flexible residential living is expanding in Continental Europe.

• Retail & Leisure: Headwinds in the UK moderated on the Continent and acting with a lag. But high-quality retail is becoming increasingly difficult to access, with little meaningful shopping centre development.

• Private Debt investments: Best risk-adjusted returns to be found in France, Germany, the Benelux region, the Nordics, and Spain.

In the UK, our assessment of the risk factors and investment opportunities in the late-cycle environment is as follows:

• Market overview: London will remain a top destination for international capital throughout 2019, with the devalued pound incentivising foreign investors and pricing remaining attractive relative to other major European countries and amid very low real interest rates.

• Industrial & Logistics: Industrial, particularly logistics, is currently the stand out sector in the UK, as it is in many other countries; we see opportunities in converting edge-of-town retail into logistics centres.

• Residential: PRS (Private Rented Sector) remains a long-term winner, with the profound supply-demand imbalance driving robust rental growth and the sector benefiting from stamp duty reduction and larger local planning schemes.

• Private Debt investments: Following a post-2008 record volume of CRE (Commercial Real Estate) loan origination in the UK in 2018, structured finance and special situations (whole loans, mezzanine debt, and preferred equity) will be increasingly attractive given the regulatory framework facing traditional lenders.

• Office: Supply was modest in 2018, with the exception of the City of London, where the extra space is being reduced due to strong and diverse tenant demand.

• Retail & leisure: Only the best shopping centres or high-street pitches, or pitches that can facilitate retailer omni-channelling, are likely to buck trend of broadly flat or negative rental growth and negative investor sentiment.


UKSector Overview

Sector Investment drivers & risk factors

Industrial & Logistics

• Rental increases driven by competition for land

• Multi-let industrial developments serving major urban locations offer most attractive risk-adjusted proposition

• Autonomous vehicles threaten big box motorway logistics in long term

Residential

• Supply-demand imbalance will continue to drive robust rental growth through to 2023

• PRS to remain long-term relative winner

• In London, and particularly among prime properties, prices fell in 2018 and could drop further; overstretched developers may be willing sellers

Private Debt Investments

• Total CRE loan origination volume for 2018 exceeded the £50bn from 2014-17

• Regulation of traditional lenders allows alternative lenders to provide structured finance solutions to the UK market at stringent LTV cushions

• Likely to be pricing volatility linked to Brexit

Office

• Supply being reduced in London by strong tenant demand for modernised, amenity-rich space, creating conditions for positive rental growth from 2020 onwards

• Manchester and Bristol buoyed by combination of solid demand and moderate supply, but focus should be on best locations and refurbishment opportunities

• No-deal Brexit places London economy at greater risk and diminishes demand

Retail & Leisure

• Distress evident, driven by strong online retail penetration in the UK market

• Rental growth expected to be broadly flat or negative in 2019-20; declining asset prices reflected in NAV fall in retail-exposed REITs

• Best shopping centres & high-street pitches and those facilitating retailer omni-channelling, best placed to achieve rental growth

While it may be quite rational to up-weight more resilient strategies given the rather late stage in the cycle we are in, there are also specific higher-return strategies that can outperform core, even during and following a downturn. These strategies capitalise on strong secular trends (e.g. the shift in distribution from retail to e-commerce or urban regeneration) or on overreactions to those trends (e.g., mispriced retail). In addition, some strategies can be executed quickly and exited prior to an economic shift (e.g. residential upgrades and office leasing). Ultimately, we recommend investors to calibrate their exposure to multiple investment styles based on their investment requirements and risk budgets, with core real estate providing traditional beta portfolio benefits, and higher return strategies providing positive alpha benefits where market conditions are supportive.


Market OverviewThe draft withdrawal agreement reached by the EU and UK in early November 2018, setting out the rules that will govern the negotiation of their future relationship after March 2019, has been ratified by the EU but (as of this writing) still needs to be approved by a fractious UK Parliament. Under the terms of the draft withdrawal agreement, the UK would enter a transition period whereby current EU rules will still apply to the UK, but the UK’s ability to influence EU institutions and rulemaking will be limited. During the transition period, the regulatory status quo for UK and EU businesses will be preserved. If ratified, the draft withdrawal agreement suggests a softer form of Brexit, with only modest economic decoupling between the UK and EU. However, a no-deal Brexit without any transition period cannot be ruled out.

The remarkable feature of the UK economy is that, despite Brexit uncertainty and modest economic performance (we expect 1.7% GDP growth in 2019 in our base case scenario), unemployment is at its lowest level since 1975. Similarly, the country’s Purchasing Managers’ Index has hovered moderately over 50 since the Brexit referendum in mid-2016 and indicates sustained levels of office take-up – particularly in London, which has also seen a remarkable growth in flexible office space providers over the same period. The resilience of real estate markets (particularly office and logistics) demonstrates that occupiers and investors continue to make decisions even during periods of political uncertainty. Despite the noise and political uncertainty of Brexit, property returns have remained resilient with ~6% total unleveraged returns in 2018.

There are three reasons we remain positive about the UK property sector over the next three years, and the wider economy’s resilience to a severe recession, even in the event of a no-deal Brexit:

• The Bank of England’s independent monetary policy that does not have to reverse quantitative easing or severely raise interest rates,

• An improved fiscal position that allows for “growth stimuli”,

• A labour market that remains one of the deepest, most flexible, and highly skilled in Europe, with London still attracting financial and business services, technology firms, and expanding global retailers.

London—with its deep stock, high liquidity and transparency, and deep human capital pools—will continue to be a top destination for international capital throughout 2019. The devalued pound will remain a positive factor for foreign investors and we expect core UK property values to remain resilient, thanks to attractive pricing relative to bonds and the weight of overseas capital seeking a home in the UK, while continuing to diverge from secondary values. There is also strong demand from Asian and European investors seeking larger prime assets or portfolios, operating assets, and alternative sectors with strong fundamentals.

Pricing also looks attractive relative to other major European countries. For example, prime London offices offer a 100-125 bps premium over Paris and Munich prime yields. Low interest rates, and especially very low real interest rates, will continue to make income-producing real estate look attractive. The interest rate unwinding that began in late 2017 will be slow and gradual in 2019. We believe gilt yields probably need to rise to 3.00%–3.50% (from ~1.30% in late 2018) for investors to start meaningfully repricing core real estate.

With the wider economy providing no clear boost for rents in the near future, rents will be supported by modest demand but limited supply. Sectors with resilient rental growth prospects, such as hotels, residential in DTU+E rich locations (locations that LaSalle has identified to be set to benefit from strong drivers in demographics technology, urbanisation and Environmental improvement trends), and industrials (particularly urban), are expected to fare best in 2019.

Pricing also looks attractive relative to other major European countries. For example, prime London offices offer a 100-125 bps premium over Paris and Munich prime yields.


Sector Analysis

Industrial, particularly logistics, is currently the standout sector in the UK, as it is in many other countries. Rental levels have significantly increased over the past two years due to an intense competition for land, particularly in urban locations, with e-commerce logistics competing with residential use. The new London Plan highlights the key role of logistics. It encourages colocation and intensification of logistics, residential, and other uses, yet states that there should be no net loss of industrial floorspace. Although pricing is not an immediate concern, it could become one over the next 18 months if prices continue to grow faster than rents and supply becomes a concern. For example, we are seeing decelerating rental growth and increasing vacancy in the Midlands, likely due to increased supply. We nevertheless continue to expect above-inflation rental growth, if a bit slower than experienced in 2018.

We see opportunities in converting edge-of-town retail into logistics centres, as we believe the physical footprint of retailers will partially be converted into fulfilment centres. In the logistics sector, development remains the best route to accessing good risk-adjusted returns. The speed of construction and strong demand for modern space in the best locations means multi-let industrial developments that serve major urban locations are an attractive risk-adjusted proposition. Investors should pay attention to capital values per square foot as some parts of the market may not offer value. We do not recommend straying outside of the very best locations, unless pre-lets and long leases are secured to top covenants. The threat of autonomous vehicles makes us cautious of holding traditional big box motorway logistics beyond the medium term.

Commercial real estate (CRE) lending activity in the UK remains active and healthy. The total CRE loan origination volume for 2018 exceeded the £50 billion recorded in the previous four years (but still well below the £80 billion recorded pre-GFC).

In 2019, structured finance and special situations (whole loans, mezzanine debt, and preferred equity) are going to be increasingly attractive given the regulatory framework facing traditional lenders. Alternative lenders who can offer attractively priced real estate debt solutions in the form of whole loans, stretched senior, mezzanine, or preferred equity are well placed to service the UK market and generate high-yield coupons. There may also be some pricing volatility linked to Brexit, and investors should be able to exploit any short-term fear. These structured finance strategies should ensure stringent loan-to-value cushions and selectively target good quality transitional assets or developments in DTU+E-rich locations.

The residential or private rented sector (PRS) remains a long-term relative winner despite a slowing housing market and easing demand from foreign workers. In 2018, greater London house prices recorded their first annual decline since September 2009, dropping by 2% year-on-year since 2017:Q3, with the prime end

INDUSTRIAL & LOGISTICS

RESIDENTIAL

posting steeper declines. Prices still stand at historically high levels and could fall further, given how stretched affordability is in the capital city. In 2019, we expect that active investors will be able to find good quality assets in London at a discount relative to recent prices.

Overstretched developers may be willing sellers, particularly if Brexit results in further stock market volatility. Given the profound supply-demand imbalance, the residential sector will continue to experience robust rental growth in 2019–23, as it is both filling a housing gap and creating a new living experience with enhanced amenities and more services, better community spaces, and longer guaranteed lease tenures. The sector may also benefit from a more positive government stance (stamp duty reduction) and local planning (bigger schemes).

PRIVATE DEBT INVESTMENTS

Office supply was modest in 2018, with the exception of the City of London, where the extra space is being reduced due to strong and diverse tenant demand. The type of space actively taken up is new or modermised, significantly more efficient, and has plenty of amenities.

OFFICE


Distress is evident in the retail and leisure sectors in the UK. Retailers are facing strong headwinds as online retail penetration in the UK is one of the highest in the developed world. But e-commerce is not the only factor at play. With the exception of the best shopping centres or high street pitches, or pitches that can facilitate retailer omni-channelling, rental growth is expected to be broadly flat or negative in 2019–20 as creating tension between prospective tenants is very limited. Public real estate is aggressively pricing-in significant potential income losses: large cap REITs with significant retail exposure in their portfolios are trading at deep discounts (-28%) to net asset values (NAVs), whereas industrial REITs and specialty REITs (such as self-storage and student housing) traded at a 3% discount and 2% premium, respectively, versus LaSalle Securities NAVs (on February 18, 2018). In 2019, we expect prime and secondary retail yield spreads to widen further in the UK, while secondary retail will continue to struggle. The speed and steepness of the distress has confounded many market participants. We believe that some segments may drop in value, which could create investment opportunities, as even operationally superior prime retail will also find it hard to justify high valuations with low yields in the current investment environment.

RETAIL AND LEISUREIt is ideal for modern, agile office workers and flexible office operators. As an illustration, London is viewed as a global fintech hub, with established players and start-ups attracted by its favourable regulatory framework, strong capital markets, and talented workforce. The fintech sector is expected to grow by 30% and to surpass 100,000 employees by 2030. As these firms grow, they will probably move out of flexible space to take traditional leases. Looking ahead, we expect positive rental growth in London from 2020 onwards.

We believe that the Brexit transition will be long, but the City of London should retain some form of passporting or equivalence rights. This, combined with limited office supply in part of central London, could make value-add an appealing option. For enhanced returns, we particularly like central London properties that can be adapted to meet the rapidly changing occupier market. The office markets of Manchester and Bristol are proving strong through a combination of solid demand and moderate supply, but investors should focus on the best locations only. Investors should also look for potential opportunities in obsolete offices that can be refurbished (in central locations) or repurposed (in trendy locations), for example, into coworking space.


Sector Investment drivers & risk factors

Office• Low vacancy rates and strong demand offer strong rental growth and superior returns

• Central office submarkets in cities like Paris, Munich, Copenhagen-Malmö, Amsterdam, Madrid, Hamburg, Berlin, and Frankfurt looking attractive

Industrial & Logistics

• Changing retail patterns and consumption growth facilitated by e-commerce and nearshoring driving strong logistics demand

• Rental growth previously limited to German submarkets but, going forward, prospects are strongest in France, Italy, and Spain

Residential• Secular trend of flexible residential living is expanding in Continental Europe

• Exhibit resilience to macro volatility

Retail & Leisure

• Headwinds affecting UK less pronounced and operating with a lag

• Dominant urban centres offering affordable, flexible, and accessible retail space and potential for future-proofing are most attractive

Private Debt investments

• Supply of credit very strong; narrower lender universe in the value-add space

• Best risk-adjusted returns found in France, Germany, Benelux, Nordics, & Spain

• Maturing capital market cycle necessitates adjustment in risk allocations

Continental EuropeRisk investment sliding scale


Market OverviewThe Eurozone’s growth momentum is expected to remain robust in 2019, after reaching 1.8% in 2018 - a respectable level given the low population growth rate of the EU – despite headwinds including slower global growth, trade tensions, and Italian political instability as the year came to a close. Real estate fundamentals responded positively to this stable economic environment, with offices and industrials experiencing low to very low vacancy rates and rents growing. In addition, the unemployment rate in the Eurozone reached its lowest level since December 2008, at 8.1% in October 2018, with wage growth expected to pick up modestly in 2019 as a result. Growth forecasts for 2019 stand at a modest 1.9%, enough to support job growth and tenant demand in the region.

Across the Eurozone’s largest individual economies, we forecast that:

• In Germany, with the headwinds of slowing global trade, lingering uncertainty, and regulatory changes in the automotive sector easing, the economy is well equipped to weather any macro shocks, underpinned by a strong labour market, fiscal easing (one of the few developed economies that can afford this), and steady expansion in the construction sector. Overall, GDP growth could still average 1.5% p.a. in 2020–21. However, the country’s large and competitive industrial sector is exposed to the impact of slowing global trade and rising protectionism: a 25% tariff on German car exports to the US would lead to a 0.2% p.a.

GDP reduction by the end of 2021.

• In France, concerns about the more assertive trade stance taken by the US have led to a significant fall in new export orders, but the structural reforms implemented by President Emmanuel Macron’s government, along with a modest fiscal stimulus in the form of reduced employer social security contributions, should help lift growth in both the short and long term.

• In Italy, the government’s plan to loosen fiscal policy risks pushing Italian bond yields to unsustainable levels. Warnings about Italy’s budget deficit have started to weigh on Italian banks and the yields of fragile economies across the eurozone. Forced by market and EU pressures, we expect the Italian cabinet to adopt a more conservative stance and keep the budget deficit close to 2% of GDP to contain the increase in Italian spreads.

The relatively weak inflation outlook in the eurozone means that the European Central Bank will continue to be wary about withdrawing monetary support. We therefore anticipate that interest rates will slowly climb over the coming years, with no rate hikes before the second half of 2019. Our outlook includes slightly rising rates from the second half of 2019 to 2020 onwards, which should reflect the beginning of a normalisation in monetary policy conditions. Bund yields probably need to rise to c.a. 2.50% before investors start meaningfully repricing prime real estate. In our view, prime real estate yields should stabilise in 2019–20 and expand marginally in the medium term.


Investors seeking defensive assets in this mature part of the capital market cycle should focus on centrally located office submarkets, including well-connected central districts outside of the CBD that benefit from lower rental values, in cities like Paris, Munich, Copenhagen-Malmö, Amsterdam, Madrid, Hamburg, Berlin, and Frankfurt – with German offices looking particularly strong. The combination of a lack of quality space (the Europe-wide vacancy rate fell below 5.5% in Q3 2018) and strong demand offers rental growth and superior returns. This opportunity set includes forward-funding or refurbishing traditional offices, as well as coworking space in Munich, Hamburg, Berlin, and Paris.

Our forecasts for office rents have two phases: a long phase over the next 18 to 24 months and then a sharp slowdown (albeit remaining in positive territory).

Sector Analysis

OFFICE

Prime high street rents are expected to record solid growth despite ongoing structural e-commerce changes. The headwinds at play in the UK apply on the Continent too, but only to an extent and with a lag. As in the UK, dominant urban schemes will outperform and secondary will underperform.

High-quality retail is becoming increasingly difficult to access, with little meaningful shopping centre development in the region. Medium-to-large urban or dominant shopping destinations (particularly in France, Spain, and Poland) are currently being repriced; those that offer affordable, flexible, and accessible retail space and a clear potential to be future-proofed are attractive investment propositions.

RETAIL AND LEISURE

The industrial/logistics sector in the region has thrived over the past decade, with a structural component largely driven by the rise of e-commerce and a cyclical component driven by the more recent economic and industrial recovery. Changing retail patterns and consumption growth facilitated by e-commerce and nearshoring (pulling production back to Europe from Southeast Asia) are the primary drivers of strong logistics demand.

Until recently, logistics rental growth was limited to a small number of submarkets in Germany. Going forward, rental growth prospects are strongest for France, Italy, and Spain and are expected to exceed historic norms, even if they remain muted compared to the logistics markets in the U.S. and UK In 2019, income returns will be robust and will help drive investment performance over the next two to three years. The overall vacancy rate for logistics is at all-time lows in a number of markets (e.g., 4.4%) . At the same time, new supply is mostly coming in the form of pre-leasing, which means that for the moment the risk of oversupply is limited.

The secular trend of flexible residential living is expanding in Continental Europe. We favour quality lifestyle-related residential concepts that include micro apartments, aparthotels, and student housing in Paris, Munich, Hamburg, Berlin, Amsterdam, Milan, and Madrid. These sectors are less sensitive to macro volatility.

RESIDENTIAL

Ten years after the global financial crisis, key Continental European CRE loan markets, such as France and Germany, show highly competitive levels of loan offerings to finance a variety of risk profiles. Banks are adhering to strict risk covenants and average senior LTV levels have

PRIVATE DEBT INVESTMENTS

INDUSTRIAL & LOGISTICS


ContactsMahdi MokraneHead of European StrategyLondon+44 (0)20 7852 4605 [email protected]

Chris PsarasAssociate StrategistLondon+44 (0)20 7852 [email protected]

Rene HoepfnerSenior Managing Director, Client Executive Client Capital Group – DACH region +49 160 [email protected]

Simon MarxInvestment Strategist, UKLondon+44 207 852 [email protected]

Anne Lucking Senior Managing Director, Client Executive Client Capital Group - UK+44 (0)7774 079 315 [email protected]

Samer HoneinSenior Managing Director, Client Executive Client Capital Group – France +33 (0)1 56 43 18 [email protected]

This document does not constitute an offer to sell, or the solicitation of an offer to buy, and is subject to correction, completion and amendment without notice. This document has been prepared without regard to the specific investment objectives, financial situation or particular needs of recipients. No legal or tax advice is provided. Recipients should independently evaluate specific investments. By accepting receipt of this publication, the recipient agrees not to distribute, offer or sell this publication or copies of it and agrees not to make use of the publication other than for its own general information purposes.

The views expressed in this document represent the opinions of the persons responsible for it as at its date and should not be construed as guarantees of performance with respect to any investment. Any target returns, and performance forecasts are based on assumptions about future events and LaSalle makes no guarantee that the target return will be achieved by the investment opportunity. Past performance is not indicative of future performance.

Copyright © LaSalle Investment Management 2019. All rights reserved. No part of this document may be reproduced by any means, whether graphically, electronically, mechanically or otherwise howsoever, including without limitation photocopying and recording on magnetic tape, or included in any information store and/or retrieval system without prior written permission of LaSalle Investment Management.

only modestly crept up. There is generally good liquidity across almost all asset classes and risk profiles, and we are seeing a continued growth of debt funds and the re-emergence of the CMBS market. It is in the value-add space that the lender universe tends to narrow to a handful of players in the region.

We believe the best risk-adjusted returns in Continental Europe are to be found in France, Germany, the Benelux region, the Nordics, and Spain. In a stable but modest growth environment and given Brexit risks, we do not believe it pays to dive into the riskiest parts of the real estate market at this point; and we would avoid high-yielding secondary locations, DTU+E- poor locations, or non-dominant discretionary retail. We think it is an opportune time to begin steadily adjusting risk allocations to a maturing capital market cycle, while taking careful stock-specific risks in DTU+E-rich locations and continuing to reap the benefits of today’s strong fundamentals in many continental European markets.


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finding value late in the cycle - lasalle investment management · 2019-03-08 · lasalle...

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