Head for homes

Prices are spiralling; demand outstrips the supply of investible assets; yet investors and policy makers can only guess at where the next salvo of political interference will come from. As investment categories go, European residential is hardly a risk-free punt.

Even categorising European residential as an asset class is problematic. Take two adjoining markets - Switzerland and Germany - as examples. Swiss pension funds (never as wild about real estate as their other European counterparts, despite Credit Suisse economists urging earlier his year to increase their allocations to up to 30%) face a paucity of investible residential. Predictions of a demand-driven surge in housing to replace much stock that was built more than a century ago have only partly been fulfilled.

The solution - at least for Swiss federal pension fund Publica - has been to build rather than buy. Faced with a shortage of residential, the scheme in the summer invested €70m to build its own. The Erlenmatt project will involve the development of 240 units in Basle “for families and the middle class” by the end of 2008. Publica head of real estate Danilo Menegotto cited as reasons for the acquisition, in addition to expected returns, “social factors” and the pension fund’s ability under the project to “positively influence” it. In total, the fund has invested in almost 30 residential development projects in the past few years.

Outside niche residential, European residential largely means German residential. But would-be investors in German housing are faced with a highly complex and uncertain market.

First, investor interest tends to be located in a few tier-one cities. Asset management firm Aareal, for instance, focuses on growing cities in economically sound regions. “We’ve seen a hollowing out in the middle of Germany,” says Aareal CEO Charles Pridgeon. “There’s been a flight, for instance, from Lower Saxony, which is losing its population to Belgium, Hamburg, Dusseldorf and Dortmund.” Aareal was acquired by Schroders in December 2006.

It is an opportunity rather than a risk factor, he says, forecasting a strong uplift in pricing. “For a long time, Germany lagged behind. Prices are low; debt capital is low. In the next five-10 years it will move more towards the European norm.”

Aareal’s German residential fund has attracted “a mix of pension funds”, as well as other institutional investors and government organisations. Yet the complexity of the market could well discourage European pension funds from direct investment.

Much of the focus in Germany has been on privatised social housing - but not necessarily for pension funds, which would be competing for residential investments with deep-pocketed, risk-relaxed private equity firms, especially in Germany. Since 2003, firms including Goldman Sachs and Blackstone have invested €15bn in German residential. In March, Fortress crowned it with the acquisition of Dresden’s entire residential portfolio of 48,000 units for $1.2bn (€910m). Since it entered the German market in 2004, Fortress has acquired three residential real estate firms with an aggregate portfolio of 160,000 units.

Apart from private equity firms, local real estate companies have a distinct advantage. Patrizia is on an acquisition spree - with acquisitions of almost 10,000 units in the final quarter of last year alone. In December 2006 the firm paid €300m for 2,600 residential units acquired from insurer HDI Gerling.

Unlike a market such as Switzerland, where the issue is finite investible housing, there is plenty more where that came from. “It’s still a big market,” says Patrizia spokeswoman Astrid Schuler. “There are many more units in the public and institutional sector.”

“You can buy but you have to be socially responsible,” she says. “If you deal with tenants, you’re close to what you bought. It goes down to personal conversations. It takes a lot of time and experience to deal with their fears. You have to do what you say you’ll do or you’ll lose your reputation and you’ll never get another portfolio, especially in the public sector. At the end of the day, a company with a portfolio to sell has to decide: ‘who do we sell it to?’ The decision won’t just be about price. It’s also about reputation and experience.”

If residential spans a number of different sub-classes, depending on the market, investment strategies are just as diverse. Like Aareal, Patrizia plans to dispose of the properties. Patrizia made two acquisitions in the last quarter of 2006 comprising around 7,000 and 2,800 units, with the intention to sell them on to tenants.

In contrast, Fortress, which chases larger-sized portfolios, “has a totally different strategy - a buy-and-hold strategy”.

The supply is unlikely to dry up any time soon. Germany has 39m residential units, 43% of which are owned by tenants. The state and insurance companies own the rest, and they are trying to get rid of it. The problem? Political interference is in equally plentiful supply. It is not as though governments have stayed clear of other segments, but the political sensitivities over housing (because it houses voters and straddles the fault-lines of economic liberalisation and the apparent demise of welfare states) make it a neon target for government interference. On the sell-side, Aareal’s German residential fund will not invest in privatised social housing, citing the regulatory framework and long-term government-controlled caps on rents.

“There’s huge potential for privatisation,” says Claudia Kellert, IR manager at Patrizia, though she estimates that only 10-15% of residential portfolios offered to Patrizia are of sufficient quality and in attractive enough locations - that is, those in mid-sized cities in western Germany - to be of interest.

“The biggest potential obstacle is that [government] policy on privatisation will change. “Parts of the political parties protected tenants because they were potential voters but the government and the local authorities also need money. The political sensitivity to selling residential is sometimes difficult to understand, because every tenant who buys his apartment is independent from rent increases.” If a small private investor buys the apartment he prefers to buy a rented apartment because the paid rent is an additional income.

In Freiburg the local government held what amounted to a referendum on privatisation, with the result that the process has been suspended for a three-year period. Elections in parts of Bavaria slated for 2008 will likewise hoist a question mark over the southern regional privatisation process.

Political involvement in the residential market is not confined to Germany. It is the most egregious example simply because there’s so much of it and so many (domestic and international) investors scrabbling over it. But the Netherlands is just as problematic, says Richard von Ovost, director of international real estate at MN Services, pointing to the recent decision to “put in the fridge” plans to privatise social housing.

“We have 4,500 units of residential there [in the Netherlands] and they’re performing well. We’re very happy with it but it’s in a specific segment. Either side of that segment, we could find ourselves competing with housing associations or, at the luxury end, with companies that have tax advantages.

“We’re targeting the Netherlands for privatised social housing, but we’ll be very, very selective,” he adds.

Nor is uncertainty over regulation confined to direct investment. The legal and political context, for instance, is a significant influence in the development of REITs. “REITs are a good example - specifically, the issue of whether residential should be allowed in REITs. It’s important to leave the initiative to the marketplace but political parties want control over rents,” says von Ovost.

 

In other markets, it is not political interference but transparency that is the issue hence the small institutional base in the Belgian market and terminal complaints about the difficulties of gaining planning permission in Italy.

The answer to seemingly all real estate conundrums is to look east, but at least for the time being, the absence of reliable data rules out MN Services investing in residential in central and eastern Europe. “We’re still working to get the right figures for those markets,” says von Ovost, citing data on the history and condition of properties. “It’s progressing - I expect to see it within three to five years - but at the moment we just don’t have the feeling in our fingertips that we do for the Netherlands and the UK, which have excellent data.”

If there is a move to get into specific residential markets, there is a simultaneous trend to get out of others in favour of overseas property in other sub-sectors. ‘Cross borders’ was the advice from Credit Suisse to domestic pension funds earlier this year. Then in July, Denmark’s largest insurance, PFA Pension, sold its 43-strong residential portfolio to a consortium led by RREEF. The sale of the portfolio, made up of more than 2,000 apartments in the country’s main cities, reflected the scheme’s withdrawal in the late 1990s from direct investment in real estate and its announcement at the beginning of 2006 that it was looking for a buyer for its domestic residential. Fund spokesman Søren Esperson says the move reflected rising prices over the previous years and a move into overseas commercial.

Not that Scandinavian residential as a regional investible category is a particular flight risk. Prudential subsidiary Pramerica in December announced its investment in a $65m three-way venture to invest in under-supplied Swedish residential - it said on behalf of Dutch and Irish pension funds. The novelty in this case lies in the venture’s plan to convert office into residential as what Pramerica spokesman Thomas Sipos says “an arbitrage opportunity”.

German house prices, long lagging, will likely catch up in the next few years. But European prices show no signs of dropping. An Investec research note from December sees no end in the short term to the current inflated house-prices, at least in the UK.

In the UK, they have quadrupled since the 1980s (compared with commercial prices, which have doubled over the same period), according to the IPD Index. Not that housing is independent of commercial, of course. “Office property, or even industrial, can be converted to residential use, and developers will build whatever maximises profits,” says Investec.

“What goes up doesn’t necessarily come down,” argues the note. Low interest rates, planning restrictions and immigration-inspired population growth make a bear market unlikely. Despite recently announced government policy to build new residential on brownfield and greenfield sites - including on Olympic regeneration sites - supply is nowhere close to meeting demand. Among investors, Invista, for one, agrees that the UK residential market “remains solid” - even at current prices.

Despite the price prognosis, the caveat that in residential it is not particularly useful to think in terms of a single market trend still stands, and there are lessons around caution for pension funds.

First, be prepared for due diligence beyond the call of commercial. Cross-border investment in residential is trickier than that in other sub-classes. Partnerships and joint ventures - which MN Services is considering for its European residential investment - supplements shortfalls in local knowledge in the absence of local operations.

“The market is segmented. You need to be very precise in investment guidelines. You need to be working in local teams, composing the right investment guidelines and timelines,” says von Ovost.

He acknowledges that residential demands more cautious due diligence than, say, retail. “It isn’t just an economic, physical real estate market. You also need to study other elements, including the role it plays in the market and how high it is on the agenda.”

Second, keep strategies flexible. Acquisitions have been direct (from Publica’s development projects to ready-built bricks and mortar) and indirect (Fortress’s acquisition of three German property firms). In Germany, MN is looking at new-build residential as well as privatised social housing. “We’re always open to opportunistic or value-add,” he says.

Failing adequate residential acquisition opportunities, pension funds could always punt for niche. Where pension funds are seeing opportunities across European markets is in niche segments. UK student accommodation in an obvious example as shown in the previous issue of IPE Real Estate, but it is not the only one. Nursing homes make up another growth segment; holiday homes a third.

Earlier this year, CalPERS, the world’s largest pension funds said it planned to invest €231m in holiday homes in southern Europe with long-standing partner Hines. Spokesman Clark McKinley said it was part of an overall strategy to take advantage of global opportunistic ventures.

Although the investment made up just 2% of the scheme’s $11.2bn real estate allocation, residential, he said, “was one of the several categories of our global real estate investments that was particularly promising, especially on the Spanish coast”.