In a briefing by Cushman & Wakefield at the end of October, it became clear that the British market for commercial real estate continues to be a battlefield. In September and October prices in the United Kingdom dropped by 7.2 percent and the average initial yield resulted in 6.49 percent by mid-October, the highest level since 1993. The recent price reductions haven't increased the buying interest, which is evidenced in the decrease in the transaction volume by 22 percent as compared with the previous quarter. Cushman & Wakefield expects the initial yields to continue increasing, at least until June 2009 anyway.
That is favourable news for Peter Mackaness and Christopher Morrogh from Threadneedle. At the end of October and the beginning of November, both the property investment specialist and the fund manager/director, undertook a tour of Europe and the Middle-East at breakneck speed. In the two days that they were in the Netherlands, they spoke to eight pension funds. They're still going to Scandinavia, Germany and the Middle-East. According to them, the Dutch delegates from the pension funds were ‘extremely interested’. ‘Dutch pension funds are looking more and more towards foreign real estate. The British market is extremely attractive’, says Christopher Morrogh, a fund manager/director at Threadneedle Property Investments.
Worldwide
Threadneedle, which was established in 1994, is an asset manager which operates worldwide with managed capital of about €69.8 billion. Of this amount, about €9 billion has been invested in indirect British real estate. The company has offices on four continents and in fifteen countries, including an office in the Atrium building in the Amsterdam suburb of Zuidas, the international business centre of the Netherlands. The real estate experts only operate from the United Kingdom: Threadneedle in London employs 37 real estate specialists and has a back office with a staff of 21 people. In Amsterdam, Peter Mackaness and Christopher Morrogh are keen to tell why Dutch pension funds would be wise to enter into British real estate.
Mackaness: ‘We haven't established a leveraged fund for the past four years. At that time the cycle was most disadvantageous. The prices for commercial British real estate were ridiculously high. We anticipated a reduction in the prices and that has finally happened. The returns in the past year have dropped sharply by an average of more than 200 basis points. For pension funds on the mainland, it is now unwise to buy continental real estate. The biggest price reductions still have to take place. However, the United Kingdom (UK) is about eighteen months ahead of the European mainland. In the next six months the real estate market here will perhaps be at a low point. At the same time the interest rate in the inter-bank money market in the UK is dropping. A few months ago banks still demanded 6.5 percent. For us that is now almost 2 percent lower. In the UK we've come a long way: in December 2007 there were still negative returns; the financing costs were in excess of 6 percent, while the yield for prime offices was below 6 percent. In the coming months we want to fetch £300 million (about €380 million) to close the fund within the first half year. Then one enters at the lowest point and a considerable return is almost guaranteed.’
Only British real estate
What is Threadneedle Property Investment's track record? Fund Manager/Director Morrogh explains that Threadneedle currently manages £6 billion worth of property, which is slightly less than €9 billion, and only invests in British real estate. ‘That is where we have built up our expertise and have achieved our results in the past fourteen years. Perhaps we'll also enter the real estate markets on the continent in the future, but we'll only do so if we have top experts to tackle it. Threadneedle manages six ‘boring’ pooled real estate funds for British pension funds and insurance companies, which are not leveraged and have a low risk profile. These institutional funds showed an average yield of 17.4 percent during the past five years and 14.9 percent over the last decade.’
‘Threadneedle has also introduced more adventurous funds with a higher risk profile and corresponding returns in the market. We want to introduce these funds in the markets outside the United Kingdom. Since 1994 they've had three funds which each attained an internal rate of return of between 20 and 30 percent. Two funds have been terminated, we will close the third one next year. The funds have not suffered from the credit crunch. Though the funds were financed at 65 percent, we intervened on time. In August 2006 we deleveraged the fund from 65 percent to 0 percent. Halfway through 2007 we had phased out all the financing and were no longer exposed to expensive refinancing’
The prices of commercial British real estate may have dropped sharply, but who says that the bottom has already been reached. The financial crisis has seeped through into the real economy; in the third quarter, the British economy shrank by 0.5 percent. Is it not better to wait for yet another year before entering into such a fund?
Mackaness says that he's experienced worse situations: ‘Indeed one sees that companies are affected and people are being retrenched. There's been a severe number of retrenchments in the City and substantial vacancies will come about in the offices market and rental incomes will drop. In the forthcoming two years the vacancy rate will rise to about 13 percent, which includes the new developments which will not be filled then. In the rest of the UK, however, the situation is less bad than in the early 1990s. At that time we had an enormous surplus of offices on offer. Now we have built wisely and with very little risk. The British real estate market is very mature and well developed. Contrary to the Netherlands for example, we have very little outdated property. The vacancy rate, including that in the logistics real estate market where there is a high vacancy rate, amounts to an average of 8 percent.’
Supply
Is there an adequate supply in the British market? If so, how does one finance such property in a country where the money market has almost come to a standstill after all the bankruptcies and nationalisations of banks? After all, 65 percent of the fund is financed. The supply is still good, Morrogh assures. ‘The commercial British real estate market is gigantic. Over the past year 60 percent of all the European transactions took place here. In the forthcoming half year a lot of British property will become available in the market. Many property owners entered the market at the wrong time and are having a great deal of difficulty in refinancing their property. That not only applies for private individual owners, but also for large UK pooled funds and retail funds. Those parties want to get rid of their property. Attractively priced high-grade property is already becoming available in the market. We have acquired property at a yield of almost 9 percent which, until recently, was still below 6 percent.
Our latest acquisitions were a retail portfolio and an office in Edinburgh which is leased to the Scottish government, both at a yield of 9 percent. We have no problem in getting financing. Yet it is still difficult to get money – money is scarce. It is still possible for us though, because we've worked with the same banks for many years. Our track record has earned their trust to continue the financing. Our latest acquisition was even financed at a most attractive rate of 4.7 percent.’
Maximise profits
What is the new fund going to invest in? Mackaness states that it will become a portfolio in which a lot of protection and securities will be built. ‘It will be a closed-end fund with an investment horizon of five years and an option for two extra years. The timing is designed to maximise profits. We structure a portfolio with a great deal of protection. We look for the best property throughout the UK with long term rental agreements of five to ten years. Not only offices, but also retail property. We won't invest in warehousing; the vacancy rate is too high in that market. We'll also not do any acquisitions in the City. The acquisitions that we do undertake will not often be reported; no sexy deals, only deals with the highest earnings. Between now and the end of the fund the investors can expect an IRR of at least 15 percent. That is a conservative estimate, but our marketing is not for spectacular yields.’
