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

 

 

 

 

Point of view

Following the publication of our latest annual reports we had a number of discussions with some analysts and investors (as we did last year for that matter) with respect to the write-off in value that we have published on our short leased assets.

We usually argue that from our perspective we would offer a lower price for a vacant building than we would for the same asset with a one year lease, which in turn should be cheaper than the same building with a two years lease … We always felt it makes a lot of sense to reflect this into our valuation process, and thus devalue every year the short dated assets to reflect the shorter lease term.

A recent article published by property magazine international (http://aox.ag/Ii71mp) is bringing a new perspective to the subject, based on a recent IPD analysis (this is the IPD Press release http://aox.ag/HVdOBX).  

According to IPD (as quoted by the article), UK landlords who give tenants five years leases immediately wipe out almost 2% of the value of their building.

Quote: “IPD lease length analysis shows that signing a new five year lease leads to a fall in value of around -1.8%, despite the property being let.”

Let’s all take a deep breath and step back for a minute to look closer to what IPS is suggesting here? If I read this correctly, the valuation of building which have signed a new five year lease (so which obviously were vacant or closed to be vacant) have LOST value because of the new lease. In other word, if investors would have paid 100 for a vacant building, they would only pay 98 for the same building with a five year lease. In essence, you would be better off keeping the asset vacant, rather than signing a short term lease. I don’t know about you, but this does not pass my smell test.

I might have a very twisted mind, but I would like to suggest another explanation for the whole story. What if the initial valuation of the building was wrong? What if the asset was never worth 100 in the first place? What if the new lease has shown beyond dispute that the assumption to get to the 100 value cannot be hold on to? Can it be that if the building was initially worth only 90 or 95, then the 5 year lease did increase the value to 98?   

From where I stand, in 99% of the cases, a cash flow producing asset is going to be worth more than the same asset vacant. Regardless of the length of the cash-flow. As such, we do devalue our assets when they are close of becoming vacant and we do show an increase in value when leases are renewed.

Where do you stand?

Same Player Shoot Again.

A recent article in PropertyEU (http://bit.ly/dXPKja) and other real estate newsletters report on the last IPD/IPF conference where a number of commentator have indicated that the solvency II directive will increase insurance companies willingness to lend to real estate. This might as well be true, but between you and me Solvency II will have potentially more far reaching implication for the real estate market as a whole than just additional lending. 


More interestingly, one of the main commentator is reported to have said: "I expect CMBS to return 'in some form or shape ... because without access to the capital markets we don't stand a chance".