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Europe beckons

The easy money has been made, but the outlook still seems promising for EU real estate.

The easy money has been made, but the outlook still seems promising for EU real estate.

By Sharon Reier
June 2001
Institutional Investor Magazine

The easy money has been made, but the outlook still seems promising for EU real estate.

Inside La Défense, the sterile but sought-after office tower complex just outside Paris, Unibail, France's largest publicly held real estate company, is wrapping up work on Coeur D,fense. Twin towers with 182,000 square meters of space, the buildings will be home to Axa Group, Société Générale, ING Group and other corporate clients that have preleased about 90 percent of the available space. The going rate: Ff3,500 to Ff4,000 ($460 to $520) per square meter. That's roughly double the price that Unibail charged when it started leasing Coeur Défense two years ago.

The outlook for commercial real estate in and around Paris seems particularly promising, but property values are on the rise at the moment across much of the Continent. Commercial space is tight in Barcelona, Madrid and Munich, among other markets. Credit an imbalance between growing demand from corporate tenants that are still expanding - even amid the current European slowdown - and a limited supply of suitable office space.

One result: For the first quarter, the Global Property Research index of European real estate securities rose 3.9 percent in euro terms, versus a 10.3 percent decline for Morgan Stanley's MSCI Europe index. For 2000 the real estate index increased 16.4 percent in euros, while the MSCI Europe fell 1.9 percent. Although the easy money has already been made in European real estate, in both direct investment and equities, the market still holds considerable promise.

Weary of high-tech blowups and sobered by the high prices that prevail in many U.S. property markets, more and more pension funds and other U.S. institutional investors are committing new capital to European real estate, in the form of stocks, funds and direct investments. Says Ted Bigman, a Morgan Stanley managing director for real estate funds, "Our big-picture statement is that while the U.S. real estate market has reached equilibrium, this is a good time to get into Europe."

All the same, many institutional investors that entered the European real estate market during the slump of the mid-1990s are now taking some of their chips off the table. LaSalle Investment Management sold its $300 million Francilienne portfolio, acquired in 1995, to German investors for a return in excess of 60 percent a year. Goldman, Sachs & Co., American International Group and Standard Life Assurance Co. are disposing of selected properties and pocketing impressive returns.

Outsize returns may be tough to come by now. As Van Stults, managing director of Orion Capital Managers, whose firm has invested E750 million ($640 million) in Europe over the past year, admits, "Last year was as good as it gets." Nevertheless, Stults and other investors say European commercial real estate still represents a highly attractive market that ought to provide returns of more than 20 percent to direct investors over the next couple of years, barring an outright global recession.

Stults contends that many European cities face an acute shortage of the kind of top-quality office space demanded by multinationals. In Paris, where the office vacancy rate is a minimal 2 percent (versus an equilibrium rate of 6 percent), about 75 percent of the office space is in older buildings that are awkwardly laid out and - no small defect for a foreign executive - not yet wired for air conditioning. In February his fund picked up a E450 million portfolio of diversified French properties when it acquired Locafinancire, a publicly traded real estate company based in Paris. But Orion also has a number of other buildings that will soon be open for business in outlying Parisian neighborhoods. "We have exceeded our expectation for properties in nearby suburbs like Issy-les-Moulineaux and St.-Denis," he says. "These buildings are very cost-effective alternatives for firms in central Paris. The rents could be half those of central Paris."

Carlyle Group is raising $500 million for its first European real estate fund, which will make direct investments. Apollo Real Estate Advisors hopes to raise about $500 million for its International Real Estate Fund, primarily aimed at Europe, and Goldman Sachs' Whitehall Group has amassed $2.3 billion, a significant portion of which will be invested in Europe.

Jeppe de Boer, a London-based real estate analyst at Goldman, sees firsthand evidence of the growing interest in Europe. Several months ago he published an extensive analysis of European real estate stocks. "If I had written this the year before," he says, "I might have [been asked to visit] ten U.S. institutions after publishing the report. Now I am visiting almost 40."

Still, the industry is unlikely to return to the dangerously heady days of the early 1990s. Back then, banks dangled far too much capital in front of eager developers, financing empty buildings, and European office markets became seriously overbuilt. In 1992, for example, Kowa Real Estate Co., a subsidiary of the Industrial Bank of Japan, paid Ff100,000 per square meter for Washington Plaza, an office property near the Arc de Triomphe that was in dire need of renovation. Kowa spent a further Ff20,000 per meter to modernize the space. Recently, a consortium of French institutions led by Société Fonciere Lyonnaise bought the property for about Ff60,000 per square meter - roughly half the price paid by Kowa.

Although European Union real estate values are not yet approaching their early '90s peak, rental rates have climbed back to levels not seen since the start of that decade. Says Eric Sasson, head of Carlyle's new European property investment group: "Ten years later you are back to rental prices of Ff5,000 per square meter for top locations in central Paris. But ten years have gone by, and there has been inflation."

Whether today's deals will look good several years from now will probably depend on two factors: the growth rate of European economies and the rate at which new real estate space becomes available. Jay Henry, head of the European real estate investing group at Morgan Stanley, remains optimistic on both fronts: "Europe may weather the storm as well as any economy out there. And on the supply side, it has been very difficult to deliver supply. In cities like London, Paris and Milan, the regulatory structure is more difficult than in the U.S."

Others are not so sanguine. Jones Lang LaSalle, a Chicago-based real estate brokerage and research firm, estimates that while Paris will see a minuscule 2.4 percent increase in new space coming to market this year, with a further 2.5 percent added in 2002, other cities will face more substantial additions. Madrid anticipates a 6.5 percent jump in 2001 and an 8.2 percent increase next year; Munich is looking at 5.1 percent and 7.5 percent increases for the next two years.

As for the economy, if the U.S. goes into recession, Europe - and European real estate - will undoubtedly feel the effects. Orion's Stults says: "The current question is how firm are these preleased spaces? Will the technology, telecom and media companies actually take their pre-lets? And we have to watch the financial institutions. Currently, the investment banks are in a hiring freeze, and staff reductions could mean that we'll see some sublease space coming on the market."

To circumvent any slowdown, Carlyle's Sasson says he intends to buy properties in regional French capitals like Lille and Marseille. Demand tends to be more stable in these markets, where subsidiaries of multinationals have recently opened new outposts. "When you are an EDF or Coca-Cola," says Sasson, "as much as you are headquartered in Paris, you also need tentacles in places like Lyon. It had been a city where only French companies had assets. Now you have Germans and Americans buying up properties."

As Sasson well knows, as European governments continue to sell off state-owned assets and public companies restructure, more real estate will be coming on to the market. "There is a very strong deal flow," he says.

Lehman Brothers recently joined with Beni Stabili, an Italian real estate firm, in a landmark E2.9 billion deal with debt-laden Telecom Italia to buy telecommunications and office buildings. It is now negotiating a deal with Swisscom. Five months ago Goldman's Whitehall bought Peugeot's headquarters in Neuilly-sur-Seine, a Paris suburb. In the offing: sales of property portfolios and individual properties from Siemens, ENI and Deutsche Telekom.

No one expects these assets to come on the market at vulture fund prices. "Opportunity presents itself if a property is undermanaged or underutilized," says Stults. "Money is made in adding value and modernizing."