Location paramount to achieving returns

The importance of looking for prime locations when investing in real estate has increased since the financial crisis, as investors have become more risk averse and are focused on wealth preservation.

“What changed the world in the last couple of years and cannot be ignored is that property can’t defy the wider economy,” says Chris de Pury at BLP partners, the UK-based experts in real estate law. “When you look at buying a property, you have to look at the underlying fundamentals, rather than just relying on an income stream and slicing and dicing on that basis.”

A couple of years ago, everybody piled into property thinking they could get “super returns” in a very short period of time explains Mr de Pury. In reality, they lost a lot of money, as tenants went bankrupt and the capital value went down dramatically by about 50 per cent from peak to trough.

As with any asset class, there is quite a strict correlation between the growth and the structure of the economy and real estate performance. Generally, property is expected to generate higher returns in those markets where the economy is relatively well balanced and growth is attractive.

Prime locations

“There is no point in buying a magnificent piece of real estate in an economy which is not going anywhere,” says Mr de Pury. Tenant demand and whether tenants are paying their rents on time is a key factor to consider, as is the ability to re-let the property. Core real estate in prime locations is what everybody is after, he says.

“The biggest challenge in real estate is the lack of product. Everybody is chasing core assets, the relatively well let, good covenant prime property in the main economic centres, such as London, Paris, Frankfurt, New York or Sydney.” Outside those main economic centres, there are no real markets, says Mr de Pury.

DTZ, a global property consultant, recently launched a series of Fair Value Indices – a global all-property index and 16 sectoral/regional indices – which offer insights into the relative attractiveness of commercial property across Europe, Asia Pacific and the US.

Index scores range from 0 to 100: scores close to 100 indicate that most of the markets covered by the index offer attractive returns (hot), and scores close to zero indicate that the markets covered generally offer inadequate returns (cold).

Markets are categorised by comparing expected returns with required returns. The latter are defined as the return available from a five-year government bond, plus a premium to allow for the additional cost and risk associated with property investment.

The premium takes into account the compensation required for depreciation, transaction costs, illiquidity and risk. Markets estimated to be more than 5 per cent under-valued are classified as hot. Those with more than 5 per cent over-valued are classified as cold, while markets trading in between this range are classified as warm.

The index score calculated for the second quarter of 2010 shows that the most attractive region for commercial real estate at the moment is the US, explains Hans Vrensen, global head of DTZ Research (see Figure 1 below).

“There are two factors that resolve in the US proving a very attractive market at this particular junction: prices have adjusted quite significantly and the required rate of return has come down significantly, as the government bond yields are very low at the moment.”

Asia-Pacific ranks only second. “Asia Pacific economies are growing very fast but this is not necessarily news and a lot of investors have already priced that into their decision,” says Mr Vrensen, explaining that investors are willing to pay the higher price for a property in the market where the rental growth is expected to be quite strong, but that is already reflected in the price they pay.

The markets that are least attractive at the moments are the UK, which has adjusted back on the upswing perhaps a little bit too aggressively and also Europe, particularly in the European office sector.

The UK has had its rally and yields appear to have stabilised, agrees Ed Protheroe, senior portfolio analyst, real estate, at M&G. In the absence of any rental growth, there is going to be little capital upside in the short-term, so that has to come from active asset management, he says.

Income return is estimated to account for 75 per cent of the total return, while capital return accounts for 25 per cent.

“Over the long run, our asset management teams have been very focussed on driving that income forward,” says Mr Protheroe. “Up to now, in the downturn, it has really been about securing that income, and making sure that we don’t trade on any landmines. But we are now anticipating the cycle turning up over the next couple of years and we have to start gearing up for strategies that actually push that income forwards, because that is where you get the capital growth going forward.”

Tenant engineering is the right strategy. For example, if the fund invests in an office where the expiry is coming up, instead of trying to roll over that lease, the fund manager may actually surrender it, perhaps do a short economic refurbishment and put it back on the market at much higher rent, and get a better yield premium for it, he explains.

The asset manager can add significantly to market returns in property in a way that perhaps it is not possible in other asset classes, believes Tim Francis, director, Continental European Strategy and Research at Invista Real Estate Investment Management.

It is important to consider what types of property the fund is investing in, what kind of gearing or debt is being used and the style. If it is a core fund, it invests mainly in city centre types of properties, let to tenants on very long leases, where the risk is very low and the income return might be a bit lower, as the prices are higher. If the fund is more opportunistic, lease lengths are fairly short, there is a chance tenants will leave, but property prices are generally low and there is the opportunity to implement some asset management work to increase the capital value, although there are risks attached to it, explains Mr Francis.

Invista tends to focus on Western Europe, principally the UK, France, Germany and Benelux. “It is fair to say that these are the more stable or relatively stable economies, compared to Southern Europe, where there are weak cyclical and structural economic characteristics. In other parts of Europe, like Northern and Eastern Europe, I would describe the property market as patchy, as some of the markets are fairly unsophisticated and you don’t have the same level of security of incomes or security of title.”

Similar principles

Mature Asia is also an area of focus for the UK fund house according to Mr Francis. “Asia is a slightly different kettle of fish to Europe, but in general we follow the same principles, we try and invest in the more mature and liquid markets like Hong Kong, Singapore, Japan to an extent and Australia. We identify those four as the most institutional type of property markets and monitor markets like Hong Kong and Singapore which are quite heavily reliant on China for growth.”

The return profiles in those markets are more heavily oriented towards growth than income, he explains, as a greater proportion of returns is expected to come from capital, whereas Australia and Japan are more income based, similar to Western Europe.

“Currently a lot of our funds are looking for private or good quality real estate,” says Mr Francis. “We are tending to favour properties that are good quality in terms of build quality, they are well located, so they will always attract tenants to them, generally in larger markets, where you can be reasonably sure that in all points of the cycle you can buy and sell the properties. There is a lot of uncertainty and a lot of risks in the economy, particularly for property in secondary market, where perhaps there are not so many tenants and the building quality is not that good.”

Wealthy individuals join the club

A number of options are available to high net worth individuals who want to invest in real estate. In the fund space, they may decide to invest in funds investing in actual property assets or in funds that invest in property companies, listed or unlisted.

However, most investors like to invest directly in bricks and mortar. Club deals are increasingly more in demand, where a number of individual clients invest directly into the one deal. This way they are able to gain access to properties they would not be able to access on their own and they can the risk. It is becoming important for private banks to be able to facilitate syndicated deals.

Club deals are one of the recent developments at HSBC Private Bank, which offers them through HSBC Alternative Investments. “We believe this is a key offering to our clients,” says Daniel Ellis, head Private Bank Investment Group UK & Channel Islands at HSBC Private Bank.

Early this year, the private bank has completed two syndicated deals with two buildings in Washington and it has other deals in the pipeline.“We are positive on prime locations, we have seen very good interest for the deals we have offered so far this year and we see syndicated deals particularly important going forward,” says Mr Ellis.