Despite the general economic malaise, optimism abounds in the European real estate market - and for good reason: growth remains positive, research is improving all the time, depreciation is now factored in effectively, restrictions on excessive developments are in place, controlled inflation is central to government policy, and the capital markets have become a key provider of not only policy but also discipline.
It will be different this time round. Europe has learned from its past mistakes and is not grooming itself for yet another property collapse, the last of which took place at the start of the last decade, leaving many investors out of pocket and a number of banks looking at mounting loan-loss provisions.
That, at least, is the hope. As research by DB Real Estate in December commented, although there has been a marked recent deterioration in the outlook for Europe's macro-economy and, by extension, for its commercial real estate market, a catastrophic crash seems improbable, for a number of reasons.
First, says the DB Real Estate analysis, demand for commercial space has not been hit anything like as hard as it was a decade or so ago: "Although growth is below trend it remains positive - unlike in the early 1990s when most European countries suffered several successive quarters of negative economic growth."
Second, "at the same time, new supply coming on to the market is generally lower than last time, and proving to be more flexible in response to weaker occupier markets (though in this respect there is significant variation between markets)." And third, the DB report advises, "despite rent weaknesses, demand in investor markets has been robust, pushing yields down and keeping capital values flat."
For their part, investors appear to agree that in the current climate property has better prospects as an asset class than it has in the past. In the UK, the view from Prudential is that "over the longer term we expect property to deliver returns marginally lower than equities, but well in excess of Gilts, while making an important contribution to risk reduction in the investment fund." That was the conclusion to what a report recently published by Prudential described as a "thorough investigation into the appropriateness of property as an asset class".
The conclusion was based on four reasons why Prudential believes that the failure of real estate to deliver expected returns in the past should not be taken as a guarantee that these returns will continue to be depressed in the future.
First, it believes that "significantly improved information and market research gives a far clearer view of prospective market performance, reducing the extremes of property cycles."
Second, it argues that "a return to tighter land use planning and more cautious lending will restrict excessive development, leading to a more consistent supply of property."
Third, the report says that "depreciation is now factored into property portfolio valuations as a matter of course."
And fourth, it draws comfort from the fact that "inflation control features at the heart of government policy, limiting the likelihood of runaway inflation eroding the real value of rents".
Over and above those benefits, Prudential argues that property has an important hedging role to play in investment portfolios, given that its returns tend to be unsynchronised with those of other asset classes. "Hence, diversification into property helps to reduce volatility in multi-asset portfolios," advises the Pru.
The growing popularity of property as an institutional asset class, however, tells only a minor part of the story. More important is the increased flow of cross-border investment that is now being directed towards property in various shapes and forms, which are immediately apparent in the statistics collated by companies such as property firm Jones Lang Lasalle.
According to data it published in September 2002, annual direct investment into real estate in Europe rose from Eu19.7bn in 1998 to Eu23.9bn in 1999 before almost doubling to Eu56.5bn in 2000, and stabilising at Eu52.3bn in 2001 and Eu24.7bn in the first half of 2002.
Granted, there have been sporadic shifts into international property as an investment alternative in the past, often prompted by investors' re-allocation of funds outside their home countries when their domestic markets have become absurdly overheated. Japanese investment in international property in the 1980s provided one example; so too did the propensity of the Swedes to throw money at the market in the latter part of the same decade.
Generally, as the Japanese and Swedish examples brutally demonstrated, undisciplined and unscientific investment in international property markets has generally ended in disaster. This time round, however, cross-border flows into real estate look altogether more robust.
Capital market discipline
One reason for that is that the capital market, generally recognised as being a much more disciplined medium than the bank market that fuelled much of previous cross-border property booms, is playing a conspicuously more important role in promoting international investment in property than ever before, in two ways.
First, the rapid growth of the asset backed market in Europe - in the form of both residential and commercial mortgage backed securities (RMBS and CMBS) - is making an essential contribution to the more realistic pricing of risk throughout the property market.
Equally or perhaps even more important, the growth of the ABS market in Europe is removing the barrier that has traditionally served as the most persistent deterrent to increased institutional participation in real estate markets - illiquidity.
A second reason for the increased importance of the capital market as a bridgehead for institutions into property in general, and cross-border real estate in particular, has been the explosive expansion in recent years of the credit derivatives market, which in Europe is little more than five years old.
In Germany in particular, credit derivatives have opened the way for the dynamic evolution of the market for synthetic securitisation, which in turn has made the country one of Europe's most rapidly expanding markets for RMBS and CMBS.
But greater understanding and acceptance of derivatives technology is not limiting increased flows in investment into property to the confines of Europe. It is also helping to boost flows of investment into real estate from Europe into the multi-trillion dollar US mortgage bond market.
Deutsche Bank in New York has recently launched an innovative total return swap (TRS) product aimed, among other objectives, at making it easier for overseas investors to access the US mortgage bond market, which is second only to the Treasury market in terms of liquidity.
"An increasing number of investors around the globe now need to get exposure to US mortgages because they are switching away from government bond indices and towards credit benchmarks, about 14% of which is accounted for by US mortgages," says Alec Crawford, head of MBS Research at Deutsche Bank in New York.
"Our thought process in launching the new TRS product was that given the complexity of the US mortgage market this would be a means of giving investors exposure to the sector without having to go through specific security selection and settlement complications."
The TRS product, adds Crawford, has already proved popular with a number of smaller European investors that need access to the US mortgage market but which have neither the time nor the resources to follow and analyse the asset class on an hour-by-hour or day-by-day basis.
Hand in hand with the liquidity and transparency of the international ABS market as a vehicle for institutional investment go its demonstrable credentials as a relative safe haven for investors caught between the Scylla of collapsing equity valuations and the Charybdis of event risk and accounting scandals in the credit market.
To date, those safe haven qualities have become especially apparent in the RMBS and CMBS markets. A recently published Moody's study of the behaviour of its structured finance ratings between 1991 and 2002 found that over the 11 year period, CMBS had a downgrade rate of 1.6% compared with an upgrade rate of 3.5%. For RMBS over the same period, the rates were 1.9% for downgrades and 3.6% for upgrades, which compares with downgrade rates of 3% in the broader ABS market and of close to an alarmingly high 11% in the CDO (collateralised debt obligation) sector.
Fair enough. But won't this safe haven attraction recede as quickly as it emerged, as and when the world comes back to its senses and rediscovers the joys of investment in equities and other higher risk assets?
The analysts at DB Real Estate are unconvinced of this argument, even though they accept that it is one that is shared by a number of market observers. Even if equities rebound miraculously, says the DB report, "institutional and retail investors have long memories. It took a decade, a stock market crash, and several years of sustained double-digit investor returns to convince investors to forget the badly-burned fingers they suffered during the last real estate crash, and it is not at all obvious why equities should be treated with any less circumspection."
Besides, argues the DB analysis, "there is a broadly-based re-assessment of the merits of real estate as an asset class going on at present. Many of the asset's qualities - its ability to retain value, its propensity to throw out returns as cash, the predictability of its behaviour and its low correlation with other assets - are only recently becoming understood by the investment community."
So much for demand for real estate as an asset class, all of which would be of limited value without concomitant supply - of which there is more than enough. Nicole Downer, managing director of European securitisation at Deutsche Bank in London, argues that a more decisive influence on the role the capital markets are playing in financing real estate is the supply side of the equation, rather than institutional demand.
"Banks are becoming more cautious and more aware of their RoE levels, which is pushing them away from traditional real estate lending methods and more towards securitisation," she says.
John Nacos, managing director and head of European real estate debt markets at Deutsche Bank in London, agrees that banks' drive for improved RoE is pivotal to the changing structure of the way real estate is now being financed in Europe.
"It is no secret that the German mortgage banks are very capital-constrained and they have traditionally been among the biggest real estate lenders," he says. "The same is true for the Landesbanks, which are now losing their state guarantees. These banks are looking to the securitisation markets because they don't have the regulatory capital they need."
Another powerful influence that is increasingly shaping supply of asset backed issuance in the real estate market, adds Nacos, is the pursuit of enhanced shareholder value in the corporate sector. "An important source of supply, especially in continental Europe, are large corporate divestitures of real estate that are much too big for the bank market to absorb," he says.
"If you look at Vivendi selling a Eu500m portfolio in France, Metro selling Eu2bn of real estate in Germany, Enel selling the same amount in Italy or Nordea offloading Eu1.5bn in Scandinavia, there is no way the bank market could fund all those transactions. They have to find their way to the bond market where the capacity is significantly bigger."