Notes from the Ernst & Young (E&Y) EMEIA Real Estate Workshop in London

Introduction:

Worrying backdrop:

  • Massively increasing debt in the UK (£1tn) Europe (€8tn) and the US ($15tn).
  • Political dysfunction in both Europe and the US.
  • Substantially increased regulation including Basel III and Solvency II which are set to further reduce the financial sectors capability to fund growth.

If Europe completed the same degree of quantitative easing as the US has then they would be able to buy some $1.3tn of assets which is thought to be likely to be enough to staunch the crisis.

Michael Portillo:

Described himself as an ex future Prime Minister turned entertainer.  He made an excellent speech in particular highlighting the reasons the Chinese gave for not investing in the European bailout namely stating that that it was because the welfare state was wholly inappropriate.  “The welfare system should not be structured to encourage sloth and indolence”.

This highlights the trend towards growth in the East (Asia) & South (South America) and extended slowdown in more mature markets in particular in Europe.

Interesting aside when the Greeks borrowed in their local currency (drachma) they paid 25% interest rates whereas they paid closer to 1% after adopting the Euro.  With that in mind you can understand why they are keen to stay and also how they got themselves into too much debt after joining.

Even though many of the troubled Southern European nations have made great improvements to their fiscal positions they are not emerging from the crisis.  The overriding issue is that many are stuck with inappropriate exchange rates as a result of their tie into the single currency.

Whatever is said about the likes of the Greeks own culpability the human cost has become very high with aid agencies that typically operate in places like Uganda now to be found working actively to help people in places like Athens.

Policymakers should consider all the possible outcomes and, in particularly difficult cases like the ‘bleeding stump’ Greece currency presents, look for the least bad option.  One major problem to-date has been European leaders have called a break up for the weakest economies ‘unthinkable’ which means they probably haven’t thought about properly yet.

In the UK Portillo believes the government effectively has a policy of shrinking the public sector to make way for the public sector.  He suggested we think of it like a great big tree casting a shadow over the private economy.  [MS: I agree, the state should step back and reduce its interference so that entrepreneurs can enjoy fuelling real growth again.  And I believe we’re very lucky that in this country we’re moving in this direction.  It should give us an improved competitive position in the years ahead.]

The austerity measures are critical for us because we need to maintain low interest rates on govt debt and markets can move against us extremely quickly if they don’t continue to display strong fiscal competence and consistency.  The deficit is fine if you can finance it at present rates of interest.  If not it becomes a very vulnerable position to be.

Opportunities we in the UK are taking advantage of include devaluing the currency and effectively printing money.  This raises the spectre of inflation which most governments are in favour of at present because it’s the easy way to deflate sovereign debt.

Government is following the Thatcher strategy of not trying to win a popularity contest rather it is simply trying to make the right decisions which it hopes to be recognised for later on.

Opportunity Funds Panel (inc BNP Paribas, Pramerica, Tristan Capital Partners & E&Y):

Audience votes generally in favour of opportunity funds buying real estate now.  Expected to be more of a medium term grind suited to stock pickers than a general gold rush.

A shrinking capital market is still expected over all with the number of managers set to halve in the next few years.

Fundamental gap between returns from  enforcement and restructuring (nominally estimated at 70% of face value of loan returned) compared with the return from a sale to an opportunity investor (nominally estimated at 50% of face value once current asset value discounted to allow for 20%pa return).  This has limited bank disposals to the wall of advisors and investors who are continually offering their help with problem loans and assets.

Bank deleveraging to meet Basel III is the equivalent of squeezing an 8 year business plan into 8 months and the total value of this is estimated at between £1-3tn.  This is likely to be focussed on low hanging, dollar denominated, fruit.

The bid ask gap hasn’t narrowed sufficiently yet for the volume of trades to increase significantly and it’s therefore still very difficult and taking a long time to close deals.

Proceed with caution.  There are and will continue to be miss-priced assets out there for those with the skill and determination to find them.

There is a sense that the best deals are in the c-grade market but that investors will ‘practically throw up all over you’ if you recommend even secondary.  Hence it’s going to be difficult to deploy substantial volumes of capital but there is money to be made.

REITs (Real Estate Investment Trusts):

Changes are underway to the REIT market in the UK in particular to encourage the creation of residential REITs.  E&Y thinks more needs to be done to facilitate significant activity here though.  In particular the trading rule needs to be allowed because residential investors tend to trade a proportion of their stock to boost yields and currently the tax implications of this are prohibitive within the REIT structure.

Strong investment & market case for the creation of mortgage REITs.

Institutional Investor Panel (inc Canada Pension Plan, Oxford Properties, Allianz & Orchard Street):

Appetite shown for increasing the allocation to real estate but cautionary comments made around some of the challenges involved.

No rush to deploy capital seemed to be the general attitude with some tentative signs of an increase in suitable deal flow.

Allianz explains that insurance companies account for 30% of the RE lending market in the US but far less in Europe.  This is probably because the margins were twice as high in the US as compared with Europe so with margins on European Real Estate loans having now increased the insurance sectors’ exposure to the lending market should steadily increase.  LTV’s around 60% and 7-10 year terms are typical.

The panel appears expects to be relatively unaffected by Solvency II because in the case of pension funds and insurance companies they have very high capital adequacy ratios already.

Real Estate Funds: Strategic Options Panel (all E&Y):

Extending again is becoming a less convincing proposition to incumbent lenders.  This should lead to some additional transactions (not a flood).

Fund raising:

  • 440 funds chasing £151bn of equity (3 times the amount raised in 2010) – so basically there are too many funds chasing too little equity.
  • Simplified fee model desired – single fee model clearly preferred over multiple transaction-related fees.
  • Sector specific funds (by geography & asset class) preferred
  • Funds focussing on fewer ‘like minded’ investors
  • Funds are raising around $50bn a quarter which is the 2004 level.  By around 2014 this should have picked up quite a bit and investment globalisation should have returned.

Future trends:

  • Uncertainty – a little bit more of more of the same
  • Maturing debt
  • More HNWI investments

The pro-Europe team (Internos, Westbrook) won the Industry Debate against the pro-Emerging Markets team (E&Y).  The transparency & security arguments proved persuasive despite all parties seeming to agree Europe was effectively bankrupt and the expectation that Emerging Markets would grow a lot faster in the years ahead.

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3 Comments

  1. Great set of notes Martin! Worthy of a page in the Grauniad.

    • Oh no, are there that many typo’s in there ??!! I did kinda rush it off without spell/grammar checking. And of course I typed it up on my iPad (and happen to be mid-way through the Steve Jobs audiobook) so I reckon you’ve rather hit the nail on the head there Nick ! 🙂

  2. The panel appears expects to be relatively unaffected by Solvency II because in the case of pension funds and insurance companies they have very high capital adequacy ratios already.


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