Has european non-prime really begun to outperform prime?

In February 2013, JP Morgan published a report speculating that 2013 would go down as a vintage year for opportunistic investors looking to invest in non-prime property as investor risk appetite begins to re-ermerge and the compressed ‘core’ segment would lead to mispriced opportunities in the secondary locations.

 

Just a month ago, they republished a new report conjecturing that capital values would expect to rise 10 per cent in the non-prime sector in both 2014 and 2015 as market conditions begin to look remarkably like those in the early 2000s when non-prime yields started from a relatively high level and GDP growth started gathering pace from a low base, investment demand began to increase rapidly due to domestic institutional demand as well as the availability of debt, which eased considerably in a short period.

 

So were they right?

 

While JP Morgan´s report pertained to Europe as a whole, from our “on-the-ground” perspective here in Berlin, they were right on target.

 

As we recently reported to our investors, despite lagging fundamentals in Germany, 2013 has been the year of the ‘risk-on’ trade for real estate.  There is no particularly compelling growth story in Germany. There aren’t any major shifts in office locations or massive new technology shifts beyond the changes already taking place in retail and the internet driven disruption that has led to increased mobility in how businesses operate.  Yet, mirroring the growth in transaction activity in Europe, German real estate transaction volumes rose 21 per cent to a five year high of €30 billion.

 

So what is bringing about this flurry of investment?  For one, unemployment, inflation, and debt levels have remained low this past year, once again making Germany a bit of a safe haven.  Furthermore, with yields above 2 per cent, real estate is perceived to be a better fixed income investment than high yield, corporate and sovereign debt.  For most investors, the increase in investment in real estate still remains a defensive rather than an offensive strategy and a sense that the ‘dark days’ of the financial crisis are over is making investors look at real estate once again.  It is perhaps no surprise that the biggest push in investment activity came through the large, conservative, domestic German institutions.

 

The banks are adding to the attractiveness of the story by providing cheap, moderate LTV loans for leased assets, which somewhat masks the underlying fundamentals for the real estate market as it becomes easier to generate returns in the high teens and the strong multiples that investors seek.  These returns become possible even with low leverage as all-in cost of funds is below 3%.  As defensive yield seekers need greater return than government bond yields or corporate debt, the push into buying core real estate yields continues.  The fact that German banks offer slightly more leverage is helping the market clear transitional real estate in secondary markets since it is possible to find high quality buildings in accepted locations where buyers are willing to own assets in the future.

 

As the banks continue to liquidate their owned real estate which they had previously over-leveraged, Activum is indeed pushing into these secondary locations and getting yields that we believe more than offset the shift in location.  As we mentioned in our last blog post, the new core are places like Leipzig, Eschborn, and Mannheim where we have recently invested in value add office assets with similar profiles – high quality, high yielding assets with stable tenant bases that are not located in one of Germany´s top 6 cities.

 

As JP Morgan alluded to, opportunistic and value-add funds are always ahead of the fundamentals, and our experience in Germany is the perfect illustration of this.

10th April 2014

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