Don’t forget Europe

The arguments for investing in UK commercial property are already well-established and widely recognised. The relatively stable returns, high income, diversification by way of lack of correlation to other asset classes, and the potential to enhance returns through good asset management are fundamental. However, by focusing solely on UK property, investors are excluding the other two-thirds of the European real estate market.

Increasingly, institutional investors are turning their attention to continental Europe, attracted by the potential for higher returns. At the heart of the European commercial property market is the fact that total returns are dominated by income. This stable and predictable cashflow is central to the attractive investment characteristics of property as an asset class. However, while similarities exist between the UK and continental markets, it is critical to be aware of the differences.

International property brings with it – among other things – differences in ownership structures, planning policies, tax regimes, levels of transparency, lease structures and measurement conventions (i.e. the lack of long-term market indices).

Of particular note is the level of transparency across Europe. There is a huge divergence of ‘opaqueness’ across continental Europe in terms of how easy it is to gain exposure. Simple things such as the availability of data in English, the robustness of regulatory and legal regimes, and even the existence of a land registry or reliable performance indices, are not prevalent across all countries. While transparency is improving, this highlights the need for specialist investment knowledge and experience when investing in European real estate.

The European market today
Europe as a real estate market, like any sector of the global investible market, goes through structural and cyclical phases. In the main, Europe is a sophisticated and well-developed market, where increased cross-border activity has greatly enhanced liquidity. Structural change across Europe includes the development of the retail warehouse market, logistics and recovery situations. It is widely accepted that the retail warehouse market in Europe is many years behind the UK, with efforts being made at present to develop this area. The logistics market is a structural development borne out of the growing European Union.

Ten years ago the European logistics market operated in a central north-south corridor from the south of France to the ports of northern Belgium. Today, however, Europe has changed considerably and the logistics market is spreading east to west, stretching right into the manufacturing and distribution markets of eastern Europe. Recovery markets also exist, mainly in Germany and in the most recent countries to have joined the EU. Indeed, while increased demand for commercial property has already been generating yield compression and capital appreciation in core areas of Europe, the less mature markets of central and eastern Europe offer new opportunities.

At present the major cyclical attraction in Europe is the upswing in the office market. The high level of rental growth in the City of London is a good example of what is happening right across continental Europe, although all of the major cities are at slightly different points of the cycle.

While as an asset class UK commercial property will always display attractive diversification benefits and currently offers relatively high potential returns, the consensus is that investors need to diversify into global property. Both structural and cyclical factors will help to boost medium and long-term total returns, while underlying characteristics will mean that investors still benefit from property exposure.

Another good year in prospect
Property markets in both the UK and continental Europe continue to offer attractive investment opportunities. Over each of the last four years, the UK commercial property market has delivered double-digit returns, and while performance is expected to moderate in 2007, it should still prove another good year for the market.

2007 should see a return of rental growth, stock picking and asset management as the key drivers of UK property performance, while the pace of yield compression and capital appreciation is likely to revert towards historic norms.

Nevertheless, at a sector level, in light of the current projections for strong rental growth in central London offices, this part of the market could see further yield compression and capital appreciation.

Overall, investors are expected to focus increasingly on the quality of individual assets, and the gap between prime and secondary property could widen. In addition, the introduction of real estate investment trusts on 1 January this year has brought further benefits, helping to boost the flow of retail money into the market. However, as institutional investors increasingly come to recognise the attractions of property investment in continental Europe, they are likely to direct further funds towards this market, both to diversify their commercial property exposure and to benefit from potentially enhanced returns.

Don Jordison is manager of the Threadneedle UK Property Trust and European Property Funds