Emerging Trends in Real Estate® Europe 2006 - Urban Land Institute

that it is going to stop in 2006.
funding rates for these players are determined by marketdriven
bond yields and swap rates that have been highly
cyclical in the past. “Bond yields look dangerously low and a
reversal in the fixed-income markets would send real estate
pricing into a tailspin.”
Inflation: Shifting to Lower
Volatility
There are plenty of players in the real estate markets who
would like nothing better than a nasty surprise increase in
interest rates and bond yields just big enough to “get rid
of the debt-driven buyers who are mucking up pricing.”
However, our interviews indicate that the majority of participants
expect only marginal increases in Eurozone interest
rates in 2006. Moreover, for the U.K., most expect another
modest reduction in interest rates.
The fixed-income markets clearly back the real estate market’s
judgement. The swap and bond yield curves are indicating
that the fixed-income markets expect both low inflation
and a low volatility of inflation. As a result, they also expect
low volatility in interest rates. They are certainly not discounting
a big cyclical swing at present. The bottom line for
real estate is that the current financial conditions driving real
estate pricing are not expected to disappear anytime soon.
There is also an important trend in the “big picture” for
bond markets that is influencing fixed-income pricing and, in
turn, the pricing of real estate finance. The growing percentage
of populations nearing retirement in most developed
countries has increased the need for assets that will generate
low-risk, long-term cash flows to fund pensions. As a result,
the demand for long-maturity investment-grade bonds has
increased dramatically. This has caused the yield differentials
between medium-term bonds and riskier long-term bonds
to diminish or, in some cases, to disappear entirely. At the
extreme, there are markets such as the U.K. where the riskiest
government bonds, the 30- and 50-year gilts, yield less than
two-year gilts. If this sounds strangely familiar to real estate
players, it is because their markets are being influenced by
the same “big picture” trends. It also explains why long-term
finance for real estate is so cheap.
A Repositioned Asset Class
While it is hard to find anyone who is not wary of pricing
going forward, there are few—even among the sceptics—who
firmly believe that we are in a market bubble that will burst
in the next 12 months. “A pending disappointment” or “a
slow deflation back to realistic levels after 2006” are more
common expectations. For others, “current market levels
potentially represent a new mean for values.” What tempers
pessimistic opinions and underpins the beliefs of the optimists
is the increasing consensus that real estate has been
repositioned as an asset class. This contention is supported
by the continuing increase in strategic (i.e., long-term) institutional
weightings in real estate.
“The pension funds are back because they ‘lost the ranch’
in equities” is the sceptical view of the current institutional
enthusiasm for real estate. While there is a kernel of truth
here, it ignores demographic trends and the changes in the
way pension fund liabilities are accounted for in corporate
balance sheets, which are the major drivers of renewed
appetite for cash-generating assets. The principal force behind
the twin shift to higher fixed-income and real estate weightings
in institutional portfolios is the ageing populations in
the majority of European countries and the need to fund
their pensions with long-duration, low-volatility assets that
generate reliable cash flows. Real estate now “fits the bill”
in a way it could not even a mere five years ago.
Until recently, the absence of reliable statistical information
on most real estate markets handicapped the entire asset
class as far as institutional investors were concerned. The lack
of robust long-term statistics on performance and the resulting
inability to analyse the risk-return characteristics of real
estate with confidence meant one could not do meaningful
comparisons with equities and bonds. This is all changing
with the increase in the number of reliable indices and the
rising turnover in real estate assets. “The tool kit is now getting
there for real estate in the way it has been there for other
asset classes.” The institutions and their consultants are getting
more of the information they need to justify higher
exposure, and the improvement is set to continue in 2006.
Moreover, this information gap is declining in tandem with
a rise in liquidity. Since portfolio theory—which underpins
institutional investment models—dictates that increasing
information and liquidity will drive down risk premiums, at
least some of the reduction in yields we are witnessing makes
perfect sense. “The new equilibrium value for the market—
whatever it turns out to be—will be higher than it was when
liquidity was low and markets were opaque.”
Growth Is Picking Up—But
Not by Much
Economic growth forecasts for the Eurozone in 2006 are
actually being revised upward at the time of writing, which is
a welcome contrast to what was happening a year ago. While
no one is expecting to see strong gross domestic product
(GDP) growth in the Eurozone, the anticipated increase to
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