New Star’s verdict on property markets in continental Europe

In this note, Stuart Webster, Head of Global Property at New Star Asset Management, provides an update of the team’s views on property within Continental Europe.

Continental European office markets have been experiencing a buoyant time as improved economic growth has increased occupier demand and led to falling vacancy rates across most markets.

This imbalance between supply and demand at a tenant level and relatively positive economic prospects in most countries have led to some significant price rises for office properties. In most cases, however, this appears to be justified and the New Star International Property Fund has bought office buildings in select markets where this imbalance can produce robust income growth and the potential for capital growth.

The fund is not, however, restricted to offices and the New Star property team is actively seeking retail and logistics properties where appropriate. Research has shown that the retail property sector in more sophisticated markets has proved to be less volatile than offices. Given that retail yields are higher than office yields in some Continental European markets, there may be a mis-pricing opportunity. New Star aims to take advantage of this through selective targeting of retail assets that can generate robust income from a variety of tenants, with the benefits of better pricing and opportunities to add value through our asset management team.

le often ask if an international property fund needs to hold assets in all major economies. The answer is that a fund does not have to buy in every market; instead it needs to assess every market and pick those that best suit its risk profile to achieve a reliable and growing income stream. In pursuit of the best prospects for investors, the New Star property team is currently avoiding direct investment in countries where that would be tax-inefficient for the fund such as the US.

The good

Germany

Germany is one of the most attractive locations for both short- and long-term returns. In the last few years, the German commercial property market has substantially lagged the global rise in property values. The market offers relatively good value and is also helped by Germany’s improving macroeconomic environment. Germany has undergone enforced structural change through wage restraint in recent years. This and the country’s strong heritage in capital goods mean that it is well positioned in exporting to fast-growing developing markets such as China. Consumer confidence is also picking up as unemployment falls.

The Munich office market is particularly attractive because vacancy levels have fallen from 10% in 2005 to 7.9% this year. The level of speculative construction is low, with the majority of space under construction being built for owner occupiers. As a result, only about 25% is still available for the rental market. Space under development in the second quarter of 2007 was just 340,000 sq metres, less than half the level of 2003. This is in line with a trend in recent years of increasingly conservative construction levels.

Netherlands

The New Star property team likes the Netherlands for several reasons. First, the country has a well-educated population that is international in its outlook. This creates a strong background for long-term sustainable economic growth. Secondly, and this is related to the first factor, the Netherlands suffered in the aftermath of the dotcom bubble as many start-ups failed. The country, therefore, had an oversupply of development that is only just being worked off. This has led to some cautious pricing in its property market, providing relatively good value. Thirdly, the property market has depth, with a lot of players providing liquidity. Lastly, if the German economy is improving, the Netherlands, with its proximity and trade links, should be a beneficiary. A lot of investors seem to be failing to make this connection.

Ile de France

The Ile de France, with Paris at its heart, is to France what London is to the UK and likewise it accounts for a disproportionately large amount of the French economy. As in large parts of London, much of Paris is already built up and existing architecture is protected, so there is limited new supply in popular locations. Nicolas Sarkozy’s arrival as president may help to shake off the old, insular French attitude and make the country more welcoming to reform and inward investment. The office vacancy rate for the Paris regions is as low as 5%. There is, however, 1.6 square metres coming on stream in the next two years, equivalent to 3.3% of stock. This could lessen the current tightness of supply beyond the short term.

Scandinavia

Scandinavia is attractive following the election in Sweden of a centre-right party that is undertaking reforms to stimulate economic growth. Norway is enjoying the fruits of a high oil price bringing money into the local economy. Within Oslo, new office space is not expected to equal absorption until 2009 and this should keep the market tight and rents buoyant. This is encouraging occupiers to look at secondary markets for space.

In Denmark, pension funds have sold substantial residential portfolios and the proceeds are expected to be reallocated to commercial property and other assets. Strong occupier demand and rising construction costs are also anticipated to lead to higher rents on existing properties.

The bad

Russia

Russia’s commercial property market is attractive from an economic perspective. The country is benefiting from high commodity prices and this, in turn, is improving the government’s finances. Russian workers are also enjoying strong real wage growth, which is supporting increased consumption. More than 1 million square metres of stock is due for completion this year in Moscow but only 20% of this is grade A. This means prime rents should continue to grow strongly.

The caveat is that the currency, political and legal risks are high. New Star’s property team would have to be exceptionally comfortable about a property before venturing into Russia given the scale of these risks. This country is, after all, headed by a leader who has just threatened to target the rest of Europe with nuclear weapons.

The potentially ugly?

Ireland

Ireland’s property market has had a phenomenal run and this may not be sustainable. The market may soften as the rises in interest rates by the European Central Bank take more steam out of the economy. If, however, pricing were to fall far enough – and this is unlikely – there may be buying opportunities in the longer term; even in bad markets there can be good deals.