Emerging Trends Worldwide

All real estate may be local, but entering 2012, real estate investors around the globe are focused on Europe’s financial capitals and how the continent’s leaders deal with the Eurozone’s financial crisis.

Even in areas where local fundamentals are showing signs of strength, concern about Europe’s sovereign debt problem, and its potential to tilt economies back into recession, is keeping capital flows tight and inhibiting investment, according to the latest series of Emerging Trends in Real Estate^® reports covering the Americas, the Asia Pacific region, and Europe.

Jointly published by the Urban Land Institute and PwC, the Emerging Trends series is in its 33rd year. Combined, the reports include interviews and survey responses from more than 1,900 leading real estate experts from around the globe, including investors, developers, property company representatives, lenders, brokers, and consultants. This year’s series was released beginning with the Americas report at the ULI Fall Meeting in October, followed by presentations of Emerging Trends Asia Pacific in China, Singapore, and Australia. Emerging Trends Europe was presented at ULI’s annual Paris meeting February 1.

In Europe, survey respondents said the real estate industry is in limbo as an economic crisis “wreaking havoc with no direction,” in the words of one interviewee, causes preferred markets to be chosen more on their potential as safe havens than as high-growth hubs.

Profound economic instability is affecting providers of equity and debt directly, according to ULI Europe chief executive Joe Montgomery. “We are operating in an environment that is very difficult to model,” he says. “The uncertainty over the level of banks’ exposure to sovereign debt default, coupled with uncertainty over the regulatory changes introduced as a result, have caused significant elements of the capital markets to be reduced to a state of near paralysis.”

According to PwC partner John Forbes in London, “Debt will be the main story of 2012. There is general pessimism regarding the availability of debt this year, and, significantly, lenders are the most gloomy of all. A mere 6 percent of lenders believe that debt will be as available as it was in 2011, with 42 percent believing that it will be moderately less available and 52 percent believing that it will be substantially less. This will be a huge challenge for many but will create opportunities for others, in particular equity investors less reliant on debt, those who are able to take advantage of the opportunities from bank deleveraging, and new debt providers entering the market.

“The good news is that the view of respondents regarding the availability of equity is much more positive. Most promising is the response from institutional investors: 65 percent believe that equity will be moderately more available, with a further 10 percent believing that equity would be substantially more available,” Forbes says.

Similarly, Eurozone instability is casting a pall over markets across the Asia Pacific region. “Asia has no shortage of investment capital, and until the middle of 2011 there was more concern over inflationary pressures than lack of demand,” says Simon Treacy, ULI trustee and ULI South Asia chairman. “Suddenly, however, the prospect of a global relapse into recession is creating mounting unease. There will be ongoing and significant uncertainty in the global and regional economies and real estate markets over the coming 12 months.

“Is this a crisis or opportunity?” Treacy asks. “It’s both. Asia has entered the twilight zone, as there is still much to play out globally, given the debt and political issues in the U.S. and Europe. It’s certainly time to reduce risk, focusing on cash flow, as the report suggests.”

In the United States, survey respondents said market participants must resign themselves to a slowing, grind-it-out economic recovery confined largely to a few real estate markets that offer the primary 24-hour transportation hubs with global access.

Enduring economic doldrums and the absence of dynamic jobs generators are weighing on real estate markets, they said. The hard reality is that businesses have learned they can increase profits with less space—while people cannot afford bigger living spaces, according to the Emerging Trends Americas report. While the nation’s lackluster employment outlook is delaying the filling of office space, the related drag in consumer spending is compromising growth in retail and industrial occupancies and rents.

“Job creation is clearly the critical ingredient for a sustained recovery in commercial real estate, and the market participants we surveyed uniformly struggled to identify new employment engines. As a result, businesses are focused on squeezing profitability out of productivity gains, and families forced into belt-tightening are using less square footage, which follows ‘the Era of Less’ sentiment we forecast last year,” says Mitch Roschelle, partner/U.S. real estate advisory practice leader at PwC. “In 2012, investors expect pricing to level off in the top markets, and overall ‘buy’ sentiment will subside, selling appetites will increase, and more owners will hold until the economy untracks. This is part of ‘the new normal’ as investors are coming to grips [with the fact] that they may not be selling for more than they paid.”

Highly specialized, noncore investments are gaining attention as alternatives to traditional property types, according to Emerging Trends Europe. The prospects for any turnaround this year hinge on how recent regulatory measures ultimately affect the willingness of banks to make commercial loans, and whether another financial industry collapse caused by sovereign debt issues results in a wide-scale release of assets by banks to investors.

“2012 marks the beginning of an era that will be characterized by more negatives than positives in its early years,” says the report. “It will be the year that property financing becomes a major casualty of the measures banks take to deal with regulatory and macroeconomic-level pressures... the year the market finds that deleveraging will not loosen up capital for fresh property lending... the year when the market sees debt become more short term and expensive... and the year when the need to find alternative sources of funding becomes imperative.”

Recommendations for longer-term, noncore investments in Europe include:

• Solar energy parks and wind farms, identified by interviewees as a growth business;
• Gas storage facilities; and
• Health care, hospitals, and data centers, which offer appeal as a stable income stream.

Recommendations for short-term, noncore investment strategies include:

• Buildings in need of refurbishment on the edges of prime districts in major cities;
• Budget hotels, especially in London’s Waterloo, Paddington, King’s Cross, or Bishopsgate areas (survey respondents recommended buying secondary office space and converting it to mainstream lodging);
• Mezzanine financing for residential developers; and
• Homes in London that could be resold to wealthy individuals from Greece and Italy seeking to own a home in a country that, while in a downturn, remains more economically stable than those two countries.

This year, Emerging Trends Europe predicts, investors will continue to eschew a strategic focus on whole countries, cities, or sectors in favor of asset-led, deal-by-deal approaches. "[N]owhere can be considered a ‘must buy’ today,” the report says.

Values posted for European cities “could hardly be described as electric,” it notes, with over half the cities recording a lower investment score than last year, including major markets such as London, Frankfurt, Copenhagen, Madrid, and Rome. The top-ranked cities in the survey tend to be either in western or northern Europe, or growing regions to the east.

In addition to showing Istanbul holding firm as Europe’s top investment and development market, the report highlights other notable trends surfacing, including:

• The rise of Moscow as an investment magnet. Of the Russia-based interviewees, 82 percent anticipate deployment of more capital into real estate this year, and 75 percent expect profits to rise.
• The decline of London in the ratings for new investment, existing investment, and development. Respondents cited concerns over the difficulty of obtaining assets, strong competition, and pricing on the brink of a bubble.
• The likelihood that investment will increase in few of the 27 markets in the survey. Respondents predict greater investment in one-quarter of the cities—Berlin, Hamburg, Istanbul, London, Moscow, Munich, and Stockholm—but said capital values and rents will likely hold steady rather than rise as a result of the investment activity.

Respondents from Ireland and Turkey were the most optimistic about business confidence and profitability over the coming months. “Irish interviewees believe their economy is through the worst,” the report says. Least optimistic were respondents from the Czech Republic, France, and Portugal.

“Uncertain global macroeconomic conditions will continue to put pressure on property pricing, transaction activity, and financing,” says K.K. So, Asia Pacific real estate tax leader of PwC. “Capital flows remain volatile, affected by numerous cross-currents; inflows and outflows occur more frequently and more rapidly. However, real estate fundamentals in the region, while showing signs of softening, remained supportive of continued investment by local, regional, and international capital sources.”

China remains the largest emerging economy, although economic performance for 2012 is expected to slow, then moderate over the next five years. With three of the five top cities for investment, according to Emerging Trends Asia Pacific, China will be an important destination for investors, but the biggest question for foreign investors is whether they can get capital into the country given the central government’s fear that asset bubbles will appear in the real estate sector.

India’s economy continues to produce the second-fastest-growing gross domestic product in the Asia Pacific region, just behind China, but developers face great difficulty raising capital through the nation’s banking system. Within the country, investment prospects are brightest for Bangalore; however, respondents noted concern about the economy in general. Rankings plummeted for New Delhi and Mumbai, both affected by inflation concerns.

Japan, which is still recovering from the March 2011 earthquake and tsunami, shows the slowest growth in the Asia Pacific region. While reconstruction should provide some boost to income and employment, the economy still must deal with stagnant household spending, poor demographics, and excess government debt. Tokyo’s investment ranking fell five slots this year to 17th. This was the second-consecutive year it registered significant decline.

Across the Asia Pacific region, the industrial/distribution sector is top rated, followed closely by residential real estate, both for-sale and rental. Office and retail sectors are in the middle of the range, whereas the hotel sector is the least favored for investment.

Survey participants predict that 2012 will see an increased supply of properties for sale; however, due to economic uncertainty, interest among buyers may diminish.

Although return expectations will further recede, well-leased core real estate in leading markets will continue to produce solid single-digit, income-oriented returns. According to the Emerging Trends Americas report, more opportunistic investors will ratchet down forecasts. Even projections of returns in the midteens appear to be a stretch as risk increases from questionable supply/demand fundamentals.

“The return landscape for 2012 presents a mixed bag, and all depends on where and when investors bought, the amount of leverage employed, and asset quality,” says Stephen Blank, ULI senior resident fellow for real estate finance. “Many players will back off from bidding on trophy properties in top-tier markets, fearing that pricing is outpacing the potential for recovery in net operating incomes. Additionally, investors believe that cap rate compression has ended, and a leveling off is expected, with possible upticks in cap rates for some property sectors in certain markets.”

Respondents cited the following as some of the best investor bets for 2012:

• Blue-chip gateways. These relatively safe harbors all have issues, but over time, assets in 24-hour markets dependably outperform because they lie along important global commercial routes and attract money from all over the world.
• Job centers. These are the few cities where employment growth actually occurs, including gateways and those that rely on energy-, high tech–, and health care–related industries, as well as universities and government offices.
• Value-add plays. Look for Class B properties in good infill markets that have been neglected over the past five years.
• Fixed-rate debt. Owners should lock in long-term, fixed-rate financing on assets while they can.
• Recapitalization of troubled equity. More motivated borrowers, working with senior lenders, will strike favorable deals on mezzanine debt and preferred equity to stabilize assets; at low interest rates, investors can achieve especially favorable risk/return spreads.
• Distressed debt. Banks and special servicers will continue to dribble out loan pools with various embedded gems.
• Land holds. Cash buyers can claim single-family lots for cents on the dollar.

Despite what one person interviewed termed “tenuous” economic outlooks, only one of the 51 U.S. cities surveyed for the Americas version of Emerging Trends failed to improve its investment score over last year’s report. Over 60 percent now rate as fair or better prospects, compared with only 40 percent in 2011.

Highlighting investor angst, Washington, D.C., which remained the top U.S. city for the third-consecutive year, suffered a slight downtick on the Emerging Trends ratings scale as interviewees wondered if the market has become too dear in light of all the political talk about federal cutbacks. Just behind Washington, Austin, the moderately sized Texas capital, sneaked into the number-two spot on the survey, benefiting from dynamics created by the University of Texas, the local tech industry, government jobs, and the regional energy-based economy. San Francisco leapfrogged New York City to number three, buoyed by high-tech hiring; Boston held on to the fifth position; and Seattle, also a software and internet hotbed, stayed at number six.

The survey found that investment and development prospects continued to advance across all major property sectors, led by apartments. Interviewees also prefer downtown office buildings in 24-hour cities, warehouse properties producing cash flow in prominent port and airport gateways; full-service hotels in the major markets; limited-service hotels without food and beverage; and neighborhood shopping centers serving stable infill suburban communities. Sentiment diminished for power centers and malls; owners will not sell the best fortress malls, and most other regional centers face a shaky future. Suburban offices scored the lowest investment marks; commodity buildings in campus settings isolated from urban amenities received a big thumbs-down.

Canada’s considerable aces in the hole remain its robust banking system, a fiscally sound government, rich stores of natural resources and commodities, and steady immigration, according to the Emerging Trends Americas report. “If not for what’s happening elsewhere in the world, Canada would be on fire,” said one respondent. “It makes a big difference when the government is not broke.”

However, temperamentally conservative Canadian real estate players are grappling with tamping down unaccustomed overconfidence and wonder whether their mostly stable property markets will be buffeted by world economic turmoil. For 2012, the report says, solid market recoveries could turn more muted, sustained by modest income growth.

Markets are characterized by plentiful availability of money, but little product. Occupancies of 90 percent and higher persist in a near steady-state equilibrium across most commercial markets from coast to coast. Stringent lending practices and mortgage regulation are keeping the housing sector healthy, and condominium developers are prospering in further densifying 24-hour cores. “It doesn’t make sense to sell when you already have the best income-producing properties,” noted one person interviewed.

Toronto and Vancouver remained Canada’s top-ranked cities, boosted by international gateway status and diversified economies. Calgary and Edmonton rebounded with recent energy market gains, while Ottawa benefited from its large and sustaining government jobs base. Montreal held steady, and Halifax showed new strength from ramped-up energy exploration off the East Coast.