Whole world of choice

UK property has performed strongly over the past few years, helped by substantial inflows of funds from a wide range of sources: institutional; private companies; wealthy individuals, and overseas buyers. This has driven yields down sharply and yield compression has been evident across all property sectors as investors have competed for the limited supply of quality stock.

The market remains robust, particularly in prime office locations where limited supply and strengthening demand has supported a return to rental growth. The weight of money “chasing” property projects has created tougher competition for real estate assets and is forcing increasing numbers of institutional investors to diversify into new sectors and areas.

A major area of fund expansion has been into Europe, where cross border property investment activity now exceeds domestic investment. Clearly, it is not just UK funds driving expansion on this scale.

The whole property fund management industry is becoming increasingly globalised and the past few years have seen several US houses unveiling pan-European property operations, continental European funds extending their interest to other nations and newer investors such as Middle Eastern buyers, Russian investors and Australian companies also entering the market.

The rationale behind this move has been a combination of trying to obtain higher total returns, diversification benefits and access to stock not available in the home country.

Initially, interest was focused on the core office markets of London, Paris and other major towns which are larger, more mature and more liquid. However, competition for stock in these locations has become too much for some investors, who are turning to more distant opportunities, either in the same countries, or going further east to central and eastern Europe – or beyond to Japan, India, China and even South Africa.

The past few years have seen a marked improvement in the knowledge and information about overseas markets. In Europe, organisations such as the Investment Property Databank and the European Association for Investors in Non-listed Real Estate Vehicles (INREV) have made great strides in providing market performance data and details of available investment vehicles.

The enlargement of the European Union and the improvements made by countries of eastern Europe in making the regulatory environments more clear, fair and consistent, and market data more accurate and comprehensive, have all contributed to the creation of a larger level playing field for European property investors.

Property funds are deepening as well as widening their exposure to real estate. They are starting to look more closely at segments such as provincial offices, for example in regional cities in France and second tier towns in the UK. In these towns, yields can be significantly higher than in the capital, and, if well located and well let, they can offer value.

We are seeing heightened interest in new product classes, such as hotels, student housing and car showrooms, and investors are generally starting to look more closely at development opportunities both in the UK and abroad.

The UK and most European property markets have delivered good returns in the past couple of years and are still set to deliver solid returns over the medium term. The excellent performance of recent years has been largely yield driven but there may be only limited scope for further yield compression.

This reflects both a less benign interest rate environment in the UK and Europe, and, in the case of certain countries, a yield level which is barely higher than the risk free rate. We believe property yields in the UK will stabilise this year and that total returns will revert to the traditional position of being largely income-driven.

As a result, Europe will continue to attract institutional property investors, especially as a greater variety of property vehicles are launched.

Many funds at present are pan-European core vehicles but this is changing. As the market expands, we expect to see more country and sector-specific funds launched, allowing greater specialisation and a wider range of investment styles being promoted.

The increased availability of property fund of fund products may also attract more investors to the area, especially smaller funds. Real estate investment trusts are launched this year in the UK, and most likely in Germany too, with Italy widely expected to join them soon.

While we do not believe REITs represent a holy grail, we agree they are generally a good way to get exposure to property, as well as a defensive and lowly-correlated asset class which is now the most popular alternative investment with asset managers seeking to diversify their portfolios and to utilise in asset liability matching models.

The past few years have witnessed a sea change in investor attitudes towards property, we expect the next few years to see interest in the asset extended further, not just in volume but in the diversity of property assets held – by country, by sector and by vehicle. ?

Paul Herrington is head of property investment at F&C Asset Management