Add Value and Diversification, through Value-Add

Real Assets Research team
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31 août 2017
  • Recovering occupier demand and low levels of modern stock help create a favourable environment for value-add strategies in Europe
  • Range of options for investors such as: developing new space, redeveloping obsolete buildings and taking on vacancy and letting risk
  • A combination of strategies should reduce risk, through diversification

Positive market for value-add strategies

AXA IM - Real Assets believes the current real estate market is favourable for value-add strategies in Europe. A number of viable options are available at this point in the cycle, including developing new space, refurbishing out-moded space and taking on vacancy risk. We believe it would be prudent for a fund manager to undertake a variety of strategies so as to reduce risk through diversification.
European GDP growth accelerated by a seasonally adjusted 0.6% quarter-on-quarter in Q2 2017.1 Stronger than expected momentum at the start of the year and improvements in global growth have led GDP growth forecasts to be revised upwards in several countries. GDP growth is now projected to be near or above the long-term average in several European markets over 2017-2021.2 With confidence improving and employment forecast to continue rising, this points to a stronger outlook for occupier demand, which is vital for rental growth.3

Prime real estate yields have fallen to record lows in many European markets4 but significant further falls are unlikely,5 particularly as interest rates are expected to gradually increase. Although yields on assets in secondary locations or for poorer quality assets have also fallen, spreads between prime and average real estate remain above average,6 supporting value-add strategies that can drive yield compression through asset repositioning.

Volume of old stock creates an opportunity

Occupier demand continues to recover in many of Europe’s commercial real estate markets. For example, CBRE data suggests that logistics take-up reached record levels in each of Europe’s five largest economies7 in 2016 and that European office take-up is approaching the highs experienced in 2007. At the same time, vacancy rates have been declining in the majority of European property markets, as subdued development since the Global Financial Crisis coincided with improving occupier demand. Additionally, a considerable volume of stock has been redeveloped for other uses, such as conversion from offices to hotels or residential. As the recovery in occupier demand should continue and net additions are forecast to remain below average,8 vacancy rates are likely to continue to trend lower over the next two years in a number of European real estate markets, including Amsterdam, Hamburg and Madrid.

The modest volume of net additions seen in many European commercial markets has resulted in an ageing of the stock profile. The volume of stock that is less than 10 years old has fallen over the past five years.9 This trend should continue, as, although development is increasing, completions are forecast to remain below their long-term averages in many markets, including Amsterdam, Madrid and Munich.

In many markets, this combination of ageing stock, low availability of Grade A space and forecasts of below average net additions presents options for valueadd investors. One strategy would be to refurbish or redevelop well located but outmoded stock so that it better conforms to tenants’ requirements for modern, efficient, flexible space. Improving the income profile should also drive relative yield compression, regardless of underlying market dynamics.

Development in established locations should also be attractive, although, for a value-add strategy, AXA IM - Real Assets’ preference would be to mitigate risk, for example by part pre-letting an office, forward-funding a logistics asset or extending a dominant shopping centre. With strong investor demand for core assets driving values ever higher, development presents an opportunity to build core assets at a yield-on-cost that is higher than yields available on standing investments in today’s competitive investment market.

Value creation strategies, such as taking on vacancy and letting risk, should be suitable in markets where demand is improving, vacancy rates are low and market rents have risen to near or above previous highs. Examples of such markets include Berlin, Munich and Paris CBD. Increasing and improving the quality of income, such as by granting leases at higher rents and to stronger covenants, should have a positive valuation impact.

Some markets should not be considered

For global or pan-European investors, AXA IM – Real Assets believes Europe’s largest cities should be the focus of value-add strategies. Historically, such cities have typically outperformed their national averages,10 and on-going demographic changes (Europe’s populations are ageing and continuing to urbanise) should drive a continuation of this trend. Moreover, both occupier and investor markets are substantially deeper and more liquid in large cities than in small, which can be an important determinant of asset performance. Additionally, higher land values in larger cities could help protect against asset depreciation.

There are still considerable disparities in take-up, availability and development between European commercial real estate markets. For example, AXA IM - Real Assets’ analysis suggests that the combination of record demand and modest net additions mean that there is less than one year’s supply of available office space at recent11 take-up levels in Berlin, the lowest since 1994. In contrast, there is more than 4.5 years supply in Rome, due to seven years of modest or negative net absorption.12 Even if space that is expected to complete over 2017-2018 is included, Berlin’s supply edges up to less than two years. However, there are some markets with significantly higher volumes of new space expected to complete over the next few years, including Dublin, Budapest and the City of London.

The aggregate numbers hide substantial disparities within cities. AXA IM – Real Assets’ analysis suggests that while there is an average of 2.1 years’ supply of space in Paris Ile de France (including  space expected to complete over 2017-2018), this varies between 0.9 years in the tightly constrained CBD and 4.6 years in the over-supplied, less popular, Outer Rim. AXA IM - Real Assets’ preference is to take on risk at the asset or tenant level, rather than location.

Opportunities in emerging sub-markets

Investing in locations that are expected to become more attractive to occupiers and investors (for example due to new infrastructure projects or changes in economic drivers), but where land or assets are currently available at a discount to core, is also a preferred value-add strategy. For example, a growing preference for inner city living and the new Crossrail route has helped to drive the emergence of new office, retail and residential sub-markets in London. Similarly, AXA IM - Real Assets expects the development of the Grand Paris Express to benefit particular sub-markets in Paris that will see a significant improvement in accessibility, such as Saint-Denis and Saint-Ouen.

A number of alternative sectors, such as hotels, may also offer value-add opportunities. The hotel sector is seeing growing demand from leisure and business travellers but many cities have seen demand outstrip supply, leading to increased occupancy and room rates. While some cities have seen a considerable increase in the number of hotels under development, AXA IM - Real Assets’ analysis shows that most cities with high pipelines also have high occupancy rates, and hence new supply should be rapidly absorbed; examples include London, Munich and Amsterdam. AXA IM - Real Assets believes that selected hotel markets offer opportunities to execute value-add strategies, such as redeveloping obsolete buildings as hotels, extending hotels or taking on operating exposure through management agreements to add value through operator-driven strategies, such as rebranding or repositioning.

Considerable scope for value-add investment

While recognising that finding suitably priced opportunities is increasingly difficult, AXA IM - Real Assets believes the current real estate market environment, with recovering occupier demand but low levels of available, modern stock, is favourable for value-add strategies. Potential approaches at this point in the cycle include developing new space, redeveloping obsolete buildings and value creation strategies, such as taking on vacancy and letting risk in suitable sub-markets. However, as there are still substantial disparities between and within markets, a focus on micro-location is key to performance. A combination of value-add strategies should help a fund manager construct a portfolio that is influenced by a range of factors, and reduce risks by means of diversification, while offering the ability to enhance returns.

1 As at August 2017, Macrobond data
2 Examples include Spain, Germany and Italy. Forecasts from AXA IM Research, as at June 2017
3 We estimate a correlation of 0.75 between Eurozone employment growth and Eurozone prime office rental growth over Q1 1996 to Q1 2017, CBRE and Eurostat data
4 As at Q2 2017, CBRE data
5 AXA IM – Real Assets, forecasts as at July 2017
6 Spread between top quartile and average cap rates for Europe All Property as at Q1 2017, RCA data
7 Germany, France, UK, Italy and Spain
8 Based on Property Market Analysis’ forecasts for major European offices markets, as at Spring 2017
9 Based on Property Market Analysis’ estimates of office and shopping centres completions, as at Spring 2017
10 In terms of GDP growth over the 10 years to end-2016, Moody’s and Macrobond data, as at end-2016. Examples include Berlin, London, Paris and Stockholm
11 Take-up over the four quarters to end Q1 2017, CBRE data
12 CBRE data

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