Stubbornly low interest rates have put pressure on large institutional investors, including pension funds, to rethink and adjust their long-term asset allocation decisions.
Where institutional investors would have traditionally put their faith in the bond markets to provide liability-matching returns, we are now seeing them increasingly look at alternative asset classes, including commercial property. Indeed, many international investors have already made the call on commercial property.
Viewed from a global perspective, the majority of institutional-grade commercial property assets are concentrated in a small number of geographic areas, including North America and Europe. They account for more than 50% of global stock and are part of the reason there has been so much capital targeting these regions. Added to this is the pressure to diversify regional exposure beyond native property markets as the overall allocation to property increases. This is particularly true for overseas institutions based in the Middle East and Asia.
These investors generally have a different capital requirement compared with the short-term, return-hungry private equity and opportunistic investors we saw investing in the aftermath of the financial crisis. Typically requiring returns of 5%-7%, but over a much longer investment timeline, pension funds and insurance companies want stability and a lower-risk profile. These are characteristics normally associated with a core investment strategy and prime assets.
The issue is that for many, the word prime is associated with some of the overheating markets, such as central London, which can be misleading. In reality, London prime assets have a yield profile that is very different from prime or “almost prime” assets in many of the central business districts of European cities.
This fact has been confirmed by Valad Europe’s recent analysis of more than 160 cities across 18 European countries. The results of our research identified 28 European cities with long-term growth prospects across various property sectors, and which are set to outperform their national averages.
As the European real estate investment market continues to mature, new regions will become attractive and some of the regions that are currently popular will fall out of favour or be re-priced. For example, from our analysis we can see that retail, office and logistics assets in Amsterdam currently offer good quality, risk-adjusted returns, whereas in Munich, offices are less attractive.
Based on this regional fluctuation through the investment cycle, successful core investors will need to prioritise the selection of enduring themes rather than focus on acquiring single or trophy assets on the understanding they will provide a 5% yield indefinitely. It requires a more sophisticated and active skill set, with a combination of regional expertise and the ability to continually acquire and sell assets to ensure maintenance of the investment strategy and a stable return profile.
In many ways, the approach is like applying a value-add asset selection mindset to higher-quality and longer-leased assets.
A window of opportunity is opening up in Europe for core investors to invest in funds employing smart, dynamic strategies rather than the more traditional buy and hold approach. With interest rates forecast to remain at unprecedented low levels, at least until there are signs of an established economic recovery, the premium of commercial property yields over interest rates will continue to attract investment.
Add to this the evidence of the gathering recovery in European rental markets, underpinned by forecasts of European GDP growth and declining supply of new stock, due to subdued development activity across sectors, and there is a strong case to invest in core assets in the top European cities.
David Kirkby is chief executive at Valad Europe
