We have seen increased interest for commercial real estate assets in Croatia in the last couple of years. With the engagement of domestic institutional investors (primarily pension funds and large insurers), and the constant interest of foreign investors, the market has seen a compression of yields.
However, as this article will try to explain through comparison with traditional income-generating asset classes, commercial real estate in Croatia – on a yield basis – still presents a very reasonable opportunity.
Interest in Commercial Real Estate
What might sound like a nice problem to have? Having excess capital to allocate comes to mind. However, deploying excess capital can be difficult, especially if there is more of that capital than good opportunities on the market. Powerful monetary and fiscal stimulus (with consequent inflationary pressures), coupled with the long bull run last decade, left investment managers with lots of dry powder (money ready to be shoot, or invested). While this can be a positive thing from a market perspective, which ensures activity and liquidity, managers can have a hard time finding opportunities to put that money to work.
With unprecedently low bond yields and high-priced equities, there has been growing interest for commercial real estate (CRE) asset class in the past period. CRE offers that current yield (which used to be an attractive attribute of fixed-income securities) with potential for capital appreciation (the main attribute of many equity investments). Of course, that ratio of current yield vs value appreciation can vary significantly depending on the type of RE investment, from core to opportunistic. These attributes contributed to strong growth of alternative assets market in the last decades. Brookfield Asset Management estimates that by 2030, the real assets/alternatives market will pass equity/fixed income. Whether that prediction is too bold or not, the allocation to real assets is certainly.
expected to grow.
Game of Risk and Reward: Comparing asset classes
Legendary investor Warren Buffett said that every investment could be looked at as a bond, the only difference is that coupons that the bond will pay are known in advance (and limited by maturity), while in case of equity or RE investment, it is a job of investor to estimate what are the "coupons" that asset will pay over time (in form of dividends or rental income). And, of course, what is the probability of those payments or the risk of the investment. Investor in a bond, if that bond is bought with the intention to be held to maturity, has only one risk – will the issuer pay stated coupons and principal. If investors believe that issuer is financially strong and will not default on its payments, they will be willing to pay a higher price for that investment. In other words, the yield (and reciprocally price of a bond) depends on the level of trust the investor has in the issuer, i.e. issuer's credit (lat. credo means believe, trust). Thus, bonds are priced based on their credit rating. This means that bonds with higher credit rating will offer lower yields, or to put it more simply, their cash flows will be more expensive as they are less risky.
Same principle can be applied to other asset classes as well. The only difference is that analysis can be a bit more complex, as it includes more factors. In the case of equities, pricing can be observed through dividend or earnings yield (depending on whether the ratio considers whole earnings, or just a portion of earnings paid out in the form of dividends). The analysis includes the company's financial position, competitive advantage, growth potential, industry analysis, etc. Although the analysis can be more complicated, the premise is simple – if an investor expects stable and sustainable growth of earnings in the future, he will accept lower earnings yield, i.e. he will pay more for that expected cash flow (earnings yield is the inverse of more popular P/E ratio, but it shows the same thing).
Finally, the same can be said for commercial real estate. If expected cash flows from the asset are predictable and likely to happen, an investor is willing to pay a higher price. This must be determined based on the property's characteristics such as location, condition, tenant mix and covenant strength of tenants, WAULT (weighted average unexpired lease term), and lease conditions (break options, indexation etc.), competing projects, sector outlook and other. Again, the analysis can be more complex compared to a bond. Still, the conclusion is simple – cash flows from a quality property in a good location, with strong tenants and long WAULT (security that CFs are locked for a longer time) will be more expensive.
The above described can sum up the basic idea of investing in income-generating assets, which is paying money now for expected cash flows in the future, while the return depends on how expensive these cash flows are. The pricing of every specific issue, company or property will depend on the individual characteristics. Still, the general pricing of every market is primarily based on the strength and stability of the economy, measured by various indicators such as GDP growth, unemployment, wages, currency status, but also political stability, investment climate and others (all these attributes are built into the rate of return or yield)
Comparing cases: Croatia and Austria
Although the topic deserves more detailed analysis, the aim of this text is to point out the potential existence of discrepancies in the pricing of different asset classes in Croatia. The next graph shows yields on 10Y government bodies of Croatia and Austria, dividend yields for stock market indices ATX (Vienna Stock Exchange) and CROBEX (Zagreb Stock Exchange) and yields for prime office properties in Vienna and Zagreb.
As seen from the graph above, the largest spread in yields can be observed for CRE assets: around 4 percentage points for office yields compared to around 20 basis points for equity market and around 90 bps for government bond yields.
One of the reasons might be the perceived liquidity of the market. Due to the relatively small size and lack of good opportunities in the market, CRE investment volumes in Croatia can seem low compared to larger markets in CEE. However, investment volumes in Croatia fail to underscore the true investor's interest, as the demand for good income-generating assets, for several years, outstrips the supply.
What lies ahead?
As described above, CRE market in Croatia is characterized by a strong seller's position, as the supply of investment properties offered on the market currently does not satisfy the demand. Most sought after are opportunities in office and logistics sectors. However, due to strong demand, high activity in previous year was also recorded in retail and HTL sectors, which offered more opportunities.
In the last two years, the market has seen downward pressure on yields influenced by strong competition for deals, inflation panic and low or negative interest rates. Current uncertainties coupled with rising interest rates could stop further compression of yields. With strong existing demand and a significant amount of dry powder still available on the market, it is difficult to predict which force will have a stronger pull.
Due to strong demand and positive announcements in the forthcoming period (Croatia will join Eurozone in 2023 and Schengen in 2024), it is expected that yield spread between Croatia and tier markets will slightly decrease. However, we believe that commercial real estate in Croatia, on a yield basis, will still look attractive in the coming period.
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