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U.K. and Germany beckon U.S. investors.

With the United States facing a three-to-five-year oversupply of office space, a dearth of financing, and the prospect of a long, potentially damaging recession, a good many US. pension funds, institutional investors, and developers have begun to seriously examine potential real estate opportunities in Europe, specifically in the United Kingdom and Germany.

Although such firms have committed substantial resources to the study of these property markets, to date only a handful of transactions have been completed. Reasons for caution include the potential for renewed armed conflict in the Middle East, adverse exchange rate conditions, and the uncertainty and softening of many U.S. real estate markets and consequent concern regarding existing real estate portfolios.

Yet, for those American real estate companies willing to accept the challenge, Europe offers a window of opportunity that will not be open for long. Most appealing are yields on prime, investment-grade real estate in the United Kingdom, which are at all-time highs. This is a result of the combined effects of the high cost of bank borrowing, the temporary withdrawal of the domestic U.K. institutions from the market, and a relative softness in the leasing markets.

The few American investors in the U.K. market are joined by very active Dutch and Scandinavian institutions, and more recently, French and German investors, who recognize that such opportunities to buy prime properties at attractive yields will not last.

The city of London, for example, has been hard hit by low business confidence, high interest rates, and an oversupply of space. The city's overall vacancy rate is at 12 percent, up from 8.8 percent a year ago, and yields on prime office buildings have softened to 6.5 percent. City rents are currently at $117 per square foot, per month, about 8 percent below their level of 12 months ago, and total occupation costs are at $170 per square foot. Prime buildings can be purchased to show initial yields in the 6.5 percent to 7 percent range, compared to levels of 5.5 percent to 6 percent as recently as a year ago, reflecting a nearly 20 percent drop in prices from the most recent peak.

In the West End of London, where the vacancy rate is still only 4 percent to 5 percent, yields are at 5.75 percent to 6.5 percent, and the shortage of Class A buildings has helped steady the market, despite jitters about the economy. Rents have remained relatively flat at $127 per square foot, and occupation costs are at $175 per square foot.

Conditions should persist

U.K. interest rates have remained steady at a high level for some months, based on the Thatcherite policy of squeezing inflation from the economy. With the pound at what may prove to be unsustainable levels in the European market, the U.K. economy will soon suffer from recessionary pressures.

These high interest rates have put pressure on many U.K. property development companies, which eschewed the use of institutional joint ventures during the 1986-89 boom in rent levels and relied on bank financing for development projects. Consequently, any buildings which would not otherwise have been sold are either being publicly marketed or quietly refinanced with foreign capital sources.

As interest rates decline, more developers will be able to achieve a stable position and be under less pressure to realize cash by selling their best assets. These newly available prime properties are the ones which foreign investors should target.

With a few notable exceptions, U.K. institutions have not historically been strong counter-cyclical buyers of property. To a large extent, they have exceeded their target allocations to real estate as a result of the strong growth in values during the 1986-89 boom. U.K. investors are very comfortable concentrating their current investment activity in the bond markets and high-yielding money market positions. Without a doubt, they will re-enter the real estate markets when interest rates decline and the potential for capital growth in rising bond prices has been exhausted.

As compared to U.S. markets, the U.K., especially London, is much less likely to remain in imbalance for sustained periods. The difficulty of site assembly, the lengthy planning process, and overall lower density of development mean that rental levels do not react as wildly as they do in the U.S. In addition, the typical U.K. lease features terms of up to 25 years, and upward-only rent reviews every five years, with no provision to break the lease.

In practice, a mixed U.K. portfolio with suitably staggered rent review patterns should provide US. investors with a combination of stability and capital growth unheard of in the U.S. over the last 10 years.

Investing in Germany

In Germany, there is a distinct lack of supply of existing investment opportunities. The result is a push for financing new speculative construction by European investors who are unsatisfied with current yields on existing prime city center properties. As the financial capital of Germany, Frankfurt achieves rents of $4.75 per square foot, per month for prime space, and $5.00 per square foot, per month in total occupation costs for non-air-conditioned space.

Prime space in Munich is achieving $3.50 per square foot, per month, while in Berlin, rents are $3.15 per square foot, per month. In Hamburg and Dusseldorf, rents range from $2.25 to $2.50 per square foot, per month, and are about $2.05 per square foot, per month in Stuttgart.

Increased activity by European investors in Germany make the competition for properties extremely difficult. The bulk of property investment in volume terms is done by the German institutional market, although their counterparts from Scandinavia and Holland are the largest foreign purchasers of high-profile buildings.

Private investors, often acting in consortia, remain competitive bidders for even the large properties, particularly where advantage can be taken of tax-effective structuring combined with long-term reversionary positions.

These Scandinavian, Dutch, and French investors have become a major factor in the development of new buildings. With yields on existing property ranging from 4.25 percent to 5.5 percent, these investors are pursuing higher returns, through either direct development or project financing.

The shortage of investment properties is due to a number of factors, not the least of which is the fact that 44 percent of all office buildings in Germany are owner-occupied. As a result, downtown office vacancies typically range from 0 to 2 percent.

There is also an unwillingness among many institutional investors to sell properties within their portfolios, as well as an increasing worry among private investors that too frequent trading could lead to the loss of tax advantages.

Despite the demand for new space, it is extremely difficult to assemble sites for new projects in most German cities, and design restrictions make typical "American" office buildings with large floor-plates impossible. Because all employees must have direct access to day-light, German buildings necessarily have shallow core-to-window depths.

Unlike their European counterparts, U.S. investors are not ready to pursue investment opportunities on the mainland. U.S. developers are coming into the market, however, because they see opportunities to develop speculative buildings for which there is demand.

Developers currently involved

Tishman Speyer of New York, in addition to MesseTurm (which it is developing in a joint venture with Citibank and Kajima Construction), is looking for projects in other locations, including Berlin. Citibank of New York is also involved with P&O of the U.K. in a 1-million-square-foot office and trade center on the Hamburg waterfront.

Gerald Hines Interests of Houston plans to open an office in Berlin in 1991. Trammell Crow of Dallas, which has an office in Munich, is developing Fleetinsel, a business park outside of Hamburg, in conjunction with Citibank and the Klingbeil Group of Germany. Lincoln Properties, also of Dallas, is researching the German market.

Once these developers find a project, they must act quickly because the German market is very competitive.

For the most part, American developers are enthusiastic, but cautious, about opportunities in Germany. Having seen foreign developers come to America and make mistakes, they do not want to make the same mistakes themselves by going into new markets and thinking they can teach local players how to operate. But with time, a willingness to accommodate to the differences and an understanding of the uniqueness of each of Europe's markets will make it worthwhile for American developers and investors to take the risk of doing business overseas.

Richard Grillo is an international investment partner with the New York office of Weatherall Green & Smith, an international property brokerage and consulting firm. He serves as a liaison for real estate investors and developers in Europe and the United States and will eventually coordinate the firm's international financing operations from Western Europe.
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Author:Grillo, Richard
Publication:Journal of Property Management
Date:May 1, 1991
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