Europe’s big bang

The European listed property sector is poised for expansion with the debut of real estate investment trusts in the U.K. and Germany next year.

Five years ago ING Clarion, the U.S. investment management arm of New York–based ING Real Estate, was purely a domestic player. Today the firm’s portfolio managers are booking plenty of trans-Atlantic flights. Of ING Clarion’s $14 billion in assets, about $2 billion are in Europe, held by a variety of institutional and subadvised mutual funds, including the $393 million ING Global Real Estate Fund, launched in 2002, and the nearly $80 million ING International Real Estate Fund, launched earlier this year. There’s good reason for ING Clarion’s new focus: The firm’s European investments have gained more than 34 percent annually over the past five years.

ING Clarion has plenty of company. Although European real estate was once largely a national or regional play, “investment in Europe is going global,” says Fraser Hughes, research director of the Netherlands-based European Public Real Estate Association.

Theodore Bigman, head of global real estate for Morgan Stanley Investment Management, says the trend is gathering force. “In 2006 in particular, the public and corporate pension fund community has accepted and attempted to allocate rapidly to the non-U.S. listed property markets,” he says. Bigman’s team, which has roughly $20 billion under management, has been investing in publicly traded European property companies since 1997.

Other big money managers increasingly active in the sector include London-based Henderson Global Investors, which runs a global real estate portfolio of E11.2 billion ($14.2 billion), fund complexes such as Fidelity Investments and REIT specialist Cohen & Steers, which recently agreed to acquire the remaining 50 percent stake in its Brussels-based European affiliate, Houlihan Rovers, which manages $3.5 billion. Barclays Global Investors, the biggest REIT manager in the U.S., with more than $10 billion in assets, expects to soon launch a global REIT index product with European exposure, says Amy Schioldager, who oversees the firm’s REIT investments.

The publicly traded European real estate sector, which includes both REITs and non-REIT companies, has repriced accordingly. Over the past five years, the benchmark FTSE EPRA/Nareit property index has climbed by an average annual 32.5 percent, versus 22.8 percent for the comparable index of listed North American property and 23.8 percent for listed Asian property.

Interest in European property isn’t likely to wane anytime soon. The 2003 debut of REITs in France spurred healthy growth in the sector. Now a real estate “big bang” is in the offing, with the U.K. and Germany poised to introduce REITs next year. That should unlock new supply and make real estate investing simpler, more tax-efficient and more appealing for investors, especially those seeking income. The U.K. will introduce its REIT regime in January, and Germany is expected to follow closely, although the exact timing and details are still being debated.

Under the U.K. regime, REITs must pay out 90 percent of their profits as dividends, as they do in the U.S. REITs won’t pay taxes on capital gains or on rental income as long as it makes up at least 75 percent of total income. As of late October the German government’s draft legislation, though broadly similar to the U.K.’s, contained two restrictions: It capped foreign ownership of REIT shares at 10 percent and excluded residential property companies from REIT status because of concerns that higher rents could result.

Listed property markets have plenty of room to grow in both the U.K. and Germany. By year’s end, according to the Washington-based National Association of Real Estate Investment Trusts, the two countries’ investment-grade commercial property markets will each be worth about $1.15 trillion. In the U.K., though, only about 5.5 percent of that market is publicly traded. In Germany the figure is less than 1 percent.

With the introduction of REITs in both countries, the listed real estate market in Europe “could easily more than double in the next five years,” says ING Clarion’s Steven Burton, who oversees listed real estate investments from the firm’s Radnor, Pennsylvania, office. Even though growth is moderating and the sector has repriced, Burton expects European REITs to deliver a total return of 8 to 12 percent over the next 12 months, compared with 4 to 6 percent for U.S. REITs.

If France is any guide, investors have reason to be optimistic over the long haul. When that country introduced its REIT structure — called sociétés françaises d’investissements immobilièrs cotées, or SIICs — nearly all of its listed property companies converted to SIIC status. The sector that once traded at a discount to net asset value of more than 10 percent now trades at a premium of 10 to 20 percent. This year through September listed French property returned 55 percent in dollar terms (about 7 to 8 percentage points of return came from euro appreciation).

Burton, who is overweight French property, sees further growth ahead. “This is a country that has hit its sweet spot in terms of the quality of its REIT companies as well as its overall economy,” he says. Still, heightened sensitivity to the historical character of French town centers and the rights of small tenants can make development tricky. That’s why Burton favors two well managed SIICs that have been successful in bringing new supply to market: Paris-based Unibail, which invests in office and exhibition space in and around Paris and retail space throughout France, and Klépierre, a Paris-based shopping center and office property company.

In the U.K. all of the major listed property companies plan to convert to REIT status, and they are all currently trading at or below their net asset values, says Patrick Sumner, head of property equities at Henderson Global Investors. Sumner is overweight three future U.K. REITs trading at discounts to NAV that range from 6 to 9 percent: British Land, which invests in regional U.K. retail property and London office space; Land Securities, a market leader in City office space; and Hammerson, which holds London office property and shopping centers throughout Europe, including France. That makes Hammerson’s stock a cheap way to play French real estate.

The introduction of REITs in the U.K. may ultimately drive more specialization in the market, says David Sleath, CFO of Slough Estates, one of the first major U.K.-listed real estate companies to announce that it would convert. Slough has already reduced its residential and retail holdings to strengthen its focus on what the company calls “flexible business space” — properties that can be used for manufacturing, light assembly and R&D. As REITs, says Sleath, U.K. property companies will “look quite different from today.”

Many international portfolio managers are especially bullish on prospects in Germany, where publicly traded real estate is still in its infancy — and thus where the REIT market has the most room to grow. Some listed companies — including Bonn-based IVG Immobilien, which oversees a pan-European commercial real estate portfolio worth E17.4 billion — have announced their intention to convert to REIT status as soon as the law allows.

The commercial real estate market could also get a lift from German corporations, which may be driven to monetize the relatively large proportion of property they carry on their books. At the end of 2005, according to a recent study by Munich-based Roland Berger Strategy Consultants, 13 DAX-listed German firms owned E80 billion in property, tying up approximately 10 percent of their capital.

Given the recent amendments to Germany’s draft REIT legislation, the impact on the residential sector is murky. Nonetheless, ING Clarion’s Burton asserts that the tax benefits of REIT status are only part of the value equation. He owns Mainz-based Deutsche Wohnen, whose nearly 22,000 residential properties are concentrated in western and southwestern Germany. The company is “adept at renovating old apartments and converting them into something much more attractive, both financially and aesthetically,” says Burton.

As with any investment, Europe’s growth story has the potential for plot twists. David Harris, a New York–based senior REIT analyst at Lehman Brothers, contends that the tax treatment of REITs could be vulnerable to political meddling. In the more immediate term, interest rate hikes by the European Central Bank could put a damper on the sector.

Still, as the U.K. and German real estate markets become more investor-friendly, any near-term setback is likely to be outweighed by growing demand among individuals and institutions alike for new sources of returns. “The basic rationale is, if you like publicly listed U.S. REITs, you can get comparable returns but more diversification” in Europe, says Burton.

When it comes to real estate, it seems that the Old World’s biggest markets have become the new New World.