Friday Letter: PERE time in Europe

Delegates at the 2005 European Private Equity Real Estate Forum gathered in London this week to discuss the development of a small but growing European asset class: private equity real estate, or PERE.  

The mounting interest in this market segment is in part a function of the growing appeal of property assets generally. Real estate provides the kind of stable income that yield-hungry institutional investors needing to match assets and liabilities thrive on. It lacks the volatility of the equity markets, and it also helps investors achieve diversification because of its counter-cyclical nature.

What’s more, as John Carrafiell, head of Morgan Stanley’s formidable opportunity fund investment operations in London, pointed out in a key note address yesterday, now is a good time to be getting into the commercial property sector in particular. Why? In most major European markets, rents are rising as vacancy levels are falling, making 2005 what Carrafiell described as “the first year of what could be a five or six year trend”.

As a result, the institutional appetite for real estate product that can generate stable bond-style income is at a peak, as is interest in strategies that have the potential to deliver something extra – strategies such as PERE.

Although it is hard to define exactly where other types of property investment stop and private equity real estate begins, it is generally accepted that at the most fundamental level, PERE involves acquiring property assets with a view to actively transforming them. In addition to sophisticated financial engineering, private equity real estate players are good at upgrading and renovating properties, changing management, signing up tenants for longer leases, or changing the use of a building altogether.

The desired result is outperformance: where core real estate investment may be expected to produce an annual return of 10 percent, private equity real estate aims for figures closer to 20.

Unsurprisingly given the potential rewards on offer, large amounts of capital are currently flowing into the market place. Whether they can be deployed effectively is a moot point. On the one hand, asset prices are rising, debt is cheap, and talk of a bubble is doing the rounds. On the other hand, deal flow appears to be strong: according to Carrafiell, PERE deals worth approximately €50 billion have been completed in Europe over the past 18 months alone – a record.

And there should be a great deal more on its way: many European owner-occupiers of commercial real estate, like their US peers before them, are yet to switch into disposal mode. In other words, hundreds of billions of assets on the books of European governments, municipalities, financial institutions and corporates are yet to hit the market.

What’s missing, according to several speakers at the conference, is a large-enough population of competent managers with the skill-set to fully exploit this opportunity – despite the fact that different types of investors including real estate specialists, mainstream private equity firms, hedge funds, family offices and wealthy individuals are already active in the market. The majority of the dedicated opportunity funds currently practising PERE in Europe are of North American origin, and although over 120 unlisted European real estate vehicles launched last year, according to research compiled by Oxford Property Consultants, only a few of them were at the opportunistic end of the market. “We would like to see more Europas,” Noel Manns of London-based opportunity fund manager Europa Capital told delegates on Thursday.

However, given the combination of strong capital inflow and the healthy supply of assets, it’s hard to see how “too few players” should remain a hindrance to European PERE for much longer. Given how much scope there remains for facilitating greater efficiency in the European real estate market, new entrants are bound to be surfacing sooner rather than later.