A guide to European real estate investing
Investors are increasingly turning to real estate to gain exposure to real assets that produce an attractive income return, in this Q&A fund manager Tony Smedley explains his thoughts on investing in European real estate and where potential opportunities lie.
19 February 2016
The new Schroder European Real Estate Investment Trust offers investors access to growing demand in the main continental European real estate markets, as well as the extensive experience of an investment team led by Tony Smedley.
What is the rationale for launching the Schroder European Real Estate Investment Trust?
The economic recovery in Europe’s largest and most dynamic cities is driving increased demand for space which, coupled with limited supply, is leading to improved rental growth prospects. From a pricing perspective, we also believe this is an interesting entry point.
Many commercial property markets are also starting to recover from a low point in their development cycles, as a result of a prolonged period of economic uncertainty, a lack of development finance from the banking sector and the focus on residential development. The gradual improvement in demand is therefore expected to lead to shortages of good quality accommodation in key markets, boosting rental growth prospects.
What advantages can Schroders offer investors?
The Schroder Real Estate Team has the experience and knowledge to make the most of this opportunity. The team currently manages approximately £12.4 billion of real estate assets across these markets and has approximately 110 real estate professionals located in key hubs across Europe including London, Paris, Frankfurt, Zurich, Stockholm and Luxembourg¹. The combination of our on-the-ground property expertise and experience of managing listed funds gives us confidence that the new fund will be a strong addition to our fund stable.
What are the fund’s aims?
The fund aims to provide investors with an attractive income return of 5.5% (per annum, net of fees) and the potential for capital growth from investing in income-producing, institutional grade commercial property (meaning they are tenant-ready and should generate returns) in the growth cities and regions of continental Europe. It is important to note the target yield is not guarenteed.
The investment philosophy is founded on a belief that property markets are inherently cyclical and imperfect (meaning prices do not necessarily reflect the return and risk profile of the investment), which creates opportunities for long-term investors who are focused on property fundamentals and take a disciplined approach to asset management.
Can you describe the investment process?
Schroders’ property philosophy is set around core beliefs that drive the investment process.
- We invest for the long term.
- We seek to invest into assets and markets with strong fundamentals and growth forecasts.
- We seek to enhance value by increasing net income and the quality of income security.
- We aim to acquire undervalued sectors in winning cities and target assets with specific characteristics.
- We are active managers and focus on improving the quality of our investments via asset business plans agreed at the time of investment.
- We divest when the market price is greater than the value or worth of the asset, when it can no longer provide stable long-term outperformance of its target return.
Our real estate research focuses on the fundamentals, using an analytical approach considering economic, demographic and structural influences on the market.
From a risk management perspective we continually review the asset and portfolio performance drivers to maintain portfolio balance and ensure the strategy continues to fulfil its objectives.
What is the benefit of exposure to European real estate for UK investors?
It is important that this product is considered as complimentary to, rather than a replacement for, UK real estate exposure.
Continental European markets typically follow a slightly different economic and real estate cycle to the UK. This could provide an opportunity for investors to diversify risk and potentially benefit from the return prospects generated at different points in a market cycle. Investing in continental Europe also provides investors with greater choice and the potential for a better-diversified allocation to different types of real estate in key investment markets.
The other key difference is lease structure. Most leases in Continental Europe are linked to inflation rather than following the rent review mechanism commonly associated with the UK market. Index linking provides support to the income return, with rents being adjusted to market at the time of a lease break or expiry.
In France, for example, the typical lease structure is a nine-year lease and it is common for office tenants to have a break option after three and/or six years. German leases are typically five or ten years in duration. Shorter leases provide the landlord with greater flexibility to not only “re-gear” leases or an asset’s tenancy structure, but also obtain vacant possession in the event that alternate uses become more attractive or of higher potential value.
Will the fund invest broadly across continental Europe or focus on specific areas?
The fund has a focused strategy, investing in growth cities and regions across continental Europe. As a general rule, the fund will target large, liquid cities whose growth prospects exceed their domestic economies e.g. Berlin, Munich, Hamburg, Paris, Brussels, Amsterdam and Lyon. It will also favour assets located in areas where people want to live as well as work – where there are competing demands for different uses – and those locations benefitting from new/improving infrastructure.
It is anticipated that Germany and France will represent at least 60 % of the fund portfolio. These two markets represent more than half of the investible universe and are considered to be the largest, most mature and liquid markets across the continent.
Which sectors of the market will you target?
The vehicle will primarily target institutional grade income producing investments in the traditional real estate sectors of office, retail and logistics.
In addition, instances may arise where an investment is considered “mixed use” and includes residential, student accommodation, hotel or care accommodation.
Where do you currently see opportunities?
Within the office sector, we are biased towards cities with strong economic fundamentals and momentum, with growing occupier demand and constrained supply. Preferred cities include Berlin, Hamburg, Munich, Stuttgart, Stockholm, Madrid and Barcelona.
In retail, we will take a selective approach to real estate, focusing on sectors which are relatively immune to e-commerce, or which form a key part of multi-channel retailing. We favour convenience stores and supermarkets in affluent neighbourhoods and would generally avoid large hypermarkets. We would also consider flagship stores and high street units in core city centre locations.
At the other end of the spectrum, we favour large, dominant shopping centres that provide a full range of retail and leisure and a broader consumer “experience” overall.
In industrial real estate, we favour modern warehouses and parcel delivery centres in urban areas that are relatively supply constrained and that benefit from multi modal transport links (such as air, road, rail and shipping).
Where do you see the current risks?
The main risk is that strong investor demand triggers a sharper fall in yields and higher total returns in 2016 than we anticipate, although that would probably be at the expense of weaker returns in 2018-2019. Another risk is that an external shock forces the European Central Bank to abandon its policy of quantitative easing and raise interest rates, which in turn would reduce economic growth and depress occupier and investor demand for real estate.
As with all investments, it is important to note that the value of the capital invested, and the income from it, can go down as well as up and investors may not get back the amount originally invested. A financial adviser is well placed to help investors figure out the right level of risk for their situation.
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