Capital and the Changing European Real Estate Market: - Site Selection Magazine

From Site Selection magazine, November 1999

W O R L D R E P O R T S

Capital and the Changing European
Real Estate Market: Two Experts' Views

b y M I C H A E L S U L L I V A N

Europe faces a decade of low inflation, rising capital costs and the mushrooming growth of the invading mutual and pension funds that are now common in the United States. That coming shift in the way money is sourced and managed spells changing times for corporate real estate executives (CRE). It will, in fact, revolutionize how European property managers create equity.

Bank Leu So says Peter Linneman, Albert Sussman professor of real estate at the University of Pennsylvania's Wharton School, who was interviewed by SS during his visit to Cannes last spring as a featured speaker at MIPIM, the world's largest property show. Says Linneman: "Ten and fifteen years ago, central bank directors allowed governments to adopt loose monetary policies with relatively high rates of inflation. This drove the way real estate equity was created. In the 1980s, you borrowed $100 for a value of $100, and let 10 or 15 percent inflation create your equity.

"It's the opposite today, and this reverses the way the real estate industry has to function."

Capital Sourcing's Shift From Debt to Equity
The upshot of that change, as Linneman sees it, is that capital sourcing will shift from debt to equity as the wave of mutual and pension funds that have swept the USA in the past two decades begins cascading through Europe, particularly spurred on by the continent's aging population. "With no inflation, if you're no longer going to be able to borrow money, you're gong to have to come up with real equity," Linneman explains. "Why have you seen U.S. markets turn to public ownership? Because that's where the money is.

"In the 1970s, some 70 percent of the money in the U.S. market was in the hands of banks and insurance companies. Today, the same amount is with the pension and mutual funds. The funds are unregulated; they can go into equity as well as debt, and they favor market-to-market pricing. So markets increasingly turned to public ownership to attract the money."

Europe's Aging Population Fuels Pension Fund Growth
Fully funded pension funds have already taken hold in Holland. And Europe's demographics, says Linneman, could fuel the trend elsewhere on the continent.

Linneman "In Europe," he says, "I see the aging of the population creating tremendous pressure to fund pension systems. If Germany, France and Italy were to move to fully funded pension plans -- where they prepay your pension, with third-party overseers managing it, as opposed to trust-me/pay-as-you-go/I'll-pay-you-when-you-retire programs -- it would, given the size of those economies, generate a tremendous pool of money. And the managers of this money will require liquidity and transparency.

Left: With Europe's changing capital markets, The Wharton School's Linneman says, "Property prices will rise [and] loans [will] be harder, pricier and actually economic.

"You'll see this trend in Europe before long. The road will be long and tortuous, but it will happen." The search for liquid assets in real estate, according to Linneman, will also hasten the trend towards securitization.

"If the money wants transparency, market-to-market pricing and liquidity, I'll dress it up and trot it out on stage," he says. "You're changing something that's illiquid and not transparent into something that is liquid and transparent. And that's securitization.

"In 1974, before the move to fully funded pensions in the U.S., there were barely $300 million in funds. Today, there is $4.5 trillion. The same kind of growth can come to Europe, and it will help provide the pool of capital to sustain securitization."

Europe's fragmented markets, though, will act to brake that trend, Linneman concedes:

Fragmentation Brakes Trend
"In Europe, every major city has a stock market," he says. "This is not viable, and it will change. A few decades ago, the U.S. had a dozen markets. Now it has only three, and in another decade it may have only one. Europe will eventually go this route."

On the other hand, securitization could be accelerated by the need to compensate for shortening amortization schedules.

Says Linneman: "Banks have a pressing return-on-equity requirement. Every time banks have gone long on short-term money, they have found they are mismatched, and they have gotten clobbered. So they shorten amortization schedules."

With large pools of money, he says, there will be more motivation for companies to dress up for public ownership. The road in Europe, however, may be long, he adds.

"Companies that securitize have to be very big, with strong cash streams and with tremendous amounts of disclosure," Linneman says. "I can't see any firms like this in Europe yet. And, in fact, there aren't many in the U.S.

"If we think of this as Hannibal with his elephants invading Rome by going through Spain and France, the real estate Hannibals of the securitization movement in Europe are still only at the Pyrenees."

Property Owners Underestimate Low Inflation's Impact
How far is Europe from continent-wide securitization and real estate investment trusts?

"Being public adds value, but maybe not more than 3 to 5 percent," Linneman says. "Your operation has to have size. This will come as Europe moves towards the creation of large pension funds." Property owners, Linneman contends, still underestimate the squeeze of low inflation.

"Owners are still counting on 2, 3 and 4 percent inflation," he explains. "But if your tenants can't raise their prices and you're their overhead, how are they going to afford the 3 percent rent rise your model says is going to happen?"

Rising Real Estate Loan Rates on the Horizon?
Corporate real estate managers, Linneman says, may face rising loan rates as highly leveraged banks seek to meet their margins in a tight market.

"The major European banks, particularly the local state banks in Germany, don't price the generated return on equity in a way that makes any sense," he asserts. "If you're the borrower, it's super. You get double B credit at double A prices.

"But from a credit point of view, that can't last. We can't forget that the real estate business is heavily capital intensive and depends heavily on debt from the banks that has been underpriced. If the banks are leveraged eight-to-one or nine-to-one, they're going to have to get double-digit returns on equity. That means loans are going to be harder, pricier and actually economic. So property prices will rise."

Pan-European Firms Scare
What about pan-European companies?

Says Linneman: "The surprising thing Americans discover is that Europe is not one country. Every couple of hours of driving brings you into a new language, new laws and still, today, a new currency.

"Mercedes and GM operate pan-European. The closest to pan-European are the German open-end funds. And even though people say real estate is a local business, it's not more local than selling automobiles. You can't sell things in Italy that you sell in Norway. Real estate is the same."

Europe's property markets reflect varied conditions, Linneman says.

"Well, we find Western Europe a bit overpriced for our return parameters," he opines. "Central Europe is attractive, but among the attractive properties, there are lots of unattractive ones.

"As for Eastern Europe, the property market has some steep slopes, probably too steep for us just yet." SS

Another View: Tishman Speyer Properties' Speyer
In the wake of the Asian financial crisis, Tishman Speyer Properties (New York) President Jerry Speyer sees Europe presenting interesting opportunities in a more conservative investment climate. Interviewed by SS at the Cannes MIPIM show, the developer explains how his company is opting for an approach that marries a good source of capital with a taste for risk.
"Real estate today is a commodity driven by the financial markets," Speyer says. "The fundamental principles are the same. It's not enough to build a good building in a good location. For you to get some rent income, the building has to be what people are looking for in that location."
Challenges and Opportunities
Europe's low rate of return and the dominance of the market by cautious institutions presents both a challenge and an opportunity, Speyer contends.
"In one of the European business centers like Paris, you might sell a property at [a money value of] five where you might sell it at eight in New York," he says. "So there is a far smaller appetite for risk in Europe than in the U.S.
"In development, you need lots of capital, and this means lots of debt securitized by a portfolio," he continues. "If we went public, we'd have to support the share price and generate earnings for a good price/earnings ratio. But with gap accounting, if you're doing a good job, you're not generating earnings; you're concentrating on cash flow."
Paris Flexibility is essential in capitalizing on Europe's real estate opportunities, Speyer explains. "To get the best of both worlds," he says, "we have adopted a flexible formula. We form partnerships with entities that are interested in being in real estate and have pension money or endowment money or some other form of capital.
"We facilitate investment in real estate on a diversified basis, and we think the dominance of mutual and pension funds in the European market will be a help."

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