The Capital Insights debate: Real estate M&A and capital management

Key insights

  • Yields in real estate are outstripping other assets, such as government bonds, giving a boost to the industry.
  • A robust equity position is vital for investors in the current market.
  • Investors shifting from core assets to riskier propositions as the market improves will help drive the sector.
  • Companies will need to diversify their financing as banks retrench.
  • As with most other sectors, the digital world will have a profound effect on real estate.

M&A and corporate confidence in the real estate sector is on the rise — but challenges lie ahead. EY’s Ad Buisman and Christian Schulz-Wulkow discuss the state of the market with five of the industry’s leading figures

Although uneven economic performance across Europe is painting a complex picture of the industry, real estate M&A in the continent is picking up. In the first three quarters of 2013, it increased to US$63.4b compared with US$54.6b in the same period last year, according to Mergermarket. In addition, confidence in the sector is building. Respondents in EY’s European real estate assets investment trend indicator 2014, which surveyed more than 500 investors across Europe, felt that transaction volumes were set to increase in 2014 and that European countries were viewed as attractive investment destinations.

However, these optimistic figures are tempered with caution. Obstacles such as low growth and continuing instability in the Eurozone still need to be overcome.

AB: EY’s research suggests confidence is building in the real estate sector. Is this justified?

JB: I think the optimism is generally justified. Interest rates have remained at historically lower levels than was ever expected and look set to continue in this vein. Real estate offers better returns than bonds, and so the industry is in a good position to do deals. Here in Germany, we saw an increase in real estate deal value over the previous year. And you’re seeing property values rise in some of Europe’s major cities, such as London. There is a lot of money looking for investment in the sector.

AK: I agree that it’s growing, but I’d argue it’s more a case of cautious optimism and that it varies according to region. In the UK, as each set of quarterly statistics comes out, there are positive attributes. However, in Spain, for example, the sentiment is different. This divergence is quite normal and you have to put it into context: it’s less than two years since Mario Draghi made his statement [to do whatever it takes to support the single currency], and that was a game changer in Europe.

The general consensus is that there won’t be a major bounce, but that growth will be steady and slow. Interest rates look set to remain low for some time yet, and there is a degree of stability in Europe. That helps with business decision-making after a highly volatile period.

OP: I’d agree with both points. But, like Anne, my feeling is more middle of the road. You have two competing forces at work. One is that you still have low or no growth in many European countries and, as a result, you are seeing some weakness in commercial asset rents. This is only just starting to show through because of the long-term nature of leases. That’s why I can’t be an optimist.

Yet what drives me to the middle is that there seems to be an almost infinite amount of capital to invest in real estate. Institutional investors, insurance companies and sovereign wealth funds are all coming to Europe in much the same way as Japanese investors came 25 years ago. This means that, while rents are softening, prices are stabilizing. Some might say the amount of capital going into the market is dangerous. But I’d argue that there is a strong rationale behind it. As Jan said, the low-interest environment means that investors can get yields on government bonds of around 2%, while investment in sound assets like real estate can yield around 5%. The gap between the two is the highest it’s ever been. In addition, real estate provides a hedge against interest rate rises in a way that bonds do not, because rents are usually indexed against inflation.

CC: The real estate market remains attractive. This is especially so for investors because, as the others have mentioned, interest rates remain low and yields are high. There are many opportunities in the real estate market. We at Unibail-Rodamco focus on a specific segment of the market — prime shopping centers in the best European locations and offices in Paris’s Central Business District and La Défense. Even though the current business climate lacks the dynamism we’d like to see, we believe there is still much value to be created in our sector.

CSW: What main challenges does the real estate sector face?

PK: The main challenge in Europe is that the process of deleveraging has not yet been completed satisfactorily. In contrast, debt markets in the US and Asia are functioning better, with higher loan-to-value ratios. The other challenge is the low-growth environment, where there is a polarization between different types of assets. The prime market is best positioned, while in secondary markets, you really have to question whether there is a future for many of the assets built during the boom. This polarization is present in retail — with shopping centers — but also in office space. The challenge for investors is how you run your portfolio and ensure that you make the right selections. Investors are now strengthening their focus on income. Capital growth is important, but income is much more so now.

JB: Yes, I agree that selection is vital in today’s market. Most investors want core real estate. But this is limited, so prices are rising. To be successful, investors need good networks and quick decision-making processes — and they must be able to put money on the table quickly. Those with a good equity position are well placed in this market.

OP: Like Patrick, I think that one of the main risks in the market in Europe is that the economy remains in low-growth mode. As a result, vacancy rates are rising. If we see another two or three years of low growth, higher vacancy rates will soften rents and returns will fall. However, what mitigates this is that most of the assets acquired today are with equity. Investors now have limited appetite for debt. A fall in rents would therefore not be so dramatic, unlike in the past, when leverage was much higher.

CC: The economic turmoil is still impacting the companies’ strategies. Performing retailers are becoming more selective and are looking for outstanding locations with high footfall and large, wealthy catchment areas.

Our main challenge is to stay ahead of the pack, as being a market leader is not a guaranteed position. Among the other issues, the internet is probably the most well known. However, we see this as an opportunity.

The assets that will continue to outperform the market are those that offer a differentiating customer experience, and the internet is an incredible tool that helps you achieve this. It’s a means of communicating directly with our customers and, more importantly, it enables us to understand how to go even further in satisfying the customer.

Lastly, office assets face more difficult times. However, there is still room for well-located, well-connected, user-centric offices. The recent letting of the So Ouest offices tower in Paris to SAP definitely proves this.


AB: What will be the main drivers of real estate investment in 2014?

PK: Our focus will continue to be on areas with strong employment growth that have a healthy demographic outlook. Globally, there is gravitation toward larger urban areas. This is more pronounced in the emerging markets, but it is also happening in more developed markets, where economic activity is centered increasingly on growth cities, such as London. We have invested in these cities over the last few years and will continue to do so. However, we are also starting to look again at southern European markets, because in some of the prime markets, we have found ourselves outpriced by, for example, investors from the Middle East and parts of Asia. We already have exposure in southern Europe, so we will be looking to build on that and optimize what we have in our portfolio.

AK: Every investor we speak to around the world is looking for stable, secure cash flows. Since the financial crisis, there has been significant demand for core assets. But as we start to see tentative signs of recovery, investors are becoming more prepared to move up the risk curve — although with the risk-reward ratio strongly in mind. We’re starting to see more interest in core-plus and value-add investing, something we haven’t seen for the last two to three years. That’s a shift that I think will continue.

OP: One change may be that investors ask whether we are at the bottom in the countries that were most hit by the crisis, such as Spain and Ireland. While we may not yet be seeing signs of growth, some more opportunistic investors may see the coming months as time to reposition themselves to invest there. In the prime markets, investors will only make 5% if the assets are unlevered, or up to 7% if they use debt — and that’s over time. Many are happy with this. But others have raised capital under a different mandate, so I think you’ll see people start to reinvent markets such as Ireland and Spain. However, at Allianz Real Estate, we remain cautious about them. Until we start to see signs of recovery, we may lend there, rather than take more risky equity positions.

Top three completed European real estate completed M&A deals, 2013
 Completion Target Buyer Deal value
Nov 2013 GSW Immobilien (Germany) Deutsche Wohnen (Germany) US$5.2b
Jul 2013  Silic (France) ICADE (France) US$3.3b
May 2013 GBWAG Bayerische Wohnungs-Aktiengesellschaft (Germany)* PATRIZIA Immobilien-led consortium (Germany) US$3.2b
Source: Mergermarket     *91.2% stake           

CSW: Leverage has been mentioned a few times now. So how will the debt finance market for real estate develop over the next 12 months?

JB: Much has changed since the crisis. Investors have a lot of equity now, and some aren’t even using debt because they want to invest their equity. At the same time, banks are acting more like investors now. They want to lend on core assets and don’t want to take risks. We are looking to lend against real estate with stable cash flows and in good locations. It is harder to lend against value-add, opportunistic investments or on assets that are not centrally located. There are new developments, though. We have seen an increase in the amount that single banks are willing to underwrite — up to €500m (US$680m) in a few recent cases, although the assets have to be right.

On the horizon, we see that finance will be affected by increasing regulation. The European Central Bank is examining European banks at the moment and applying stress tests. We don’t know what the outcome will be. We know it will look at shipping and real estate books.

By the end of 2014, we’ll know the results of the stress tests and how that might affect banks’ equity requirements. Until then, we may see only moderate lending by banks.

In addition, we are seeing competition in the debt market from insurance companies and debt funds. The insurers are tending to lend on higher-profile assets — core and big transactions. But increasingly, we will see smaller insurers enter the market and finance smaller transactions.

AK: We are moving toward a better functioning debt market. There is more competition for senior debt and mezzanine provision, although the general trend is for investors to seek less debt than before the crisis. At the peak of the market, 90% loan-to-value was not unusual on prime locations; now, it’s more like 60%, although you might not see that on secondary locations.

As Jan says, there is a shift in the providers of debt and you’ll continue to see that happen. For example, we’ve moved more into the debt space because we could see a long-term opportunity to diversify fixed-income portfolios.

OP: We are also looking to grow our debt position in Europe. But there is increasing competition, and margins are dropping to below 200 basis points in some cases. We take the view that we are not a bank and so, while we’d like to grow our debt business, we are under no pressure to do so. Two years ago, we’d planned to get to around the €5b (US$6.8b) mark. And we are reviewing our objectives in accordance with the market opportunities.

CC: Companies will need to diversify their funding sources as banks appear to be retrenching. Banks are constrained in their ability to extend credit across Europe as they did before the crisis. Alternative capital sources, such as insurance firms, have emerged, but there is a large role for the capital markets, too. They will increasingly become a source of funding for those that have not yet done so. However, the cost of these resources will eventually depend on credit quality, including asset and management quality.

AB: What does the future hold for real estate?

PK: In the short term, we’ll see investors looking to more complex deals as they face a lack of available prime locations. We’ll see more take-privates and restructuring-type deals. In the long term, we’ll continue to see the shifts stemming from e-commerce and new ways of working. Retail spaces will continue to be driven by the need to attract customers through, for example, the provision of leisure alongside shopping, as well as good transport links. Outlet centers will continue to have a strong position because of their unique offerings, and new logistics centers will be attractive as more people order over the internet.

AK: The digital world is having a profound effect on the sector. It is affecting occupier bases and locations. Take the technology, media and telecoms (TMT) industry as an example. There is a talent war that makes businesses ask where their people want to be and what kind of office space they want to be in. An office space designed for the finance sector will not necessarily fit the TMT sector. On the investment side, the future for real estate is bright. There is a greater appreciation of real estate as an asset class that provides stable income in a balanced portfolio.

In addition, the role of policy-makers will be very important — we need better decision-making across Europe. For example, the price and provision of housing is an issue in many areas and we need good leadership on developing cities. We’ve seen this in some places, such as Manchester and some regions of Germany. The industry could be far more proactive in helping to form the right policies.

OP: The sector will have to be smart about how it makes supply and demand work. One of the most interesting developments over recent years has been the recognition among many in the sector that good real estate can transform the way people live, consume and operate. The most successful investments will draw on that insight.

At the table

Jan Bettink (JB)

CEO of Berlin Hyp; President of German Mortgage Banks

Christophe Cuvillier (CC)

CEO and Chairman of the Management Board, Unibail-Rodamco

Patrick Kanters (PK)

Managing Director Global Real Estate and Infrastructure, APG

Anne Kavanagh (AK)

Global Head of Asset Management and Transactions, AXA Real Estate

Olivier Piani (OP)

CEO, Allianz Real Estate

Ad Buisman (AB)

Partner, Real Estate Services at EY Netherlands

Christian Schulz-Wulkow (CSW)

Partner, Real Estate Services at EY Germany

For further insight, please email editor@capitalinsights.info