If diversification of asset classes is seen as an antidote to economic crises, then real estate may be an important part of the cure. Amid speculation about possible effects of the global credit squeeze on property investment levels and the pain (for some) of dramatic market price corrections, experts believe the financial markets turmoil may make way for new crossborder investment opportunities in some markets and the best yields for more than a decade.
Michael Haddock, head of European research at real estate consultancy CB Richard Ellis, does not believe the current financial downturn will lead to a decrease in cross-border investment in property. “Three or four years ago, higher returns abroad were driving investors to look outside their markets,” he says. But more recently, the motivation has been to achieve a more mixed investment portfolio as global equity markets become increasingly correlated.
“When Japan goes down in the morning, London goes down in the afternoon and New York goes down overnight,” he says.
Genuine diversification of returns means assorted asset classes, and real estate – at least on a global level – offer some good opportunities for diversification.
The destabilising effects of the US subprime mortgage crisis prompted a slowdown of 12.5% in commercial real estate trading volumes worldwide in the second half of 2007, according to research by Cushman & Wakefield. But despite the slowdown, a combination of momentum from the first half of the year, a weakening dollar and contributions from emerging economies meant that trading volumes for the year finished at a record high of $930bn – an increase of 29% on 2006. The global total for 2008 is expected to be about $770bn – a fall of 17% – because debt markets are still frozen and sentiment about commercial property is uncertain in many global markets.
Foreign investment activity in the commercial property market grew 54% in 2007, driving commercial real estate growth, accounting for 34% of total global investment compared with 29% in 2006. The pace of foreign investment growth was slowest in Europe, reflecting its slowest overall turnover rate globally – but, at 36%, money from abroad was still a significant driver for its trading activity.
The breadth and disparity of European markets meant that some regions have been affected more than others by the credit crunch. Parts of central and eastern Europe have so far remained immune to the effects of the global crisis whereas the UK commercial property market has, by far, been the worst hit. Dramatic UK commercial property price corrections of 15% to 20% in some UK regions in the past four months have prompted panic selling in some quarters.
The UK market was in good shape when London’s mayor hailed the iconic Shard of Glass skyscraper development over London Bridge as the city’s own Empire State Building. One year on, and UK property tycoon Simon Halabi is withdrawing his £10.5m ($20.5m) backing from the £1.4bn project, selling his one-third stake to Qatari funds fronted by QInvest, a Doha-based Islamic bank formed last year with Gulf Finance House backing.
And in January, one of Britain’s biggest property funds, Scottish Equitable, froze its £2bn property fund for up to 12 months, with deferment payments to deter panicky investors from divesting their interests.
“The correction in the UK’s commercial property market was only expedited by the credit crunch and had already been anticipated,” says Jones Lang LaSalle UK director of research Paul Guest. “The big difference from prior commercial property price corrections is its accelerated speed because it took 20 months in 1991 to achieve the same kind of correction we have seen over the past four months.”
In some ways, a quick correction is a good thing because it brings values down and sends yields up to create buying opportunities for foreign investors, especially in city offices and retail. In January, Australian property group Valad launched a £500m opportunity fund to buy into the distressed UK property market, for example. It is the firm’s first UK fund and follows a £940m acquisition of UK property companies Scarborough and Teesland. Others may well follow suit, especially as the price correction is not over yet, according to Mr Guest, who believes prices will continue to fall for at least another quarter.
That is good news for investors who found the UK overpriced in the past couple of years, with yield compression driving returns to unsustainable levels. If there is any further significant fall in the capital value of real estate, the UK may start to look attractive again.
Mainland Europe does not seem to be suffering quite as much. Price corrections in western Europe, where the market is most comparable to that in the UK, have been the sharpest.
Foreign investors are the dominant players in Europe, accounting for 55% of the $349bn market. Although European foreign investment into commercial property was the weakest globally, the priority is to avoid a downturn – and so far there is no sign of one.
In western Europe, the credit crunch impact on investment is likely to continue into the first half of this year. But, despite a likely fall in activity, equity-rich investors, such as the German open-ended funds and sovereign wealth funds, are expected to support market activity throughout the coming year.
While more mature markets may be suffering the effects of more cautious investors, the emerging markets of Asia and Latin America beam a ray of hope to real estate speculators with the mettle – not to mention the liquidity – to continue investing.
Attention on Asia
Cushman & Wakefield predicts that emerging markets will increase their global share of investment turnover from 7.3% to 12% this year. Indeed, many savvy investors are turning their attentions east towards Asia’s rapidly growing economies, which seem much less affected by the global credit crunch at present.
“In the short term, there seems to be less damage in Asia by what is happening in capital markets than in Europe and the long-term economic prognosis for the region is phenomenal,” says PricewaterhouseCoopers UK real estate industry leader John Forbes.
Foreign investment into the Asian real estate market increased 87% in 2007 to almost $73bn, partly driven by major global funds increasing their investment allocations to the region. Although the market value is relatively small compared with the more mature global markets of the US and western Europe, Asia is drawing foreign capital to its rapid growth in countries such as China. More mature Asian markets, such as Singapore, Malaysia, Hong Kong, Japan and some Australian office markets, have also attracted a lot of attention in the past couple of years as they are going through a cyclical economic upswing.
According to the Urban Land Institute, Shanghai, Singapore and Tokyo ranked the three most promising Asia-Pacific cities for real estate investment prospects. Eight of the world’s 10 tallest buildings are in Asia, and Shanghai will have yet another mammoth real estate project added to its ever-expanding skyline in mid-2008: the World Financial Centre’s 101-storey tower will eclipse the current highest contender, Jin Mao Tower, by 23 floors. Shanghai’s rapid growth demonstrates a level of urbanisation that is replicated all over the continent, not least as Bejing prepares for the 2008 Olympics.
“The Asian market has seen foreign investors becoming more cautious since the credit crunch because commercial real estate is a relatively capital-intense asset class,” says property consultancy Vigers’ Asia-Pacific executive director Raymond Ho. “But well-capitalised investors are still in a better position to snap up assets in Asia, which remain a shrewd investment.”
Latin America on the rise
Asia is not the only emerging economy proving attractive to foreign investors. Latin America had a stunning 136% increase in foreign investment levels in 2007, which begs the question: can such growth be maintained as less global financing becomes available?
On the surface, low vacancy rates in the continent’s biggest cities, including São Paulo, Mexico City and Buenos Aires, and huge flows of foreign investment make the Latin American market look buoyant. However, financing conditions for commercial real estate have become much tougher since mid-2007, when the subprime crisis began in the US.
“The first six months of last year were characterised by euphoria with a long line of foreign investors searching for opportunities, but investors have become more conservative following the subprime crisis,” says Danilo Monteiro, head of investment at CB Richard Ellis in Brazil.
Before 2006, interest rates of 30% to 40% meant that construction in Brazil could not be leveraged, creating a market in which investment in office space in São Paulo, for example, was only $200m to $400m a year with no foreign investment.
A significant interest rate drop in 2006 resulted in investment rising sharply to $1bn with 30% of funding originating from foreign investment. And last year, $800m was invested in the sector, 52% of which was from foreign investors.
In the case of Mexico, a retail real estate development boom during the past five years is continuing with about 17 new shopping malls under construction. Ricardo Rosette, vice-president of retail at CB Richard Ellis in Mexico, says that US and European investors have been strongly backing the retail development. “However, a recession in the US could have a big impact on Mexico’s economy, because 70% of its exports go to the US,” he says.
North American fallout
In North America, sales of US office property fell 42% to $26.5bn in the final quarter of 2007 compared with the same quarter the previous year, according to real estate data company Real Capital Analytics. Sales of property portfolios fell to $5bn, after achieving an all-time high of $105bn in the first three quarters, when the credit squeeze hit commercial mortgage-backed securities and made borrowing more expensive in late 2007.
With only just over 10% of market activity in North America originating from abroad (despite growing from 8% in 2006), the continent can be characterised as a domestic buyer’s market. But a combination of a weakening dollar and the credit market turmoil may drive a key change in the investor profile of 2008.
“We’re currently in a situation of dislocation in terms of pricing as a result of what is happening in the credit market,” says David Harris of Lehman Brothers’ REIT research team member. “There is a general air of caution among investors but, assuming the credit markets don’t materially decline from here, I think it’s quite probable that we may see an increase in foreign investment.”
Despite proportionally higher levels of domestic investment in North America, the US still attracts more global property investors than any other country destination, with China rapidly catching up. And analysts say commercial property is not expected to suffer the same slump as housing because there have not been such high levels of overbuilding. However, a US recession would put commercial property at risk as demand for space is intrinsically linked to the state of the economy. A survey by the Association of Foreign Investors in Real Estate placed New York and Washington, DC, top of the list of preferred global cities for inward investment in the property market.
The survey found that foreigners are finding it easier to invest in US commercial property than it has been for years because the credit crisis has eliminated a tranche of buyers who relied on cheap debt to finance property deals.
New York real-estate mogul Harry Macklowe struggled to refinance a $5.8bn debt on a highly leveraged $7bn Manhattan real estate transaction made in early 2007 and will hand over control of the seven Manhattan office buildings he acquired less than a year ago to lender Deutche Bank.
On a national level, commercial property trading volumes in the US rose by almost 50% in 2007 despite the gradual slowdown starting in the autumn following the credit crunch, which destabilised the market with a lack of financing impacting on pricing and liquidity.
Nevertheless, Cushman & Wakefield’s global outlook predicts the North American market will suffer a credit crunch hangover in early 2008, picking up again throughout the rest of the year.
Whatever the long-term outcomes of the current capital markets crisis, the lesson learned is that a big market shock yet again drives home the benefits of diversification. “Real estate is not entirely protected from capital markets but people see it as a good diversifier and as providing good income yield,” says Jones Lang LaSalle director of capital markets Julian Stocks.
At about 5.5%, yields in the City of London, for example, are the highest they have been for a while after moving 100 basis points in the past six months, now making them comparable with those on prime buildings in Prague and Budapest, says Mr Stocks.
And, whatever the specific market conditions, there is a huge amount of capital still looking to invest into real estate, be it petrodollars, opportunity funds raised in the US and elsewhere, sovereign wealth funds or high net worth individuals who see property as a good long-term investment.
“If you look across all asset classes, you could put your money in global stock markets, yes, but it’s a pretty bumpy ride; you can put it into bonds but the yields are pretty low; or you could put it in the bank but that’s pretty dull,” says Mr Stocks. “Or you could invest in real estate, which is now looking really interesting in certain markets.”