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Investors focus on value-add segment: A boost for real estate investments

Thanks to a reliable business environment and strong fundamentals, Europe’s real estate markets continue to maintain their attraction for investors. But one obstacle here is a very limited supply, especially of high-quality, fully tenanted properties (core properties). Moreover, the persistent low interest-rate environment in the euro zone makes it hard to generate appealing returns, as the shortage of other investment alternatives causes more and more capital to flow into the real estate markets. Value-add strategies are drawing interest as a leveraging option.

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Robust global business conditions thanks to focused fiscal policy and easy monetary policy

The International Monetary Fund (IMF) expects the global economy to pick up even more strongly this year and next. Following a 2.4% gain last year, the euro zone is expected to remain on a solid growth track in 2018 and 2019. The IMF bases this assessment not only on growing worldwide support for business conditions from fiscal policy, but also on such factors as the eased monetary policy from the European Central Bank (ECB), even though the bank recently initiated a change in policy for bond buy-backs. ECB President Mario Draghi says he still intends to hold firm to the bank’s “cheap” monetary policy, at least for this year.

Low returns drive real estate investors in Europe to seek alternatives

In this environment, real estate investors are profiting from extremely low-interest lending rates. At the same time, they still find it a challenge to generate above-average returns on their investments in Europe’s markets. One source of evidence for this is the INSIGHT – European Commercial Property Markets 2018 study from PATRIZIA Immobilien AG. And so, in the search for alternatives, investors are increasingly willing to accept higher risk.

That’s why today value-add properties are being considered more and more often alongside high-quality, usually fully tenanted properties. Value-add properties are those whose value can be increased with selective measures, provided the location is good and the property is functionally intact. “In the right location and with a deep understanding of the sector concerned, investments outside top locations are also lucrative in today’s economic environment,” says Dr Marcus Cieleback, Chief Economist at PATRIZIA Immobilien AG.

Modernisation and renovation, and repositioning by optimising management performance, tenant structure, and lease terms can upgrade the value of even seemingly less attractive properties to core or core-plus levels. One example is the Apex House office complex in Edinburgh, Scotland, which PATRIZIA acquired at the beginning of the year. But the value-add strategy can also provide leverage for above-average value growth even in a top location like Madrid.

Value-add as an alternative strategy increases opportunities for real estate investments 

Stefan Glossner, Head of Fund Management Value-Add at PATRIZIA Immobilien AG, is certain that successful value enhancements towards core or core-plus levels are always “the result of first-class cooperation among Purchasing, Asset Management, Fund Management and Sales.” He points to current projects like a Hamburg office building remodelled into a boutique hotel and an upgraded office property in Düsseldorf. “Both locations now offer investors a long-term, sustainable cash flow,” he says.

As a rule, however, the value-add strategy also involves not holding a property for the long term but rather selling it at a profit after an upgrade. For example, a poorly occupied or even vacant apartment building can become a fully leased office complex through remodelling and repositioning. Renegotiated leases and an optimised tenant mix can attract more visitors, and therefore more revenue, to a shopping mall. And connecting a logistics property to existing infrastructure enhances its utility and functionality. 

Outside expertise is advisable even for experienced investors when it comes to value-add 

The strategy’s advantages are self-evident. Core properties and properties with development potential (core-plus) entail relatively little risk, yet they generally promise only moderate return opportunities at best. On the other hand, appreciation of repositioning projects (value-add) can be significant. Compared with an opportunistic investment – which is also conceivable, but entails greater investment risk and involves a substantially higher level of borrowing – the risk with a value-add investment is limited. Nevertheless, even experienced investors shouldn’t venture into the value-add risk class without professional support. 

The service providers of this support have both asset management experience and local property expertise, including mostly reliable tenant contacts and a working knowledge of legal requirements. Most of all, they know how to correctly interpret globally available data as they apply to the potential location, and how to predict cycles. Parameters used in these markets include growth vigour and demographic change as well as the current supply of properties and projected figures for new construction.

A glance at selected markets in Europe illustrates value-add’s potential. In the UK, for example, the values of many locations outside London are currently at a historic low. Office space in the Netherlands, Irish commercial properties outside city centres, and office and logistics properties in Eastern Europe have also lagged behind the general recovery of real estate prices. In Germany, vacancies are declining sharply even as construction volume in the commercial property sector remains low.

Diversifying the real estate portfolio: A boost in property innovation 

As a result, even B-level cities and locations in Germany have seen declining vacancy levels. That’s driving up investment costs and makes it hard to identify options with promising returns. In general, we can note that the spreads between core and value-add have remained high in various regions and segments – even though the prices for core properties have begun to climb. That also suggests the advisability of diversifying European real estate portfolios with value-add investments. 

Under the conditions defined above, and in view of the current shortage of product in the real estate sector, value-add looks like a promising alternative strategy. If the locations and properties are chosen well and managed professionally, there are good prospects for a boost in development and innovation through modernisation, renovation and repositioning. Value-add investments undoubtedly call for a greater risk appetite, but they also increase options and opportunities.

 

Photos: Fotolia 

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