Second in a four-part series on European Investment Issues.

A rush of capital chasing too few deals and the race to place at least a portion of that capital in alternative investments–all set against the backdrop of the Incredible Disappearing Cap-Rate Environment. Sound familiar? It should. Stateside investors have been juggling these forces for some time now with varying degrees of success, some striking it big, some coming up empty-handed in the great trophy grab. The difference is that we’re not discussing the states here, but the pan-European investment scene, awash in capital and expected to gain yet more as the ground rules for placing funds undergo a dramatic shift. In an exclusive interview at Mipim in Cannes last month, Gordon C. Black, managing director of international private equity for Heitman Real Estate Investment Management in London, talked about the shifting dynamics of European commercial real estate and how Heitman plans to harness them. It was an explosive ’05. What does the investment pipeline look like today?

Black: The latest numbers I heard were about 130 billion euros of transactions in 2005, and that number is up anywhere from 30% to 50% over the past three to five years on average, with a lot of institutional and retail interest. Going forward you’ll see more monetization and privatization of corporate and user-held real estate, as we started to see in 2005. In all, the money that’s been allocated to real estate is just growing and it needs to find a home. In the states, necessity’s been the mother of invention, and some creative alternative plays are being recorded. Same here?

Black: That’s a very interesting pocket. In the US, we raised $400 million of equity capital in a fund called Heitman Value Partners. A significant amount of funds have been allocated to what we call the specialty sector–student housing and parking, for instance. Interestingly, even within the alternative class there’s an alternative thought process as we get further away from what people traditionally define as real estate. For instance, public storage works in the US because people there are pack rats there. In Europe, we’re in much more confined spaces, so there’s no accumulation. But people in transition and divorce are changing that. How large could the alternative market grow?

Black: It’s certainly a smaller subset, but if it’s going to be 10% of the market–of 130 billion euros–that’s significant. And it’s not an unreasonable target. You’re not playing at all right now in the UK market, correct?

Black: We’ve been concerned about valuations. It’s very much a core market today, so when you hear people around this conference talking about yields of 4% or below, there are a number of complications. It’s more expensive than your going-in yield and it’s dilutive to your transactions. The ability to see real growth in other than rental rates is hard. So the same shift from cap rates to building performance that we’re seeing in the US is playing itself out here as well.

Black: It’s time to roll up your sleeves and get value the old-fashioned way. This may not be true for everyone, but over the past few years a number of investors have seen the benefit of cap-rate compression in various markets and there’s been a lot of wind in the sails of returns because of the capital-market activity. There are still pockets and opportunities, so you may be able to extract value, but it’s harder today. Cap rates have been squeezed to a point where you have to start looking at asset management and pulling value out of the lease transaction. What does the outlook appear to be for continued European investment in the states?

Black: It will slow. European investors are driven by a couple of things–changes in legislation, for instance, that let German open-ended funds start investing abroad, not just in Europe but in the US as well. There was an arbitrage between European and US return levels that was very attractive. That spread has narrowed, and some of the capital that was being deployed was coming from sources that might not have as much capital today. The open-ended funds are focusing on their business throughout Europe and you won’t see quite as much US activity there, but you will continue to see European investors in the US, and we’ll continue to see North American investors in Europe. We’ve been a manager of US-based capital, and we’ve expanded that and been able to invest for a number of large European institutions. We’re seeing more interest from North American buyers today than we have in the past, and it’s not because of yield, it’s because of diversification. If you see more European money going to the US it’s not going to be yield driven as much as diversification driven. What’s going to be the lingering impact of the German fund freeze of late last year?

Black: It’ll be small. There’s clearly a benefit for the retail investor to have that kind of structure available. If you look at the US, there are open-ended funds that are $11 billion, $12 billion, $13 billion. It’s a marketplace that continues to work not only for the retail investor but for the institution as well. There’s increasing pressure to deliver returns to their clients. We already have an efficient market that allows people to move into and out of a relatively illiquid asset class, and that’s attractive. Increasingly, you’ll see separate accounts looking for open-ended funds for office, for example, and with several managers to pick from. I don’t see the open-ended market in Europe or the US doing anything but growing. There are a couple of new initiatives for Heitman on the drawing board. Do you want to share some of those? You mentioned that you were looking at new opportunities in Eastern Europe.

Black: Turkey and Russia, farther east than we’ve typically operated. But the timing depends on the identification of local operators who can provide the necessary market familiarity. In the meantime, we’re going to roll out a public-securities product in Q2, a global product that will pick up activity in Europe for publicly listed entities. We have a small office in Tokyo, so we have an arrangement to cover Asia and Australia as well. It is both institutional and retail. What’s the potential?

Black: We currently manage $3 billion in REIT stocks in the US. We feel confident it can easily be that size in three to five years.

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