This time it is different

It has been a while since I have not written anything on alstria’s blog. I started from time to time, but never get to finish the work. This morning however, when I read the piece about the German real estate, that was featured in the daily newsletter of Property Investor Europe (which is usually the first think I read in the morning), I knew I would get through.

 

The “Expert view”, which is called “Upward trend on the German commercial real estate market” (and available here: http://aox.ag/PIE_German_office ) gives an overview about why investors should be investing in the German office sector, which per see, should not lead to any specific comments from my side. Except that, when I finish reading the post, I suddenly felt younger by 7 to 8 years. If you want a list of all the bad reasons to invest in the German office market, this post is definitely the right place to start. It is making 5 assumptions that should lead a decision to invest in German office space.

Assumption 1: Economic growth in Germany is resulting in increasing demand for office space

This is a graph that was published on this blog four years ago (and would lead to the same result if extended to 2014).

I am amazed to see that some commentators are still arguing about the fact the GDP growth correlate with office rental growth. This might have been the case 30 years ago, but it is clearly not the case anymore. The way tenants are learning to optimize their office space, and the efficiency gain they are realizing are by far outstripping any additional need of space created by GDP growth. Do not expect any substantial rental growth in the German office sector, nor substantial vacancy reduction.  It is unlikely to happen anytime soon.

Assumption 2: Financing of commercial real estate is becoming cheaper

That is absolutely true. Financing is cheap. I would have thought that I would never again hear this as an argument for buying  real estate (nota: alstria always underwrite assets based on unlevered returns), but apparently I was wrong.

Assumption 3: Rising demand for office premises with a positive impact on rental markets

See point one above. This has never happened in the past, and I see no reason why it will happen in the future. Absorption in the market is at best neutral, more realistically negative.

Assumption 4: Ongoing investment pressure is driving transaction volumes and is reducing risk aversion

The first part of the assessment is absolutely correct, investment volume is going up, and has accelerated drastically over the last weeks (mainly on long term leased assets, driven by yield seekers). But I am not sure that risk aversion is reducing. Short term leased assets, or other assets with potential operational risk/leverage are not so much in demand. Not sure though that the risk aversion is reducing, but clearly the risk return profile of some of the assets which are being considered for trading is deteriorating.

So what is the German office market all about then ?

Obviously we all have our views on the market and how it is going to develop, and mine is as good as any other. The fact of the matter is that our position is based on an educated guess, not a crystal ball. We believe that the German office market is going to be driven by operational excellence, vs. financial engineering. That real estate needs more operators and less financial sponsors.  that driving returns should come from increased market share, better scaling of costs, operational excellence, better services to the clients (some call them tenants). That expectation of market rental growth driven by macro factors, should not be considered, and will only enhance returns if its happens. 

In my last roadshow meeting, when I was discussing the state of the investment market and the increased transaction volume we are seeing in Germany, I was asked by an investor if I felt any similarity with 2006-2007. My answer at this point was that I did not, as I believed most of the players in the market still have the deep scares and bad memories of what happened then. I think it is Mark Twain who once said "History does not repeat itself, but it does rhyme". Well PIE this morning was rhyming very strongly with 2007 (and if in doubt here are the same arguments put together in 2007:  

Deutsche Bank research: German office Market (April 4, 2007) 

At that time DB concluded as follow:

"The greatest risk in the years ahead therefore lies not in a downswing on the property markets, but in exorbitant expections on the part of investors and project developers"

I guess this last point is still up-to-date

 

 

 

 

Life Insurance

The say on the street is that there is a funding gap in the European property market. The say is also that new players are coming along to fill, or benefit from this gap. These new players are called debt funds, or insurance companies. Reports are piling up announcing the raise of new funds, or the billions that this or this insurance company is planning to invest in the new yield Eldorado. Advisors are warning about banking regulation risks looming on the new sector, and offering advice… And journalist have been writing about it (for instance here http://aox.ag/12tjxdn, here http://aox.ag/12tjw9c and here http://aox.ag/TbXMdh )

I have been wondering how much of all of this is actually for real, and how much is there to help us sleep at night. The white knights are coming to save our industry from its own cliff.

The fact is that there are a number of high profile loans which have been put together by insurance companies (not so much by funds so far). The Deutsche Bank and the Silber Towers in Frankfurt, some prime assets in London… So there is some action going in there. But is that really new? In the syndicated facility of alstria back in 2007 we also had AXA as part of the consortium with one of its debt fund (alongside with 25 banks). Today we do have a fund from Deka as part of our banking syndicate.

We also hear that unlike in the US, insurance companies have never really be involved in the financing of real estate in Europe. This is not exactly true. The lion share of the Pfandbrief bonds (the German cover bond market which finance real estate across Europe) are actually sold to insurance companies (although we could not identify any statistic in that respect). According to the Vdp, the total amount of Pfandbrief loan outstanding in Europe at the end of 2011 was around EUR 297 billion. The pfandbrief banks granted EUR 90 billion of new real estate loan in 2011. This compares with, for instance, Allianz target of EUR 5 billion loan book by 2015 ( http://aox.ag/UhbZHW )or the total EUR 2 billion of new loans by insurance companies in 2011…

From my perspective, the key question in this debate is not really whether or not insurance companies will step in the lending business. But are they going to do this with new capital, or is the lending business just part of the existing real estate allocation. GE Real Estate for instance (which I appreciate is not an insurance company, see here http://aox.ag/T3EytC ) is stepping out of equity, and coming back into debt. Net net, the move is neutral… No new capital.

    

There is clearly something going on in the field of new debt providers. It is however too early to say if this is going to be a game changer, or just a capital reallocation, which will leave us as naked as we were before. The only certainty I still have is that there is still too much leverage in the system. It will take us more than just a life insurance to secure the future of our industry