For many years property investment has retained a decidedly home bias, with the majority of institutional investors in the Nordic region only having limited real estate exposure outside their own region. In recent years, this mainly domestic focus has started to widen and we are now witnessing a tipping point for cross-border property investment. As with any tipping point this is the result of confluent trends:

The internationalisation of equity and bond portfolios has meant that the general argument for cross-border investment and diversification has become widely accepted. The relative performance of property compared to bonds and equities in the early part of this decade (see figure one) has in turn led to a re-appraisal of the asset class amongst investors.

Diverging performance amongst countries and sectors has also resulted in investors looking at other markets. The adoption of the euro, the development of benchmarks for continental European property markets and the general improvement in transparency all facilitate cross-border investing.

Nordic investors have increasingly started to look at investing outside of their domestic markets, often starting by looking at other countries within the Nordics. Moving to a more pan-European approach is therefore a natural progression for these investor bases - a sentiment that is now increasingly shared by other European investors.

In response to this increased investor demand, we have witnessed an explosion of private unlisted property funds offering new cross-border means of access to the various domestic sub-markets. Unlisted funds allow investors to gain exposure to specialist managers with in-depth knowledge and experience of the target markets. As investors exercise this new ability to invest in diversified funds, they can also reduce their specific risk to a market.

Performance

The Nordic property markets were some of the worst performing in Europe in the first half of this decade, following the bursting of the tech bubble. The Nordic economies and Sweden and Finland in particular are heavily reliant on the TMT sector. The huge influence exercised by TMT firms, in particular Nokia and Ericsson, meant that tenant demand for office space dried up during this period. This followed a period in the late-1990s when office rents in cities such as Helsinki and most noticeably in Stockholm reached extraordinary highs, which was the cue for developers to build. When the tech market burst we saw a combination of tenant demand evaporating, existing tenants returning space to the market as they downsized and a significant amount of new space coming to the market. This resulted in office vacancy rates rising to levels previously unheard of. In one particular office submarket of Stockholm called Kista, where Ericsson is located, prime or grade A vacancy rates are reported to have reached a staggering 75 per cent at one point.

The case for European investment – diverging returns

Looking forward, we are broadly optimistic about the prospects for the Nordic region. Over the next five years, economic growth prospects in the region look relatively strong compared to the rest of Europe. In the office sector, we are seeing a pick-up in demand, which should lead to an improvement in rental growth rates over the next five years. However, office markets such as Helsinki and in particular Stockholm have been volatile in the past and we expect that this will continue.

Diversification

Diversification suggests the next major argument for investing outside of the domestic market or region. Property provides investors with indigenous exposure to a market in a way that equities or bonds do not. Property largely reflects the fortunes of the economy in which it is situated. Often this is not at the national economy level but at the city, suburb or local level. For example, the above-mentioned heavy reliance of Stockholm and Helsinki on telecoms has meant that the fortunes of their office markets have to some extent been determined by the fortunes of Ericsson and Nokia respectively.

Another source of diversification benefits comes from characteristics inherent to each office market. These include the myriad of tenants who occupy space in the market, local planning regulations, transaction costs, management costs and lease conventions. Lease lengths in the Nordics are relatively short in a European context. The UK, for instance, has generally longer leases and has benefited from five-yearly upward only rent reviews. Continental European leases do, however, benefit from typically having some degree of inflation indexation, albeit the inflation level of the country invested in, not that of the investor’s home, which has contributed to the predictability of their income stream in real terms in that currency.

Concerns that investors should have

When investing outside of a home market investors need to consider:

Benchmarking and tracking error: As with any investment that is outside the investable universe of the benchmark, this increases the tracking error of the fund. The Nordics have well-established property benchmarks but, while established direct property benchmarks are becoming more widespread – there are now 13 European countries with an IPD benchmark – some of these suffer from limited years of back data. While the UK series goes back to 1971, other countries have much shorter data series, such as Italy going back only to 2003. This makes calculating optimised allocations for European property, based on the level of volatility and past returns very challenging.

Currency: With the notable exception of Finland, none of the Nordic countries have as yet adopted the euro, albeit that Denmark is closely aligned to the euro zone via the European Rate Mechanism (ERM-II). Hence cross-border investing inevitably means taking currency risk. Finnish investors could concentrate their investments on euro zone countries but that inevitably would mean foregoing exposure to the highly liquid markets of the UK or Sweden which are currently out of the euro. Investors always have to bear in mind that currency exposure can either be a drag or a boost for performance. Investors need to make a judgment call whether they are prepared to bear that currency risk or not. If currency risk is unacceptable, a hedging programme can be established at a limited cost (but cash calls have to be accommodated).

Type of investment vehicle: Investors investing outside their home market generally have to contend with a lack of knowledge and experience of cross-border markets. Some Nordic investors who invested in foreign property markets in the late-1980s, concentrated on direct investment (buying buildings outright) and later regretted it. Investing in a pooled vehicle can reduce this issue, but many investors may still feel exposed as it is harder to select a manager for a less well-known market, particularly when these markets are immature and lack transparency. As a first step, a broad fund of funds solution may be more appropriate.

Conclusion

Over the medium term, we believe that Nordic investors will continue to benefit from investing in other European markets both in and outside the Nordic region. It will not only lead to greater diversification, but also has the possibility for higher returns. By expanding their investment horizons into other European funds, investors have a wider range of markets to invest in and more options when prospects for the domestic market look less appealing.

Printer friendly version

Email this article to a friend