November 2007

Do your research

With UK commercial property having performed so well over the last decade and with double-digit returns looking increasingly unlikely over the next few years many investors are now looking further afield. As a result Europe has become a particular point of interest. The case for investing in European property is quite simple. Diversification, high yields, low interest rates and good growth prospects make it a lucrative investment area. However, dig deeper and it becomes apparent that not every part of the European property market offers equal appeal.

Despite the UK property market's strong overall performance, results across the main sectors has been quite varied. The office sector had a total return of 23% last year as measured by IPD, whereas the retail sector had a total return of 15.2%. In comparison to that, offices returned just 3.2% in 2003 whereas retail returned 15.5%.

These historic results demonstrate the potential performance differentials at stake. The UK example uses broad market data but actual investments are made into specific, individual funds, and these returns can be quite different from the market average return. It is possible to avoid stock selection in equities by investing in an index tracker fund. However, in European property this is not yet possible so one needs to buy properties.

Economic conditions

One also has to consider that economic conditions are important when investing in property markets. Strong economic growth drives increased occupier demand for space which in turn drives rents forward. Capital market forces often drive property values even in the absence of strong economic growth and such growth is a positive support for property investment.

Only three months ago the Eurozone GDP consensus growth forecast for 2007 was 2.1%. This figure has now risen to 2.5% based on higher forecasts for investment growth. The consensus for GDP growth in 2008 is 2.2%.

However, predicting the way the growth forecast is likely to move in the near term is as crucial as the spot forecasts for growth. One example of this is the German economy which put in a stronger Q1 2007 performance than generally expected. This has led to upward revisions in the GDP forecasts for 2007 and 2008. The importance of this can be seen in the IPF consensus growth for European office locations. The consensus view showed a notable increase in the growth outlook, which coincided closely with this uptick in short-term economic views.

Table One shows recent property performance across Europe.

Large divergences exist across countries in terms of total return for the IPD All Property index, both over 2006 and the three years to the end of 2006. Apart from Germany, the historic results show that the France All Property index returned over 5% per annum more than either of the other two markets. On the basis that many investments in European property are likely to be made on a geared basis; such a difference in total return will be further magnified.

[QQ]Measuring performance

Germany's performance raises several important questions about how to measure property performance. On the surface Germany appears to have been a poor performer last year. However, data for specific funds investing in Germany reveal performance figures that were significantly higher than that recorded by the IPD All Property index.

One explanation is that the Germany index includes data from domestic open ended funds that historically have adopted approaches to re-valuation that were not fully mark-to-market. This then leads to distortions from the underlying performance. It is imperative to note that the availability, scope and reliability of data for property market analysis are extremely different to data on, for example, equities and therefore their interpretation and manipulation require a higher level of market knowledge.

Country selection can have a profound effect on the total return received by an investor as the historic performance data demonstrates. On the other hand, as we know from the returns in the UK market, the returns across sectors within a given country can also vary widely.

One can see the divergence in performance across the three main commercial property sectors within each country in Table Two below right.

Following the investigation into recent historic performance of four countries and their main sectors, we will consider which countries look most attractive at the moment.

Predicting and identifying which markets and sectors are likely to outperform is a challenging task. Even if only the Eurozone is considered, there are considerable variations in market practice across the different countries.

A snapshot of our current views is given below:

- Favoured Sectors

Short-term outperform

Offices

- Medium-term outperform

Industrial

Retail

- Favoured Countries

Germany

Netherlands

Finland

Sweden

Having identified preferred countries and perhaps preferred sectors within a preferred country, it is necessary to make the actual investment by selecting one or more specific funds.

We know that the performance of any given fund can differ widely from the performance of the underlying target market and that manager selection is at least as important as market selection. In this situation there is no substitute for detailed fund due diligence.

Brett Robinson
Chief Executive
Seven Dials