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


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.


Notes from the Family Office Investment Europe Summit

On Wednesday I was a guest at the Family Office Investment Summit

I’m glad I took notes because Patrick Minford in particular was excellent!

Patrick Minford CBE (Economist) – Economic Outlook

Crisis & Response

  • Commodity shortage, US housing crash causing subprime defaults, Lehman failure in Sept 2008, bank panic & banking crisis
  • Collapse of world GDP 2008Q4-2009Q1, massive bank bailout, money printing, zero interest rates
  • Great Depression turned into Great Recession
  • Strong recovery in emerging markets, muted recovery in developed markets
  • Productivity growth held back by commodity shortage in developed countries while emerging markets productivity growth grew fast despite this.  “Commodity wall”
  • Biggest mistake was Lehman

Strength of Recovery

  • Muted recovery in the West (c2%pa GDP growth) – stock markets weak, high unemployment, weak consumer spending, high industrial production growth (exporting to the emerging market consumers).  No double dip but a slow recovery.
  • Strong growth in the East (c4-9%pa GDP growth) – leading to near record world GDP growth which is causing inflation and EM countries are having to raise interest rates to control it.
  • Strong carry trade – borrow in the West at near zero rates to lend/invest in the East where growth is at near record highs.
  • Boom in money and credit in the emerging market economies.
  • World commodity prices soaring, wages rising in EM, general world inflation (e.g. 3-4% in the West and near 10% in much of the East)

Summary & Outlook

  • Expectation of higher interest rates of around 2.5%pa in the UK for 2012 and staying around that level through 2014.
  • Supports Osborne’s plan which should bring Public Borrowing under control even with low growth rate peaking in 2014/2015 Relative price of housing pretty much on track (not over-valued) – housing is a commodity shortage Profits will go on growing as real wages fall and yet growth keeps going.
  • Real wage growth expected again in 2 years or so.
  • Structural reform will not occur in Europe where countries like Greece and Portugal don’t like reform and will only do so at a slow pace.
  • The likes of Greece will go bust, it’s just a matter of when & how.  Typically this happens by devaluing a country’s currency and dropping out of the Euro to achieve this would be the best thing for Greece, Portugal & Ireland but they don’t seem to understand economics very well on the continent so can’t say what they will do.

Asset Allocation “In the New Normal” Panel

  • Caroline Butler (Lord North Street) – Greater awareness that who you surround yourself with really matters. Hedge funds provide an alternative to bonds in reducing volatility.
  • Michael Turner (Aberdeen AM) – Regulation and government intervention to affect asset class returns much more than in the past.
  • John Moore-Stanley (Cardona Lloyd) – Strong focus on liquidity and time horizons.  Likes hedge funds & CTA’s.  We will constantly be going through cycles of uncomfortable inflation and this will push us towered cash and away from bonds.
  • John Veal (Stonehage) – Managing underlying family businesses is key because often cash calls occur during crisis just when the best opportunities arise.
  • Jean-Yves Chereau – The crisis is generating lots of opportunities and beautiful assets as banks clean their books and as lending has dried up opportunities arise providing debt looks interesting.  Do you have the management capacity to access the deal flow or who are your advisors to assist with this?

Notes from the Ernst and Young EMEIA Real Estate Workshop

Ernst & Young EMEIA Real Estate Workshop

Here are my notes from the excellent E&Y Workshop I attended recently.

Bid-ask spreads narrowing
Transaction levels rising

Sir John Gieve (former Deputy Governor of the BOE)
The uncertainty is still there because:
Economic forecasting models are broken
Prediction: big swings in market sentiment & lots of volatility in the markets Currently fiscal (spending) and macro-prudential (regulation) brakes on while the monetary (interest rates, QE) accelerator is firmly on Expectation that private sector investment, consumer spending and emerging market growth will pull the UK towards around 2% GDP growth in 2011 MPC likely to be cautious about raising rates early in 2011 but if growth continues throughout the year then rates could rise faster than the market currently expects (to somewhere between 3-7%) Emerging market economies in particular the Chinese likely to lead to a big inflationary boom that spreads to the West through commodity prices

Adrian Cooper (CEO, Oxford Economics & ITEM club advisor)
World GDP growth is outstripping already relatively bullish forecasts North and South Europe dramatic divergence in growth and prospects German competitiveness has improved significantly over last 10 years whereas southern European states have become significantly les competitive as labour costs have risen Fiscal tightening and divergence in investment will also hold back the Southern economies for a prolonged period c50% chance of Greek debt restructuring and/or smaller chance of some form of Eurozone breakup Other notable risks include oil and commodity inflation and recognition of Spanish debt/losses as a result of their boom time lending to construction In the UK massive switch in govt spending worth around -1% on annual GDP growth Household de-leveraging to hold back growth further Rising exports will help though past failings in exports to emerging economies (Italy exporting more to the BRICS than the UK for example) Modest growth forecast in office-based employment and consumer spending leading to limited demand growth in offices and retail property High single-digit total returns expected for prime commercial property

Macro-Economic Panel
Huge demand from the Middle East for construction and infrastructure but there are major risks around political risks as a result of underinvestment in food, healthcare, education, employment and social stability.
If we can see civil unrest in the UK then we can expect to see unrest in other states as austerity measures start to bite.
US deficit is not expected to be a major threat in the next couple of years but it will be in the longer term – the UK had the same problem when it ran the reserve currency and that held us back for 50 years after the second world war Currency disparities and interventions make life difficult for global Investors seeking to hedge out risks Pension funds slowly increasing allocations to real estate but notably focussing on core assets and focussing increasingly on specific cities rather than whole countries Negative real interest rates could lead to a bubble in some asset values.  Highly leveraged investors even in core assets are at risk from interest rate rises designed to combat high inflation Euro stress tests back in July showed 84 out of 91 banks were well capitalised including the 2 largest Irish banks which are now bailed out.  This will prove a drag on the economic recovery and it will take quite a long time to relieve c50% of maturing real estate debt is underwater and although resulting opportunities are few and far between they are worth looking for

Drivers of Real Estate Panel
Property looks more interesting than bonds but less attractive than equities (Harm Meijer, JPM) Lots of inflows to direct investment funds moving out of bonds (Harm Meijer) JPM are positive on property, more prime but starting to find opportunities in secondary Institutions are currently underweight in property and increasing their allocations.  Increased inflation driving this demand as they look to protect themselves.  Harm Meijer is astonished that they are coming so late to the party Trust issues will endure for years ahead while funds re-align their interests with LP’s and increased co-investments are demanded UK retail funds raised a lot of money in Q1 2010 and 2007 opportunity funds are all sitting on a lot of cash but is there a bubble in prime and super-prime and do return expectations need to come down.
“If you look at what is happening to real estate, it is exactly what happened in 2007 and 2008 when cap rates were plunging and LTV’s were going up without cash flows”. (Starwood Capital Chairman & CEO – Barry Sternlicht) Caveated with in certain prime sectors (Doug Kirkman, Blackstone) It’s probably the best time in living memory to setup a bank because margins are very high and lenders can pick their borrowers and properties.
Existing lenders cannot afford to take the losses on existing loans so they are very limited in their capacity to lend.  Particularly in the UK where there is still no securitisations market in contrast to the US which has begun to close some and is expected to increase this flow.
Insurance companies may increasingly likely to enter the market (Solvency II will encourage them to do so) but it will take them time to build their teams and they are unlikely to buy up existing debt portfolios.
According to Knight Frank 2010 occupier take-up in Financial Services in the UK was actually higher than during the boom years however this is substantially offset due to impending lease expiries and competition from Internet based businesses etc so net absorption and rental growth is likely to be quite limited and generally restricted to prime.
London and Germany are relatively booming whereas regional locations are really struggling.
Supply of product is going to be slow while the clearing prices continue to sit below the holding values and supply of debt is highly restricted and it is likely to take some years before big non-performing loan books really come to market due to political debates around bank break ups etc.
Sustainability – opportunistic investors are less interested in this than price etc however pension funds are pressuring listed owners and occupiers are increasingly expected to demand higher standards.
Increased transaction activity is expected though only by around 10-20% and from a relatively small base.
Banks will have to extend and pretend until deals break and have to be dealt with or they have generated sufficient profits for their capital base to enable them to take losses on existing holdings.