Boom or bubble?

Holidaymakers may have been soaking up the Spanish sun this summer, but it is not only the beaches where temperatures have been sizzling.

“Prime office yields in central Madrid are pretty hot just now, compared with other cities,” says Richard Plummer, executive chairman, Rockspring Property Investment Managers.

Rockspring, whose clients include the BBC Pension Trust, runs several funds giving access to Spanish property.

The €550m Rockspring PanEuropean Fund is currently invested 15% in Spain.

“The availability of cheap debt and the activity of local investors has bid prices up to relatively high levels,” says Plummer. “And although yields are low, many people believe that rents are going to rise further. The current boom in Spain is mainly in residential property, but this still has an effect on other sectors.” However, he warns that investors still have to be cautious.

“Some economists would suggest that government deficits, the level of inflation and the amount of construction activity suggest that it is a time to be prudent rather than to pile in,” he says.

But he does say that compared with previous Spanish property booms, there is now more domestic capital at work than there is international capital. “This suggests greater liquidity in the market and a more ready pool of capital for exit routes,” he says.Institutional investors seem to agree.

The Emerging Trends in Real Estate Europe 2006 survey, a joint undertaking of PricewaterhouseCoopers and the Urban Land Institute, collates views from over 250 institutions including ABP, the State Pension Fund, Finland and the European Public Real Estate Association (EPRA).

Survey participants said the top markets for solid risk-adjusted returns in 2006 will be Paris, London, Helsinki, Madrid and Barcelona. Madrid is a new entrant to the top ten. All the favoured markets have good prospects for rental growth. Barcelona is also in the top five cities for development prospects. The survey notes: “While Madrid remains a heavily supplied market [for offices], there has been little change in the vacancy rate in 2005. “Demand has been steady in 2005, giving respondents more confidence to include Madrid on their prospects list. A solid majority (61%) rate Madrid a ‘buy’ market for office properties.”

The survey adds that solid prospects for industrial property are expected in 2006, as its location creates opportunities in the main corridors from Madrid to Barcelona, Valencia and Toledo. Respondents expect to see a rise in demand from tenants and investors in these areas.

Survey respondents frequently mentioned Madrid in the context of urban regeneration opportunities, and see a variety of redevelopment opportunities in the capital’s ageing industrial locations.

Without the adjustment for city risk, Barcelona would in fact have taken the top spot for risk-adjusted returns expectations, because of its prospects for rent increases and capital growth. But the city’s relatively small size and lack of liquidity hold it back. However, the survey suggests that “second-tier-city” syndrome is now hitting Spain.

It says: “Respondents mention Valencia and Malaga as high-growth areas that are attracting interest from international investors which in the past only considered Madrid and Barcelona. In these second-tier cities, they say, pricing has not adapted to reflect the growth prospects.” Dutch pension fund Mn Services invests in European real estate via listed and non-listed funds. One of those — the ING Iberian Fund - focuses on retail property in Spain and Portugal, with the rest, including Orion, Carlyle and ProLogis, investing on a pan-European basis.

Bas van den Ijssel, senior fund manager, international real estate, Europe, Mn Services, agrees with Plummer about the impact of domestic investors.

“It is often difficult to get started in real estate because there is not too much stock in the market — the typical Spanish investor hangs on to it,” he says.

But he is bullish about Spain at present.

“I am trying to get more money invested there,” he says. “We are quite confident about Spain because it is still growing economically, and at above the average EU rate. In terms of the quantity and quality of available property, Spain has grown a lot over the past 10 to 15 years. As a result, the current demand for quality is high.”

Van den Ijssel says the spending power of the Spanish is still increasing, although there is quite a high unemployment rate which he says could dampen the growth in the office market, as well as consumer confidence.

“The only worry we have is that the growth in the economy is largely provided by the construction sector, from the big infrastructure projects of the past few years,” he says. “That might fall away in the future.” Mn Services invests in Spanish property via pan-European and more opportunistic funds.

“The funds focus on offices and under-managed shopping centres - managing the risks, waiting for rental growth and then selling them,” he says.

The funds in which Mn Services invests include both the retail and office sectors. The retail properties are held all over Spain, while the office segments of the portfolios focus on Madrid and Barcelona. “At present, the Spanish office market looks very good, with high prices,” says Van den Ijssel. “However, there is a danger of future oversupply. Outside central Madrid there is so much land available to build offices that this might lead to overcapacity.” In the retail sector, he says that property returns are below the EU average, but he believes they will increase.

These days US, Asian and Australian investors have to compete over the Spanish market in the same way as they compete over the UK market as Kathleen Jung, head of European property at Hewitt explains: “Property prices have increased significantly and Spain has had equally significant yield compression. Three or four years ago, you could buy a core office property in Madrid on a 6.5 - 7% yield; now it is much closer to 4.5%.”

Jung says the benefits of investing in Spain are diversification, the size of the market - she says there is a wide universe of choices - and the return forecast.

“The drawbacks for most non-Spanish investors are that they will not be familiar with such a market outside their own country,” she says. “For instance, in Spain you have to consider that Spanish real estate can be transferred by verbal agreement. Clients should get legal advice on the local system if they plan to invest.”

“The market is less transparent than in the UK, with a lot of owner-occupiers and domestic investors who may potentially not show their hands 100%. So we advise clients who want to go abroad to use a fund manager who knows the market and go into a pooled investment. In any case, buying just one property in Madrid isn’t diversifying your portfolio.”

Furthermore, with a segregated account, Jung says that pension funds are looking at a five to seven-year time horizon for each investment, whereas a pooled product gives them more flexibility in taking out their investment.

And she says that pooled products will enable pension funds to transact investments using the secondary market.

“At the moment, the secondary market in Spain, as in the rest of Continental Europe, is really tiny,” she says. “But it is growing because of the activity of multi-managers and fund of funds investing in property in Continental Europe. So we think that over the next five years, the secondary market will be as efficient as it is in the UK, and that there will be better liquidity in these markets than there is at the moment.”

Jung says that investors will be able to cut transaction costs using secondary securities. “The secondary market operates on the principle of matched buyers,” she says. “The average bid-offer spread in a fund is 7% but with matched bargains you pay an average 3.5%, although it could be as low as 2.5%.”