Market Perspective
May 2015
Weight of money is a key driver
in European real estate
By Matthew Richardson, Director of Real Estate Research
The weight of money likely to be invested in core eurozone and UK real
estate is expected to remain at close to record levels this year. This is
spurred on by international cross-border US dollar investors targeting
prime assets in Germany and the UK, and domestic investors buying
higher-yielding assets in regional markets across northern Europe.
While investors should be alert to potential macro risks, real estate in
these key markets is supported by favourable fundamentals with few of
the risk factors we have seen in previous cycles. Indeed, as German and
UK real estate markets begin to come of age on the international
investment stage, the industry needs to improve transparency and
reporting so that it can compete squarely with other global asset classes.
AT A GLANCE

The weight of money invested
in European real estate is
expected to reach a record
level in 2015

Prime and secondary real
estate yields are very attractive
compared to other incomepaying investments like bonds

Weakness in the euro and in
sterling is attracting US dollar
investors to Germany and the
UK

International investors view
Germany and the UK as safehaven real estate markets

Interest in UK real estate on the
part of investors has become
sentiment-driven, much like
equity investing

Current cycles in Germany and
the UK appear favourable with
limited industry risks

We believe total returns in 2015
in Germany could exceed 8%
and 15% in the UK
INTRODUCTION
Interest in real estate among investors has always been influenced by the cyclical nature
of capital returns. In a low-yielding world, property’s high income yield is also a standout.
Yet, the present weight of money chasing quality investment opportunities in core
eurozone and UK real estate is also heavily influenced by currency fluctuations, with
international investors attracted by the relative weakness of the euro and sterling. Once
the preserve of domestic investors, pricing in key European real estate markets is
increasingly driven by global capital flows as investors search for an attractive real yield.
Germany and the UK are particularly appealing real estate markets for US dollar
investors keen to preserve their capital in what they perceive to be cheap, attractive
assets located in a safe haven. The inflow of global capital is unprecedented compared
with previous cycles, and has implications for value (for instance between prime and
secondary pricing) and the focus of domestic property investors.
Capital flows into European real estate will remain focused on Germany and the UK as
these countries benefit from financial stability, stable and sophisticated legal regimes,
and, of course, an undervalued currency relative to long-term trends. EMEA inflows
dwarfed other regions in 2014 – and in 2013, EMEA recorded a healthy level of inflows
compared with Asia Pacific and the Americas, which both experienced outflows (see
Chart 1 below).
Chart 1. Net beneficiaries of inter-regional flows in 2013 and 2014 (US$bn)
14.52
Americas
-4.69
36.99
EMEA
19.22
2.65
Asia Pacific
-8.58
-20
-10
0
2014
Source: Fidelity Worldwide Investment, JLL, December 2014.
10
2013
20
30
40
However, as demand for European real estate strengthens and the asset class matures,
fund managers increasingly have to compete directly with other asset classes to secure
investor commitments.
Though the UK and German real estate markets are considered to have very good levels
of transparency, the asset class overall needs to make further improvements to help
convince investors that real estate should be part of their global asset allocation. In short,
the level of disclosure and the quality of asset- and fund-level information needs to be
brought up to the standard seen in the equity and fixed income markets.
OVERSEAS INVESTORS ARE DRIVING DEAL PRICING IN GERMANY AND THE UK
The current real estate cycles in Germany and the UK have strong international
investor participation, primarily from North America and Asia, which is driving deal
pricing. In the UK, for example, we have seen many domestic investors become
profitable net sellers to international buyers. The presence of attractive yields and the
strength of the US dollar relative to the euro and sterling (see Chart 2 below) are one of
the main drivers behind the weight of money looking for access to the asset class.
Investor interest in Germany and the UK is evidenced by the fact that together they
accounted for 55% of the €207 billion of European real estate purchases made in 2014.
Last year’s deal volume exceeded every year since 2008; in the 2007 peak, the market
recorded almost €300 billion worth of deals.
Chart 2. Currencies' relative strength versus IMF Special Drawing Rights – 1998=100
1.3
1.2
1.1
1
0.9
0.8
0.7
12/1998
12/2002
12/2006
EUR
USD
12/2010
12/2014
GBP
Source: Bloomberg, December 2014.
DEMAND FOR GERMAN REAL ESTATE ASSETS IS INTENSIFYING
Strong demand for German property, particularly in and around the country’s main cities,
is underpinned by the perception that German euro-denominated assets are undervalued,
given the strength of the German economy relative to other eurozone economies. Investing
in the prime real estate asset class can offer yields in the region of 3.5% to 4.0%, while
10-year Bunds yield 72 basis points (at May 12, 2015). European secondary real estate
yields are on average two percentage points higher than European prime (See Chart 3).
Some investors are also attracted to German real estate assets because they offer a
hedge against a potential break-up of the euro currency, which remains a potential threat.
If this eventuality were to happen then investors believe they would be left with assets
denominated in a high-quality currency.
Deflation is another concern motivating real estate investors in Europe and a reason that
they typically favour Germany and the UK, because they are among the select group of
countries with some price inflation. Deflation is hugely negative for real estate because it
depresses rental values and erodes long-term capital values, killing hopes of growth.
Chart 3. European property yields have remained relatively constant
10%
9%
8%
Euro Corporate Bonds
Euro Secondary Property
Euro Prime Property
7%
6%
5%
4%
3%
2%
1%
0%
09/2007
09/2008
09/2009
09/2010
09/2011
09/2012
09/2013
09/2014
Source: Bloomberg, CBRE, March 2015.
UK REAL ESTATE HAS BECOME MORE SENTIMENT-DRIVEN
Pricing in the UK real estate market has traditionally been based on a premium of around
150-200 basis points over the risk-free rate, but the yield on 10-year UK Gilts is now
relatively low on a historical basis at 2.03% (May 12, 2015), down from over 2.7% a year
ago. Chart 4 shows UK prime and secondary yields relative to UK corporate bonds.
The relationship between real estate and 10-year Gilts has arguably become dislocated
and less relevant, particularly as international investors have become more prominent
and are typically focused on a different set of risk premia. Among other factors, this has
contributed to investment in UK real estate becoming more sentiment-driven, much like
equity investing. Overall, the internationalisation of the investor base in UK real estate is
a positive development and reflects its more mature qualities as an asset class.
Chart 4. UK secondary yields likely to be boosted by robust rental growth
12%
10%
UK Corporate Bonds
UK Secondary Property
UK Prime Property
8%
6%
4%
2%
0%
09/1999
09/2002
09/2005
09/2008
09/2011
09/2014
Source: Bloomberg, CBRE, March 2015.
CONTINUING APPEAL OF SECONDARY REAL ESTATE
If there is continuing strong demand for property in London and the regions then the
sheer weight of money we are seeing chasing deals will logically place downward
pressure on yields if investors focused on prime begin to switch into secondary. That
said, we should consider that the complexities of today’s real estate market go beyond
rudimentary supply and demand dynamics.
If the UK economy continues to grow and corporate confidence translates into buoyant
demand for leased property then we could also see secondary real estate rental growth
benefiting further as prime property fills up or becomes too expensive for some tenants,
creating a trickle-down demand.
REASONS WHY GERMAN AND UK REAL ESTATE IS ATTRACTING SUCH A
WEIGHT OF MONEY
1. Bond yields are at historic lows. This has caused a significant dislocation to open up
between bonds and real estate yields. Investors are yield-hungry and real estate offers
attractive returns.
2. There has been no development boom in the UK and Germany unlike in previous
cycles and there is limited availability of debt finance for speculative development. Chart
5 shows that the limited supply in the European office market will likely create growth on
the back of rising rental values, which clearly appeals to investors. Completions at less
than 2% of total stock, which is the range shown in Chart 5 for the period 2015-2018,
have historically triggered periods of robust rental growth.
Chart 5. European offices – medium-term limited supply will create growth
4.0%
3.5%
3.0%
2.5%
2.0%
1.5%
1.0%
0.5%
0.0%
1980
1986
1992
1998
2004
2010
2016
Note: The data shows completions as a % of stock (1980 to 2018F) In Western European (inc. UK) prime offices.
Source: Fidelity Worldwide Investment, JLL, December 2014.
3. There has been no lending boom as the banks have not been as active as they were
in previous cycles when 15-20% of their loan books were typically lent to real estate. With
the typical cost of capital at 3.5% to 4% all-in, this is more or less the level of where
prime yields are, so there is little motivation for investors active in the prime space to use
bank debt. Likewise, if demand for secondary properties pushes yields further down then
there could be limited appetite for bank debt given the tight margins.
4. More macroeconomic shocks in overseas investors’ home markets, similar to the
original reasons why many of them have targeted Germany and the UK, would arguably
encourage more safe-haven investment from these investors rather than cause them to
repatriate their invested capital. Indeed, the London prime market was an early
beneficiary of the global financial crisis. So, we can assume a stability of capital – even if
some international investors were to leave the market, then there is a strong likelihood
that new investors would be ready to take their place. This is likely to avoid situations
where there are extreme swings in yields as in previous cycles.
5. The most probable outcome of the European Central Bank’s €1.1 trillion QE
programme is further investment flows into Germany in 2015 where we can expect to see
huge competition, further supporting property asset values. With QE, we are likely to see
a transfer of capital from the European periphery to the core eurozone, chasing topquality assets.
CONCLUSION
We can already see from the scale of competition bidding for real estate deals in
Germany and the UK that the weight of money appears to reaching record levels. This is
likely to drive property capital values higher in 2015. Real estate yields remain very
attractive compared to bond yields at historical lows and real estate is increasingly prized
among international investors for its ability to pay a stable and attractive income.
We can expect to see a number of tailwinds support real estate this year. The ECB’s QE
programme will boost asset values in the core eurozone, which is an area institutional
investors favour, but not so in the eurozone’s periphery countries. With a lack of
development in Germany and the UK we are also likely to see robust growth in rental
values in selected supply-constrained markets.
We expect 2015 to be another strong year with total returns of about 8+% in continental
Europe and about 15% in the UK.
With many of the ‘classic’ industry risk factors such as over-development and debt
financing absent, investors need to stay alert to macroeconomic risks such as a potential
euro crisis, deflation and external/overseas economic shocks. However, real estate
investment managers also need to make further efforts to improve transparency to
encourage real estate to mature further as an international asset class.
IMPORTANT INFORMATION
This document is for Investment Professionals only, and should not be relied upon by
private investors.
It must not be reproduced or circulated without prior permission.
FIL Limited and its respective subsidiaries form the global investment management organisation
that is commonly referred to as Fidelity Worldwide Investment. Fidelity Worldwide Investment
only gives information on products and services and does not provide investment advice based
on individual circumstances. Any service, security, investment, fund or product outlined may not
be available to or suitable for you and may not be available in your jurisdiction. It is your
responsibility to ensure that any service, security, investment, fund or product outlined is available
in your jurisdiction before any approach is made regarding that service, security, investment, fund
or product. Past performance is not a reliable indicator of future results. Returns may increase or
decrease as a result of currency fluctuations.
Issued by FIL Investments International (FCA registered number 122170) a firm authorised and
regulated by the Financial Conduct Authority. FIL Investments International is a member of the
Fidelity Worldwide Investment group of companies and is registered in England and Wales under
the company number 1448245. The registered office of the company is Oakhill House, 130
Tonbridge Road, Hildenborough, Tonbridge, Kent TN11 9DZ, United Kingdom. Fidelity Worldwide
Investment’s VAT identification number is 395 3090 35.
Issuer in Germany: Issued in Germany by FIL Investments International - Niederlassung Frankfurt
on behalf of FIL Pension Management, Oakhill House, 130 Tonbridge Road, Hildenborough,
Tonbridge, Kent TN11 9DZ. Issuer for Austria, Hungary, Slovakia and Czech Republic: FIL
(Luxembourg) S.A., 2a rue Borschette, 1021 Luxembourg
Fidelity, Fidelity Worldwide Investment and the Fidelity Worldwide Investment logo and currency
F symbol are trademarks of FIL Limited. The availability of the investment discipline(s) and
portfolio manager(s) proposed in this document is based on the situation at the time of
submission and may be subject to change.
Reference in this document to specific securities should not be construed as a recommendation
to buy or sell these securities, but is included for the purposes of illustration only. Investors should
also note that the views expressed may no longer be current and may have already been acted
upon by Fidelity Worldwide Investment.
ITL15-18