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The Urban Land Institute and PriceWaterhouseCoopers

Market opinion is both divided and undecided as to whether we are in a period of structural change in the equilibrium value of real estate or in the thrall of "irrational exuberance." The major challenge in 2006 is to negotiate the imbalance between investable funds and available assets without moving pricing to a dangerously unsustainable level.

Sentiment is hugely weighted to the "buy" side. Even the lowest ranked city markets have much higher "hold" recommendations than "sell." A vocal minority of those surveyed believe this is indicative of a market nearing its peak. However, there are a few who firmly believe that we are in a market bubble that will burst in the next 12 months.

There is an increasing consensus that real estate has been repositioned as an asset class. This contention is supported by the continuing increase in strategic institutional target weightings in real estate. Private equity, venture capital, and hedge funds that invest in real estate related assets are all now the recipients of increasing percentages of institutional allocations in addition to core investments.

The German open-ended funds are in deep trouble and will be the only source of equity not expanding in 2006. According to official figures, they experienced 3.43 billion outflows in 2005, 3.05 billion of these in December alone as fear left investors running for the exit doors following the freezing of one of the largest funds. A general loss of confidence has taken hold and the funds currently face potential regulatory changes from both within the industry and from the German federal government. The only ray of light is the timely explosion of international interest in German real estate that could bolster the value of the funds' holdings. The increase in cross-border traffic hunting for German assets is one of the most significant changes highlighted by our survey and interviews since a year ago.

The non-listed vehicles sector is experiencing growing pains. The number of investors now wishing to get into funds has created waiting lists for some funds. In addition, many large institutions are questioning the utility of investing in closed-end funds when the biggest problem they face is reinvestment risk. The new "flavour du jour" is the institutional open-ended fund, which has no expiration date. Despite the current problems, indirect investment is still deemed the most efficient route to cross-border investment for the majority of investors.

Listed real estate in Europe will receive continued firm support in 2006. There is growth in global investor interest and European institutions have huge sums to put into the listed real estate sector if more tax-transparent REIT vehicles become available. French SIICs will expand markedly in 2006 as more corporates sell their property assets into the sector. REIT legislation has been proposed in the U.K. that would come into effect in January 2007, but crucial details have yet to be disclosed. The German government has also committed itself to introducing a G-REIT, but the vehicle may not be tax transparent.

The past year saw the emergence of a real estate derivatives market in the U.K. The range of potential transaction types is already on the rise because established derivatives professionals who are familiar with how quickly these markets can grow are keen to develop the market. The world's largest interdealer broker has expressed intent and another major international interdealer broker has partnered with an international real estate advisory group to create over-the-counter (OTC) property derivatives for both U.K. and continental commercial property. In addition, at least three major international banks have committed themselves to the market.

Growing numbers of investors are now prepared to take development risk. Even speculative development is making a comeback. A significant number of investors are looking to team up with developers to get product for their portfolios.

The shortage of conventional real estate is forcing investors to look at a much broader range of assets than ever before. A huge array of investors are interested in gaining exposure to new areas such as nursing homes, retirement communities, student housing, self storage, car parking facilities, pubs, recreational facilities, spas, resorts, entertainment complexes, condo-hotels, schools, hospitals, airports, and other infrastructure assets.

There will be a substantial increase in the availability of debt finance from all sources. Rising competition has sent margins on a downward trajectory and no one expects any relief this year. The investment banks engaged in securitisation are frequently cited as the major force behind increasingly aggressive pricing.

Substantial further growth in CMBS issuance is expected for 2006. This will be driven by rising numbers of conduit programmes, expanding appetite for CMBS on the part of a widening pool of investors from all over the world, and the fact that his is the cheapest form of real estate finance for many borrowers. B note issuance will also grow because it enables CMBS arrangers to achieve better pricing on the senior or A-note of a securitisation. There is also a considerably expanded pool of dedicated mezzanine investors looking for B-notes.

The top markets for solid risk-adjusted returns will be Paris, London, Helsinki, Madrid, and Barcelona, in that order. Paris and London were in the top five last year, but Helsinki has risen from fifth place while last year's number two, Milan, has fallen well down the rankings. All the favoured markets have good prospects for rental growth. The sustained downward shift in yields has sent many investors seeking higher returns out to new markets-most of them to the east. A surprisingly diverse set of investors is now looking at Romania and other nascent central and eastern European markets. However, the big movers are heading to the Far East and India because they offer investment opportunities in larger scale.

Istanbul and Moscow retain the top rankings for development prospects for the same reasons cited in last year's report. These are fast-growing economies with a shortage of modern high-quality assets, but the risks have to be carefully mitigated in any project. The best sectors in which to invest will again be retail parks and shopping centres, but there are increasing concerns about a number of markets, so investors must be discerning. Hotels rise to third place from sixth in last year's survey, pointing to their increasing acceptance as a mainstream sector. In addition, they are beneficiaries of improving cyclical factors as well as the secular increase in intra- European leisure travel.

Acknowledgement

This article is taken from Emerging Trends in Real Estate^® Europe report - a joint undertaking of the Urban Land Institute (ULI) and PricewaterhouseCoopers. A trends and forecast publication now in its third edition, the report provides an outlook on European real estate investment and development trends, real estate finance and capital markets, property sectors, metropolitan areas, and other real estate issues.

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