Over the past few years, news flow and investment activity in Europe's residential sector have focused on Germany, as more international and domestic investors have sought to establish or increase exposure there. The following characteristics attracted the early entrants five or six years ago, and many remain compelling today:

n Positive asset and market level dynamics, including a projected rise in the number of households, the population's changing age structure, supportive economic and social reforms and greater mortgage market liquidity;

n The low volatility of residential rental yields and reliable cash flows;

n The ability to enhance rental yields with more efficient asset management and more intensive property management;

n The opportunity to create acquisition platforms to identify and execute deals to reach a desired scale, replenish privatised stock and integrate newly acquired portfolios to capitalise on operational synergies and economies of scale;

n The positive fundamentals underlying an arbitrage opportunity between portfolio acquisition prices and privatisation sale prices in a low owner-occupation environment;

n A low interest rate environment, which can help generate attractive leveraged cash flow returns and can support privatisation rates;

n The profile of German house prices over the past decade, which has been fairly flat, makes Germany's residential sector seem defensive in an environment of rapid asset price appreciation and excess liquidity in the global financial system (exhibit 1).

The early entrants in the German residential market (international private equity funds seeking opportunistic-style returns) have begun to exit (or partly exit) the sector. For some, exit represents the completion of business plans and investment strategies. For others, it is a natural response to a more challenging acquisition environment that has made original strategies more difficult to execute on several levels.

First, the sale of large portfolios by municipal housing companies and co-operative owners, a rich source of supply for the early entrants, has slowed greatly over the past year (exhibit 2). These sellers remain under huge budgetary pressures, but public and press scrutiny of these deals has intensified, making them politically sensitive.

Second, competition for portfolios has increased enormously. This stems partly from the fact that more investors, many of whom have a much lower cost of capital than the early entrants, recognise the sector's attributes (outlined above) and its defensive qualities. But their entrance also reflects a partial institutionalisation of the German residential sector. Typically, these investors (private and listed property companies, REITs, pension funds, and high-net-worth individuals) focus on longer-term, lower-returning strategies and are motivated more by diversification (sometimes to counterbalance overinflated domestic markets) than by performance enhancement. Thus they can afford to pay much higher acquisition prices than opportunity funds can. The rise in prices is evident in the data (exhibit 3).

Third, higher portfolio acquisition prices are eroding the arbitrage opportunity vis-a-vis privatisation sale prices, which for many early entrants was key. The recent abolition of subsidies for first-time buyers, which has hurt owner-occupier demand, and only modest (at best) appreciation in German house prices (albeit with much regional variation) have diminished the opportunity.

Finally, the more challenging acquisition environment is thwarting the achievement of scale and thus the ability to capitalise on economies of scale and operational synergies. While it may still be possible to achieve the desired (or at least sufficient) scale, time is an enemy of investors seeking opportunistic returns.

Importantly, this transformation reflects the fact that first-mover advantage has been exercised and will continue whether or not residential buildings are permissible assets in any future REIT structure. Germany's residential sector still looks defensive in an environment of rapid asset price appreciation and excess global liquidity. The diversification benefits, favourable demographics and low vacancy in some regions, plus the stability of the tenant base and the predictability of income, appear to offer substantial downside risk protection.

Investors seeking opportunity-style returns may find conditions more challenging and thus look for exits, but the market is far from mature and still provides rich opportunities for many (investors with a lower cost of capital seeking more modest target returns, and whose business plans depend less on high leverage, rapid privatisation rates and achievement of scale). For them, the keys to success remain the quality and location of assets and the local portfolio management team's ability.

 

s private equity investors quit the German residential market, attention will increasingly focus on other opportunities in Europe's residential sector. Some investors have been pursuing office-to-residential conversions in mature markets where structural office supply problems may exist. The Amsterdam, Frankfurt and Stockholm office markets, for example, have high vacancies, poor quality assets and unproven office locations. Given a weaker recovery for occupier demand relative to previous cycles, some of this space may never be re-occupied. Some planning authorities are keen to support initiatives to convert to residential use, especially in residential districts with high demand for condominiums and apartments. In Barcelona, the historic CBD is rapidly converting back to residential use as alternative office locations offer large, more flexible floorplates near good transport links.

Other investors are targeting opportunities in central and eastern Europe (CEE). Years of underinvestment there have caused acute shortages of basic housing. Also, much existing stock is dilapidated as, during the 1990s, cash-strapped governments sold deteriorating units to tenants who could not improve them. Strong economic growth, rapid real wage growth and increasing wealth are raising demand for housing and changing its composition. While the need for basic affordable housing remains acute, demand for larger units is also rising. The population dynamics are unfavourable for housing demand (not least due to net emigration), but growing wealth will increase the number of households and the average unit size, and urbanisation will reinforce demand in many cities. The longer-term impact of greater mortgage availability, via the liberalisation of financial markets, will support these dynamics and will create significant growth opportunities.

While Germany continues to offer rich opportunities for investors with a lower cost of capital, private equity investors seeking opportunistic-style returns are looking elsewhere as the market becomes institutionalised. With capital more difficult to place in Europe's commercial property sectors, residential strategies will still interest private equity investors.

David Skinner is head of European research at Pramerica Real Estate Investors

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