Should you buy into European property?

published 19 July 2006

The commercial property sector is cyclical, so it is important to have a flexible approach if you want to exploit the unique benefits of indirect property investment. The sector's three key sub-sectors, office, retail and industrial, have all benefited from rising values in the past two years. However, as the market becomes tougher, a property fund's ability to target niche property companies will be key if it is to continue to produce attractive returns.

At present, returns from quoted European property seem the most attractive. There are two reasons for this. Firstly, Europe is where the final leg in the globalisation of real estate investment trusts (Reits) is about to take place, with the UK and Germany, Europe's largest real estate market, soon to introduce them. Italian, Scandinavian and eastern European governments are also drawing up Reit proposals.

I am particularly keen on the medium-term prospects from Germany, where around 70% of German companies are owner-occupiers. There will be a large number of sales and leasebacks of blue-chip assets spun into German Reit vehicles as these companies look to re-energise their balance sheets. This will create a significant Reit market in Germany. There are also strong prospects for rental growth there, which is encouraging. Rents are bottoming out at five-year lows and business confidence is at a 15-year high. Germany currently makes up less than 4% of the benchmark FTSE EPRA Europe index, but on the back of the introduction of German Reits, it has been estimated that Germany will represent as much as 30% of the index within the next five years.

Subscribe to MoneyWeek

Subscribe to MoneyWeek today and get your first six magazine issues absolutely FREE

Get 6 issues free

https://cdn.mos.cms.futurecdn.net/flexiimages/mw70aro6gl1676370748.jpg

Sign up to Money Morning

Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter

The second reason European is looking attractive is that there is a yield gap between property yields and the cost of borrowing. Although we are likely to see interest rates steadily rise in the eurozone, this is likely to be offset by rental growth as European leases are typically linked to the retail price index.

If you're thinking of buying into European property, I would recommend quoted property companies such as the French Reit Klepierre and Dutch Reit Rodamco. Both are long-established owners of prime shopping centres across Europe with multi-national companies as tenants and consistently high occupancy levels. Regulations and tenancy laws vary from state to state in Europe, so by investing indirectly you can tap into the local expertise of established companies with transparent track records. This is particularly important in eastern Europe, where I would invest only in those vehicles that already own the assets and have bought well. That way, you know what you're buying.

There is also a clear inherent value in British companies such as Hammerson and British Land, which are trading at significant discounts to their prospective break-up value before converting to Reits next year.

What the market hasn't picked up on yet is the significant re-structuring we will see from these companies as they try to achieve premium ratings as Reits. This could be achieved by the property company splitting its diversified portfolio of assets into sub-sector specialist Reits, as these tend to trade at a significantly higher rating. As this underlying value is realised, then I will steadily increase my fund's exposure to niche markets in continental Europe which show attractive rental growth prospects.