Hidden real estate pearls in Europe

Transcription

1 Asset Management Sustainable Investing Viewpoints Hidden real estate pearls in Europe Location rating as the first step towards sustainable and high-yielding portfolios For institutional investors only March 2017

2 2 Contents About the authors Klaus Kämpf Head of Sustainability Research Real Estate Introduction Klaus Kämpf is Head of Sustainability Research Real Estate at Vontobel Asset Management. He has been working in the field of sustainable investing since 2002, first in sustainability research for equities and bonds, and since 2009 for real estate. Mr Kämpf studied physics at the University of Freiburg in Breisgau, King s College London and the University of Hamburg. 4 The benefits of secondary urban centers 5 Method and sources how do we go about it? 7 Scandinavia on top, while SouthEast Europe lags 9 Location rating as part of the investment process Balazs Magyar, Senior Sustainability Analyst Balazs Magyar has been working as a sustainability analyst and portfolio manager in the area of sustainable investing since He studied economics at the University of Basel and is a Federally certified financial analyst and asset manager. 10 Conclusion Vontobel prints on 100% recycled paper: The production of recycled paper consumes about 1.5 times less energy and 2.5 times less water than the production of paper from fresh fibers. In addition, recycled paper reduces greenhouse gas emissions by more than 20%. We compensate for the remaining emissions through various CO2 projects worldwide. Further information: vontobel.com/nachhaltigkeit

3 Introduction Low interest rates, which have persisted in the financial markets for some time, are increasingly driving investors towards material assets such as real estate, the returns on which continue to be above the inflation rate. Interest in this investment segment has led to falling (initial) rental returns, a trend that is particularly pronounced in European capitals and major cities. At the same time, smaller secondary urban centers are becoming more appealing as an alternative. The question is, which of these numerous European metropolitan areas also represent attractive investment locations for real estate? Attractive secondary cities on investors radars. Vontobel's location rating system examines some 450 urban centers with a total of more than 500 cities in 0 European countries. The aim is to identify prospering and promising locations i.e. those that are sustainable. Through this process, we can analyse the political, legal and overall economic framework conditions at country level. We also assess the demographic and economic structure, quality of life and infrastructure at conurbation level the extended urban area. The result is a differentiated ranking of the quality of locations within European cities. Evidently, there exists a certain north-south divide with Scandinavian metropolitan areas coming out on top. (North-) Western Europe is next, followed by regions in the former Eastern Bloc and the Western Mediterranean. Locations in Southeastern Europe occupy the lower tiers. At the same time, however, it is not unusual to find differences of around 00 positions between the strongest and weakest urban centers within individual countries. Moreover, size isn t everything, as smaller and medium-sized urban centers are often on a par with major cities and capital cities. Our location rating process serves to put such prospering secondary cities on the map. In other words, location rating is the first step on the path to building a sustainable European real estate portfolio. All subsequent steps the thorough economic real estate analysis of the respective urban center and the detailed examination of micro locations and buildings which we do not address here, however, are also crucial. An investment result that is satisfactory over the long term can only be expected by having a comprehensive view.

4 4 The benefits of secondary urban centers In this persistent low-interest environment, investors are increasingly looking for investments in material assets with stable returns above the inflation rate. As a result, a great deal of money is still being invested in concrete gold. This is placing increasing pressure on rental returns, as increased transaction costs do not always go hand in hand with rising rents. In particular, this yield compression is becoming evident in the traditional investment locations of internationally focused funds and institutional investors. Such investors, who for example invest in cities like Munich, London and Paris, mainly focus on further upside potential when making new real estate investments. Rental returns are not their main concern when making decisions. Smaller secondary metropolitan areas therefore become more interesting for investors who seek lower fluctuations in value and higher rental returns. For example, empirical studies have shown that in the past, German B cities have generated higher total returns with lower volatility than A cities 1. Total returns in B cities are mainly generated by rental income. Smaller secondary urban centers offer lower fluctuations in value and higher rental returns. We have developed a rating system for European metropolitan areas in order to identify attractive and promising locations. Vontobel Asset Management uses this (macro) location rating as an essential component in a multi-step investment process to systematically build a European real estate portfolio (see figure 1). How do we define sustainable locations? The decisive question is: Which of the many secondary metropolitan areas in Europe represent attractive investment locations for real estate? In other words, of the approximately 450 largest European urban centers, we must filter out the ones that offer particularly attractive conditions for real estate investors. Therefore, we consider urban centers to be attractive if they possess a sound economic and demographic structure, good infrastructure and offer a high quality of life. After all, sustainable structures are among the basic prerequisites for successful real estate investments, which of course have a long-term focus. A reliable legal framework and a transparent real estate market are also key criteria for real estate investors. FIGURE 1 Incremental analyses for portfolio construction 50 cities in 442 European urban centers 00 cities in 241 urban centers approx. 0 cities Concrete buildings Portfolio (Macro) location rating Real estate market analysis Purchase opportunities Analysis of (micro) locations and buildings Source: Vontobel Asset Management 1 In Germany, a breakdown into A, B, C and D cities is common, although the definitions vary. For example, the consulting firm Bulwiengesa defines B cities as large cities with national and regional significance with available office space of between two and five million square meters (e.g. Dresden). C cities, such as Mainz, have regional and limited national significance. The Eurostat system lends itself to the classification of cities and functional urban areas within a European context (see page 6).

5 5 Method and sources how do we go about it? First of all, the political, legal and overall economic framework must be right for real estate investors. This involves not only individual regions, but the country as a whole. For this reason, the location rating process described here has two parts: It contains a country-level assessment, which accounts for 0% of the overall rating, and a conurbation-level assessment, which accounts for 70% of the overall rating. The country-level assessment comprises of 18 weighted country indicators in four categories. At country level, we consider general factors (i.e. not real-estate-specific). For example, a high level of public debt combined with low competitiveness hugely limits a country s prospects. The sovereign debt crisis illustrated this well. On the other hand, we consider factors that are of particular relevance to real estate investors, including all aspects related to real estate transactions such as market transparency and transaction processes, but also the complexity of building permits and legal disputes. The country-level assessment comprises of 18 independently weighted country indicators in four categories (see figure 2). The focus is on sound structures The success of real estate investments is ultimately measured in economic categories, including rental income and market value trends. However, for its part rentability is the result of a wide variety of economic and socio-demographic factors. We consider a sound demographic and economic structure to be a key determinant for the attractiveness of macro locations. This also includes a high quality of life. Furthermore, the infrastructure must meet both the needs of people and companies. For this reason, in the second part of the location rating, we measure 54 independently weighted indicators at conurbation level which are consolidated into four categories (see figure ). FIGURE 2 Overview of topics and indicators at country level FIGURE Overview of topics and indicators at conurbation level TOPICS Debt INDICATORS (EXTRACT) Gross sovereign debt Net foreign debt Budget surplus or deficit Current account surplus or deficit Competitiveness Global competitiveness index Legal certainty Transparency of the real estate market Source: Vontobel Asset Management Political stability Efficient governance Enforceability of contracts Combating of corruption Availability of market data Transaction processes TOPICS Population Quality of life Infrastructure Economy INDICATORS (EXCERPT) Youth quotient Aging quotient Fertility Population forecast Life expectancy Poverty risk Crime Pollution Accessibility with various modes of transport (multi-modal) Internet access Purchasing power Unemployment Education level Innovative capacity Source: Vontobel Asset Management

6 6 Locations are selected for analysis based on the definition of functional urban areas 2 used by Eurostat, the statistical office of the European Union. A functional urban area consists of a city with at least 50,000 inhabitants and its catchment area, also commonly referred to as an agglomeration. In most cases, functional urban areas essentially comprise of individual core cities and the corresponding commuter catchment areas. In some cases, multiple cities are in the same functional urban area the most prominent example being the Ruhr area. In such cases, the individual cities are also analyzed separately. Our analysis focuses on a total of 442 functional urban areas (i.e. metropolitan areas) consisting of 50 cities. This includes all 0 capital cities and depending on the country up to 124 additional cities. Most indicators are analyzed at city and/or conurbation level. Depending on the availability of data, higher-level data, for example at regional level, are sometimes also included in the assessment. Most data are provided by Eurostat. Other sources of raw data include the World Bank and the International Monetary Fund. All input data are collected for each of the 0 countries using a uniform method and are therefore comparable across Europe. Accordingly, Eurostat data are collected by national statistical offices using Eurostat definitions. This eliminates distortions caused by inconsistent definitions, for example of unemployment. Our location rating can point out hidden champions. Most data relate to the status quo or to the past, but owing to their inertia they also provide a good outlook into the future, as future developments are to a large extent, already determined by current structures. In some cases (e.g. when it comes to the population), the analysis is also based on forecasts. For all indicators, our first step is to use raw data to generate weighted moving averages. This way we ensure that all of the information is taken into account over time. Of course, the most recent data are weighted higher in the process. Outliers among countries are then adjusted so that the comparison remains conclusive for a majority of nations. Both steps also simultaneously serve to mitigate the impact of any data errors. We then transfer the data linearly to a scale of 0% to 100% and incrementally aggregate the individual indicators into sub-topics, topics and the overall ranking. In doing so, however, we fundamentally apply an equal weighting, from which we deviate in justified individual cases.

7 7 Scandinavia on top, while South- East Europe lags The Scandinavian countries perform extraordinarily well in our country assessment and most Western European countries have also delivered above-average results. France, Austria and Belgium are in the middle range, and most Eastern and Southern Europe are below average. Greece is at the bottom of the list. The inclusion of criteria at a conurbation level enables a more differentiated ranking of the location qualities of European cities (see figure 4). It reveals the leadership of Scandinavian urban centers, which are followed relatively closely by prosperous regions in Northwestern Europe. These are followed by the slightly less dynamic cities in Germany, the UK, the Netherlands, France and some Western European capitals. The lower middle range is occupied by urban centers in the former Eastern Bloc as well as regions in the western Mediterranean. Locations in South- eastern Europe are at the bottom of the list. Surprisingly, not one single metropolitan area in the Southern and Southeastern European countries comes out above average in the rankings. This cannot be explained solely by the below-average performance at country level, as this only accounts for 0% of the overall rating. Rather, Eastern and Southern European urban centers for the most part also score below the overall average for Europe on quality of life, infrastructure and the economy. 2 In the 28 EU countries, Norway and Switzerland Due to the federalist structure of Germany: for example, there are a total of 125 cities that are located within functional urban areas as defined by Eurostat. 4 The assessment is standardized so that the best location receives 100% and the worst 0%. FIGURE 4 Attractiveness of selected locations 4 (assessment in %) City Country Rank Oslo Norway Stockholm Sweden 97 Amsterdam Netherlands 0 89 London UK 1 89 Copenhagen Denmark 5 88 Hamburg Germany Paris France 82 8 Berlin Germany Dublin Ireland Vienna Austria 28 7 Brussels Belgium Prague Czech Republic Madrid Spain Milan Italy Lisbon Portugal Athens Greece Vidin Bulgaria Source: Vontobel Asset Management

8 8 Although a certain level of geographic differentiation in particular along the north-south axis cannot be dismissed, major regional disparities also exist within individual countries. The largest gap between the highest and lowest-ranked cities can be observed in Germany, with Munich at number 10 and Dessau-Roßlau at 52. The UK, with Cambridge (11) and Glasgow (295), and France, with Paris (64) and Troyes (44), have similarly pronounced differences in rankings (see figure 5). Not surprisingly, within individual countries, the capital cities achieved the highest rankings in most cases. However, prospering secondary cities can also be particularly interesting for real estate investors. The main benefit of our location rating system lies in its aim of identifying such hidden champions (see figure 6). FIGURE 5 Large regional disparities within individual countries Framework conditions at country level Population Quality of life Infrastructure Economy DE UK FR Munich Osnabrück Dessau-Roßlau Cambridge York Glasgow Paris Montpellier Troyes Source: Vontobel Asset Management FIGURE 6 Selected hidden champions (assessment in %) City Country Population of core city Population of metropolitan area Rank Bergen Norway 266,000 9, Utrecht Netherlands 19, , Malmö Sweden 00, , Cambridge UK 126, , Espoo Finland 258,800 1,9, Darmstadt Germany 148,800 44, Aarhus Denmark 17,400 84, Bristol UK 47,700 91, Eindhoven Netherlands 217,800 69, Freiburg im Breisgau Germany 219, , Braunschweig Germany 246, , Lyon France 1,27,500 1,925, Toulouse France 70,200 1,246, Rennes Leuven France Belgium 411,500 98, , , Source: Vontobel Asset Management

9 9 Location rating as part of the investment process Empirical studies have shown that in the past, German B cities have generated significantly higher total returns with lower volatility than A cities. The vacancy rate and fluctuations in market rents are lower. Total returns in B cities are mainly generated by rental income. There are several reasons for this 6 : The tenant structure is different. There are more international tenants in A cities and the share of the cyclical financial sector is higher. B cities have more national tenants with a broader economic base. There is less speculative construction activity in secondary locations. Investors have fewer upside expectations. Contrary to popular belief, it is not at all true that more new jobs are being created in A cities. For example, between 2001 and 2012 the number of employees subject to social security deductions rose by 5.7% in German A cities compared to 7% in B cities. Some A cities are reaching their limits as housing shortages, traffic problems and high costs of living are making it difficult to recruit employees. We expect this cause-and-effect cycle to persist and even intensify. For this reason, the benefits of secondary cities for real estate investors should remain intact for the foreseeable future. Next step: Focus on the local market Location rating can be the first step on a longer path towards building a portfolio. If the proper framework within the context of location rating exists, the next step is to analyze the local real estate market. Good sustainable framework conditions alone do not guarantee that the current real estate market will allow for favorable entry. Moreover, when it comes to real estate in secondary cities, the quality of the micro location matters. We believe investments should primarily be made in top locations. On the other hand, there are factors that impede investments in secondary cities: The transaction markets are less transparent. Market access can be more difficult. The rental market is smaller. The size of the objects must be reasonably proportionate to the size of the market. There is less market liquidity. Extended selling phases must be anticipated in the event of a purchase. 5 Also see Wüest & Partner: Investment opportunities in medium-sized German cities (2012); Institute for Economic Research (Institut der deutschen Wirtschaft): The potential of alternative real estate investment locations in Germany (2014); Corpus Sireo: Germany 21 Regional real estate market index (6th edition, 2014). 6 Compare Aberdeen Real Estate Public Limited Company: 1A results of German B (business) cities (201).

10 10 Conclusion The glossy brochures of business promoters and real estate agents emphasize the benefits of the respective location. The location rating process described in this paper paints a considerably more differentiated picture on the basis of comparable data. In particular, this location rating is tailored to the needs of internationally active real estate investors. In this respect, the results cannot be readily compared with other city rankings. 7 The location rating is a supplement to thorough analysis of the local real estate market. The location rating is a tool for systematically identifying sustainable investment locations. Its benefit is less pronounced in an investor s domestic market, as people are usually very familiar with the situation in their own backyard. Furthermore, they know how to obtain the necessary information. However, few investors are likely to have just as good knowledge of multiple countries as they do of their own market. A good location rating as the basis for good returns The location rating is the first step in a systematic strategy for building and managing a sustainable European real estate portfolio. Locations with a high rating do not automatically offer attractive returns in the current market cycle. The market may lack sufficient liquidity due to local conditions. Consequently, the location rating does not replace thorough economic analysis of the respective real estate market; however, it identifies which locations offer good framework conditions for real estate investments. From the perspective of real estate investors, investing off the beaten path is labor-intensive and fraught with pitfalls. Secondary cities have lower market transparency and it can be more difficult to gain access to the market. The size of the objects must be reasonably proportionate to the local rental market. And, reduced market liquidity must be taken into account in the event of a purchase. Nevertheless, we believe a strategy that emphasizes secondary cities is promising. Investors who have taken such an approach in the past have usually been rewarded with higher returns and lower volatility. We are confident that this will also be true in future. 7 For example, there are rankings that compare cities with regard to their attractiveness to tourists or which are geared towards the needs of managers on assignment abroad. Other factors naturally play a role. Furthermore, city rankings are usually based on considering the core city, whereas Vontobel s location rating assesses the entire metropolitan area.

11 11 Your contacts Andreas Knörzer Head of Sustainable Investing Boutique Marco Scheurer Head of Business Development Real Estate Daniel Signer Head of Relationship Management Sustainable Investing T T T Henrik Rox Hansen Head of Sales Nordics & the Netherlands T Disclaimer This document is for information purposes only and nothing contained in this document should constitute a solicitation, or offer, or recommendation, to buy or sell any investment instruments, to effect any transactions, or to conclude any legal act of any kind whatsoever. Although Vontobel Asset Management AG ("Vontobel") believes that the information provided in this document is based on reliable sources, it cannot assume responsibility for the quality, correctness, timeliness or completeness of the information contained in this document. Except as permitted under applicable copyright laws, none of this information may be reproduced, adapted, uploaded to a third party, linked to, framed, performed in public, distributed or transmitted in any form by any process without the specific written consent of Vontobel. To the maximum extent permitted by law, Vontobel will not be liable in any way for any loss or damage suffered by you through use or access to this information, or Vontobel s failure to provide this information. Our liability for negligence, breach of contract or contravention of any law as a result of our failure to provide this information or any part of it, or for any problems with this information, which cannot be lawfully excluded, is limited, at our option and to the maximum extent permitted by law, to resupplying this information or any part of it to you, or to paying for the resupply of this information or any part of it to you. Neither this document nor any copy of it may be distributed in any jurisdiction where its distribution may be restricted by law. Persons who receive this document should make themselves aware of and adhere to any such restrictions. In particular, this document must not be distributed or handed over to US persons and must not be distributed in the USA.

12 Vontobel Asset Management vontobel.com