October 21, 2014
Interviewed by: Privcap
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Expect Long-Term Low Yields in Europe

Investors are pricing in long-term low yields for Europe’s real estate markets, says LaSalle Investment Management’s head of Europe strategy, Mahdi Mokrane, who believes this means LPs should target irreplaceable assets.

Investors are pricing in long-term low yields for Europe’s real estate markets, says LaSalle Investment Management’s head of Europe strategy, Mahdi Mokrane, who believes this means LPs should target irreplaceable assets.

Expect Long-Term Low Yields in Europe
With Mahdi Mokrane of LaSalle Investment Management

Zoe Hughes, PrivcapRE: I’m joined here by Mahdi Mokrane, Head of European Research and Strategy at LaSalle Investment Management. Mahdi, thank you so much for joining me today.

Mahdi Mokrane, LaSalle Investment Management: Pleasure.

Hughes: When we look at Europe, there’s mounting concern about the speed at which capital is flowing into certain markets there and whether pricing is running ahead of fundamentals. Mahdi, I know it’s difficult to talk about Europe as one market, but do you worry that, in select markets, capital is ahead of fundamentals?

Mokrane: It’s a tempting conclusion. This is discussed with investors around conferences and investor circles. I think this comes from weak fundamentals, weak growth overall and weak job creation, which doesn’t feed into increasing demand for floor space, whether it be offices, retail or industrial. At the same time, you see low bond yields, which are actually pushing investors to higheryielding asset classes. Real estate is one such asset class, so we’ve seen height in investment volumes, but not to the order of magnitude that we had seen prior to the GFC.

Hughes: You talk about low growth and low yield. What are your future expectations, then, when you look at rental growth or at yield?

Mokrane: I think Europe can be characterized by three lows: you have low growth, low yield essentially on the back of the difference between potential GDP achievable in Europe as well as where we are today in terms of value-added creation. At the same time, you have to factor in the third low, which is low development. So, low growth, low yield and low development. Those three put together make a pretty compelling attractiveness for the real estate asset class.  We are seeing a problem, which is that most investors would want the same thing today, the same type of asset. A prime asset in one of the gateway cities—London, Paris, Munich, Stockholm and maybe a handful of other cities in Europe—and virtually nothing in terms of secondary or assets with short leases or in need of active asset management.

Hughes: That’s why we’re really seeing the pressures on pricing then?

Mokrane: Absolutely.

Hughes: As everybody’s going after those core markets.

Mokrane: Absolutely. If you compare today’s yields in prime London, Paris and Munich, for example, or even Stockholm, you’re pretty close to historical lows. That is creating a concern. Today, what is being priced is really an expectation that capital will be preserved and yields will stay low for the foreseeable future and for longer than expected initially. Actually, markets are not very good in predicting yields if you look back; we’ve done some research at LaSalle and you can really see that yields have not behaved as they were expected to. Today, we think yields will correct over time, but that will be gradual. We are telling our investors that, if some investors want prime assets, they should go for irreplaceable assets. Assets that have such a position in terms of their leasing but also their building quality and location.

Hughes: How do low growth, low yield and low development work into LaSalle’s strategy? Where do you see the best relative value today for investors?

Mokrane: That very much depends on which investors we’re talking about and which risk bucket they’re willing to invest in when they talk about European real estate. If we are talking to a pension fund, for example in the UK, one area we probably wouldn’t like to deploy capital in is in the prime markets, to compete against the large sovereign wealth funds, high net-worth individuals, investing for capital preservation and not necessarily for asset liability matching. We would probably prefer locations that will become destinations in the future, benefiting for example, from cross rail in London or from the spread of growth in the regions in the UK. We would probably look to find value with active asset management in the retail sector or a higher yielding office markets, probably in the peripheral fringes of CBD in London. Across Europe, we have similar strategies for domestic investors looking for long-term value.

Now, if you are moving up the risk curve slightly, there are obviously a number of regions in Europe that enjoy faster growth than the average—for example, the Southeast, the UK and Paris. This is the case in some markets and regions in Germany and in northern Europe.

Hughes: Do you see investors moving further out into the periphery, taking on more risk? Perhaps Tier3 cities or even looking out to central and Eastern Europe?

Mokrane: There’s a lot of discussion and interest in the peripheral markets, particularly the former socalled “crisis countries,” which are Ireland, Spain, Italy, Portugal and Greece, for example. Spain is probably the numberone destination for the expectation of bargain deals and outsized returns. But, investors are finding it very difficult to find the right product at the right price. Rents have fallen. Yields have decompressed slightly. You do find investment volumes increasing from a very low base, but I don’t think we’re seeing the order of magnitude that was expected. We’ll probably see more value in Italy, northern Italy and Poland, for example, and Tier2 cities. These cities are enjoying high growth, good demographics and good infrastructure and are driven by technology and urbanization. That’s probably where the medium to long-term value is to be found.

Hughes: Based on many of the discussions I’ve had with European managers, I know they see that Europe is much more of a value-add play today. You really have to work it as an asset. Do you see Europe as a value-add play today?

Mokrane: U.S.based investors would see it. If you talk to southeastern Asian investors, it’s probably more nuanced. They still probably want to build up core portfolios and diversify away from their own domestic markets. It is fair to say that we’re six years on into the crisis. Many assets—which probably would tick the box of location, good quality asset—are still in need of good capital expenditure; they need to be repositioned for future attractiveness. I’m not only talking about offices. This is the case for shopping centers and for retail parks. There is a lot of work to be done that hasn’t been done over the past four or five years, which hence, leads to a value-add play. Five years ago, we were only talking about core prime and, on the other extreme, opportunistic. Nothing was really in the cards on the table in terms of value-add. Today, as we gradually grow out of this crisis, it’s slow and still continues to be pretty painful in some countries. The opportunity is actually building up for that value-add play. But again, we have to be very careful in asset and stock selection. Not everything will recover.

Hughes: Obviously, you talk about the globalization of capital flows, moving from the southeast UK into the regions and the peripheries. Globalization of capital flows has been a real characteristic in the wake of the crisis. Are you actually surprised at the pace and the volume of how global capital is today for real estate?

Mokrane: The pace and speed are surprising. We have seen some spectacular deals. We’re seeing more frequent larger deals, portfolio deals and pan-regional deals. That’s an interesting feature in the market, but what is probably surprising and of interest to investors is that this is mainly equity driven. This is not a debtdriven pace. We have to be careful and monitor this—if this changes, then we’ll probably be in a more difficult situation.

Hughes: Does that reassure that it is an equitydriven capital flow rather than the debt slider?

Mokrane: Certainly, because if we’re facing a downturn and a downturn will eventually happen, we will not see a systemic risk. We will not be faced with the same banking failure or risk of banking failure and a domino effect, which ultimately affects the real economy. This will be essentially investors coping with eventual capitalvalue losses.

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