Core-Real Estate Investments in times of crisis: Exemplified by the Frankfurt and London office market

Table of Contents

1 Introduction
1.1 Leading-in
1.2 Problem Statement
1.3 Goals of Studies
1.4 Approach

2 Classification of the real estate asset class and strategy “core”
2.1 Current definition of core
2.2 Market for office core investments - putting core into general context
2.3 Requirements to the asset class core
2.4 New definition of “core”
2.5 Potential risks to core investments
2.5.1 Geographical and market risks
2.5.2 Volatility risk
2.5.3 Change oflocationrisks
2.5.4 Illiquidity risk
2.5.5 Whatislabeledcoreisnot necessarily core risk
2.5.6 Tenant and renting risk
2.5.7 Refurbishment and or sustainability costs risk
2.5.8 Demographic factor risks
2.5.9 Potentially overheatedpricesrisk
2.5.10 Secondary investmentrisk
2.5.11 Inflation risk
2.5.12 CMBS risk
2.5.13 Last resort risk

3 The two markets and there characteristics and differences as an example
3.1 London office market
3.1.1 Where are the core markets? 3
3.1.2 Characteristics of this market
3.1.3 Is core potentially overheating?
3.2 Frankfurt office market
3.2.1 Where are the core markets?
3.2.2 Characteristicsofthismarket
3.2.3 Is core potentially overheating?

4 Sovereign and financial crisis’s and their impact on commercial real estate
4.1 The current situation and crisis definitions
4.2 Drivers of crises, is this a normal crisis behavior and situation?

5 What are the alternatives to office core commercial real estate?
5.1 Where are institutional investors currently invested in?
5.2 Potential Alternatives
5.2.1 Core Retail
5.2.2 Core Residential
5.2.3 Core Investment in emerging markets
5.2.4 Core locations but not core markets
5.2.5 Secondary
5.2.6 refurbishments and or management optimizations
5.2.7 Development of core buildings
5.2.8 Blue-Chips
5.2.9 Debt
5.2.10 Holding Cash

6. Conclusion
6.1 Final Statement

Index of Tables

Table 1: Market Definitions

Table 2: Most demanded market properties

Table 3: Global Real Estate Market Capitalization

Table 4: Prefered current investment types

Table 5: The “house of core”, summarized features of a core office investment

Table 6: Correlations of five maj or office markets

Table 7: INREV Style Classifications by 2011

Table 8: Volatility of Office Properties in Frankfurt am Main and London

Table 9: Work Force Scenarios

Table 10: European Commercial Real Estate Outstanding Debt

Table 11: Germany Inflation Rate

Table 12: United Kingdom Inflation Rate

Table 13: Estimation of Maturing Loans by Deutsche Bank

Table 14: Default rate ofUS CMBS

Table 15: CMBS Risks for UK and Germany

Table 16: Non-Performing-Loans development in Europe

Table 17: Risks summery and their potential effects on core

Table 18: London Investment Analysis

Table 19: London subdivided into districts, colors indication prices andvalues

Table 20: Europe Attracting Global Real Estate Capital

Table 21: Historical Central London Development Rate

Table 22: Prime yields London compared to gilt yields UK

Table 23: Prime yield compressions in Europe

Table 24: UK real estate values in comparison to previous peak

Table 25: Frankfurt office market divided into districts and rents paid

Table 26: Prime yields Frankfurt compared to gilt yields Germany

Table 27: Crisis development since 2006

Table 28: Differentiation of crisis types

Table 29: Drivers of Financial Imbalances 1999 - 2007

Table 30: Historical view on crisis and their heaviness

Table 31: Cycles of past and ongoing real house prices and banking crisis

Table 32: UK GDP Per Capita Development

Table 33: US core fUnd real estate historical income and appreciation analysis

Table 34: Real Estate Share of Institutional Investors

Table 35: Alternative Investment to Core Office Real Estate in Times of Crisis

Table 36: Investment trends in Germany for Office and Retail for 2012

List of Abbreviations

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1.1 Leading-in

“The basis of optimism is sheer terror.”^[1]

This drastic quote comes with a ‘core’ of truth. Through the last century’s history of money and financial markets the market players were usually driven by the same factors and financial laws. For once you have to accept more risk if you want higher yields and therefore you have to pay more if you want a higher security of your invested capital.

And secondly, capital is shy and driven by fear and only partially rational rather than driven by emotions. No matter which crisis of for example the 20th century is analyzed, usually bubbles were often born slowly but steadily, market mechanisms failed and when too much money was available (often too cheap), prices of certain fields and goods went up drastically, investors became greedy and at the peak everything was bursting and fear was ruling. Afterwards, as for example after the dot.com-bubble, investments into these segments were rare and trust needed to be built up again. ^[2]

The commercial and professional real estate market theoretically is in this regard not different from other markets. A usual behavior in times of crises is the wish for more security, more stable investments, and meaning significantly less volatile and ideally very liquid and realizable investments on a market. Capital Investments should be “safe havens” and rather bring little or less money than losing heavily or all. ^[3] In the current time of crisis, after the initialized 2008 Lehman Brothers crash and the following subprime crises, followed by the global recessions in mostly 2009, some countries 2010 and even today in the days of the European and global sovereign debt crisis real estate investors are as an international phenomenon shifting money into secure real estate and on the professional site into “core commercial real estate” in A-markets. Just recently, the institutional investor’s magazine “I&P Real Estate - Global market intelligence for institutional real estate investment” asked in their current edition: “Is core overheating? Investors mull secondary.”^[4] In this thesis, the author wants to provide the real estate professionals with a broader view on the highly discussed topic of commercial (mostly office) core real estate investments in recent times and general times of crisis and market pressure. Questions looked at and discussed will be the question of the asset and investment class “core” itself, what it is, what it stands for and how it can be classified. And secondly, what does “crisis” mean and how is it linked to the investment decisions and the expanded allocation of capital into this asset class, especially in Europe. Here, the commercial real estate markets of London and Frankfurt will be taken as a fitting and hopefully transparent example. And finally, the question of alternatives for major investors will be addressed. The author intends to bring more insight and a clear and professional look at this wide and complex topic that has become more and more important and widely discussed throughout the last years and month (latest on the Expo Real in Munich 2011), especially since the further development and the potentially not short upcoming end of the recent crisis.^[5]

1.2 Problem Statement

“Ifcore effectively equates to prime,prime currently equates to over-priced - at least in some markets.”^[6]

In times of crises, especially today, we are now after first the subprime crisis followed by the financial crisis and swapping over on the world economies, in the middle of the global dept crises, Investors around the globe are aiming and even longing for secure havens for their capital. The real estate asset class “core” is right now playing a major role in the allocation of capital and liquidity. But are there problems coming along with these investment strategies and mass-shifting of capital? How are the markets reacting and what is really “core” and can be considered core? And if core implies lower risk, is this actually true for all phases of a cycle? Is this true in the current phase? Some market participants are starting to worry about a new bubble on the core property market. If this isjustifiable what results would this have?

Thesis: In times of global crisis / tensions, professional real estate markets and market participants are reacting differently. This behavior and these investment strategies can cause difficulties up to contrary results than initially indented; more volatile and unsecure investment decisions as well as mislead views on the markets.

1.3 Goals of Studies

The goal of the thesis is to get a more clear understanding and characteristics of the real estate asset class “core”. The author will create a new definition of core, related to commercial office buildings. The potential risks of core investments against the background of the current crisis will be looked at in detail. By adding to the thesis a practical component the author will have a closer look at London and Frankfurt and their core commercial real estate markets and possible different developments.

The goal of the study is, to giving the reader a clear background knowledge of what is understood by core, indented with core strategies and where the potential risks lie. Furthermore this knowledge is intended to be set into connection with the markets (here London and Frankfurt) and the crisis background that makes the situation possibly abnormal. Finally, the question will be, if the core-investment strategy is the favorable and logical result of global crisis or does it come with difficulties and problems recently underestimated that ought to be answered. Alternatives will be discussed and set into crisis connection as well.

1.4 Approach

In the beginning, the author wants to make aware of the framework in which the thesis was written. The paper was mainly created within the last two month of 2011 and first two months of 2012. During this time and the last years markets, decisions and developments have been very volatile and can theoretically change a standpoint over night. The author will try to be as general and universally adaptable as possible, but can only deliver content until the period’s end.

In this thesis Frankfurt and London have been chosen because these markets can be taken exemplary for the discussed elaboration. First, they are in international comparison very transparent, in particular the London market, additionally they are global and attract money and liquidity from all around the world and are therefore a good mirror of global investment decisions. Thirdly, they can be taken as an example of international capital being shifted into core real estate and the bringing with results. And furthermore, as a last major aspect the density of global players and decision makers in these two markets can be highlighted and taken insight from. Here the decisions from “market makers” on capital allocation can be learned from on future trends, in a positive or negative way. The general approach will be to get a clearer understanding of “core real estate”, in particular commercial real estate and office buildings, but the inherent idea will most likely be adoptable for other professional premium real estate assets classes as well. The thesis will be subdivided into four sections; the major topic is in the first “core”. The current definition, demands of core investors are derived from a new definition of core and risk concerning the investment strategy will be addressed.

The second main part of the thesis will be the “example markets”. The found knowledge of the first chapter will here be applied and set into practical context.

The third major arrangement point will be the “crisis”. This crucial part will be the “bird view” on the current crises. Here, the author will try to bring a more detailed understanding into the real estate market especially concerning core real estate. This part of the thesis will first be more general to the topic of the crisis (in terms of a better and more general understanding of crisis situations and definitions) and will then lead into a connection of crisis and core real estate and the particular effect of the current exemplified crisis on the core commercial real estate market. The last major arrangement point will look at what investors of core investments are engaged in and what the possible alternatives to core investments could be for suitable them.

It is generally very important to note, that due to the time and space requirements of this thesis the details of certain parts cannot be as profound as desired. Due to the enormous richness of detail and cross-border knowledge needed the crisis chapter will be kept shorter and focuses on real estate.

2 Classification of the real estate asset class and strategy “core”

2.1 Current definition of core

If looked at the meaning of the word “core” itself simply translates to “centrum” and can therefore be understood in the sense of real estate described as the centre of a city.^[7] The word is not legally defined in the real estate science and mostly described either as a portfolio strategy type or investment intention, for example from private equity funds as shown in appendix 1. Core is the first of usually 3-4 investment types, core, core plus (frequently left aside), value added and opportunistic. In the real estate professional scene “core” describes a type of investment strategy or risk attitude of investors and furthermore classifies the discussed real estate, mostly into “core office”, as well as “core residential” and “core retail” sometimes industrial and multi-family real estate.^[8]A clear and unified opinion of what exactly “core” is, can here not be found. American, British and for example German description of core features vary quite heavily. The US credit rater Realpoint (2010 bought by Morningstar) classifies for example core real estate total returns between 8,5% and 10% whereas the German commercial real estate company BEOS AG classifies core returns in between 5% to 8% which seems to be similar but makes a huge different taken into account the high investment volumes. ^{[9] [10]}

In order to classify “core”, different sources mean different results, but can shortly be summed up by a definition of ING core funds: “core funds can be seen as low risk funds that invest in stabilized, income producing property which is held typically 5-10 years and have little acquisition / disposal activity after the fund has been invested. Assets in such a fund are typified by stable income returns with less capital growth.”^[11] Found in the literature and mainly big investors and market player’s publications, core comes with certain “must” features that are mostlyjudged by risk, stability and volatility aspects. The properties have to be nearly fully leased, which minimizes the risk aspect. ^[12] Furthermore, the Loan-to-Value rate (LTV), the spread between equity and borrowed money has to be usually below 40%.^[13] The investment has to usually be long term, the market invested in mature and transparent, the properties of high quality. It is very important that the tenants have to bring a high credit standing and secure lease agreement.^[14]

2.2 Market for office core investments - putting core into general context

The commercial office real estate sector is a more and more unified global market.^[15] Major investors look quite often at investment opportunities in the global leading financial cities, such as New York, London, Frankfurt or Hong Kong.^[16] In these markets the office sector properties are usually categorized by the location and quality. The buildings are theoretically spread around the cities, often in the central business districts (CBD), the very centre or in the suburbs (often in the USA).

The markets for core properties mainly exist in the USA and continental Europe. “This is explained wholly by familiarity and perceptions of risk”. ^[17] Table 1 shows the typical core markets around the globe, differentiated by emerging markets mainly different in the risk attitude of the investors. Generally speaking according to Andrew Braun core markets are “[...] politically stable, have a stable currency, offer professional service necessary for institutional investment and are liquid and transparent” ^[18] For the European market Baum continuous with the requirements: “[...] Membership of the EC; membership of the Euro; political stability; generally having a benchmark (the exceptions are Belgium and Switzerland); size, quality of professional services; and liquidity”^[19]

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Source: Commercial Real Estate Investment, Andrew Baum, 2009, p. 361.

Institutional Investors who are often the buyers of core office real estate are normally only considering the A or B buildings, whereas “B” is a complicated matter, since it can be close to “A” but pretty far away at the same time. That will be due to further discussions later in the thesis.^[20] Table 2 below shows that recently the market for core properties is the most demanded one, especially in London.

Table 2: Most demanded market properties

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Source: places & spaces - The Real Estate Magazine of Union Investment, Issue: The core of a market - Everyone is talking about core - but every investor defines the term differently, 2011

The global core real estate universe, worth $ 8 trillion and growing (latest data available by December 2005) can be seen in Table 3, showing that Europe as a continent with $ 2,234 billion dollars is the second biggest market only coming after the USA with $ 2,632 billion dollars.

Table 4 displays in a PwC conducted survey on European real estate investments, where institutional money flows, showing a lead for core real estate.

When speaking of core investors and core investment, the classified buyer is not clearly defined in literature. Since usually most office and core buildings are in the millions (euro, dollar or pound) considering the purchase price, the typical investors are professional real estate companies, usually funds (mutual, private pension, state and local retirement, endowment), banks, insurance companies, foundations and private wealthy individuals, so called High-Net-Worth-Individuals (HNWI), usually acting through their own wealth management companies, called “family offices”.^[21] Appendix 2 shows a list of the 30 biggest professional real estate investors in the world, having a total investment sum of $ 458,784.7, whereas the cutoff level was just north of 6 billion dollars in equity invested. Following with a classification on the real estate discussed office buildings are usually classified into “Class A” to “Class C” or more common in the UK, “Greater A” to C buildings. Sometimes they are called “prime-office space”, “premium” or “trophy” real estate as well. In this thesis only these types of buildings will be considered since only they can be called “core”.^[22] The term “trophy real estate” is a common, mainly US- real state used term. It is not only used for office but mainly for exceptional residential properties, such as a penthouse downtown Manhattan. For the commercial real estate “trophy” goes mostly along with describing “core”, but is more focused on the building, and the awareness of the building within the city, the architecture and the image as well as the materials used. Additionally, these buildings usually belong to the newest, most technologically advanced and most sustainable ones. They have to come with for example a LEED Gold or Platinum certification..^[23] Swiss-Re Building, called “The Gherkin”, built by star architect Norman Foster, is a typical London City trophy building and also an example for core. Trophy office real estate additionally usually comes with longer lease periods (typically 5-10 years or longer), higher rents, and tenants with a higher creditworthiness. The reason for that is, besides the outstanding location and quality of the buildings, that the landlords / investors have to equip the floor spaces more individually and build a higher quality for the demanding tenants. That is capital intensive and makes these longer leases and higher rents necessary.^[24] Core is described as more than just the building, but a risk and investment attitude and strategy. Trophy buildings have to be always core though and can thus be used as a simultaneous term.

Research of what in detail is demanded from investors of core commercial real estate has hardly been subject to heavy analysis yet. In order to know what is demanded, core has to be defined first, which already states a problem. Secondly, “core” tries to be used as “flexible” definition that can easily be stretched. Core itself, even for commercial properties, means talking about offices, retail properties, industrial properties, multi­family houses or bigger residential properties and even sometimes hotels.

2.3 Requirements to the asset class core

In 2008, a master thesis written about “Anforderungen an die Assetklasse Büroimmobilie aus Sicht eines Core-Investors insbesondere unter Einbeziehung der Energieeffizienz“^[25] focused on the demands of core investors, in particular their requests for energy efficient buildings. As for the typical requirements to core commercial real estate the most important factor is cash flow stability over a longer time period. Value retention is as well of high importance followed by liquidity, being able to sell the property even in times of crisis. The asset class itself is of high importance as well, when buying prime or Grade-А office space a higher level of transparency and data material is assumed and demanded by the investors. Furthermore, usually portfolio / investment properties are asked for, not development properties due to the investors’ risk-aversion. The properties itself are usually as mentioned above premium or trophy real estate, since solvent tenants and low vacancy rates are demanded as well as little fluctuations and problems with the tenants are to be avoided. The properties are usually of highest quality and location.^[26] The demanded yields are usually 300 to 700 basis points above government bonds. The Loan- to-Value ratios are usually only up to 50% maximum.^[27] The newest but mostly strict demand is the one for energy efficiency and sustainability. Green Building is a mega trend and investors realized that progressively raising energy costs are a threat to stable cash flows and appreciation.^[28] In detail these trends and requirements to the asset vary from country to country. National differences, for example in water supply (Australia vs. Germany) vary sometimes quite strong in detail but are overall similar concerning the later assigned labels. For the German market discussed in this thesis the “Energieeinsparverordnung” (EnEV), the “Deutsche Gesellschaft für nachhaltiges Bauen” (DGNB) and the American “Leadership in Energy and Environmental Design” (LEED) are the most important standard-setters for sustainability and environmental standards for office buildings.^[29] The “EnEV” is a law that takes care of energy efficiency and buildings standards for office, residential and some industrial buildings. The DGNB and LEED are publishers of energy efficiency and sustainability certifications that are important for core office buildings in Germany and the world (LEED). The mostly named reason is the demand for sustainable buildings by the tenants which therefore leads to a more successful letting and higher reselling prices.^[30]

The investors demand this as well but usually only for new buildings, already existing core buildings that can sometimes already be 20 years old are very rare with certifications. The fist building to be certified LEED Gold is this year’s awarded building “Main Tower” owned by the Hessische Landesbank (Helaba) that was intensely adopted to modern standards in order to get the desired certificate.^[31] In the UK the system and arguments are similar; the most important certificate there is called “Building Research Establishment Environmental Assessment Method” (BREEAM). In the following appendix 3 shown is the number of BREEAM certificated buildings by end of 2008. A progressive raise can be seen that has been ongoing until today. An additional and rarely named aspect of the certificate, for example LEED for core office buildings is the marketing and image effect. A LEED Gold or Platinum (the highest standards by LEED) might result in a higher selling price, not only by the higher standards in sustainably and efficiency itself but the demand of clients and investors wanting to see this standard that therefore almost becomes necessary for core and in particular trophy properties.^[32]

Besides the already above mentioned aspects and demands of core investors to the asset class Thomas Schick addresses in his thesis in more detail the micro location of the office building. The following appendix 4 that has been integrated into Thomas Schicks thesis but come originally from Andreas Pfnür and Stefan Armonat showing the success factors of a real estate investment, led by the location with 52% of 100 points when institutional investors were surveyed. The infrastructure is here of major importance, since historically infrastructural connections do only grow slowly and can cause a disadvantage.^[33] Here, the local public transport and international connections play a major role and only make A locations as argued by regional economist Christaller who already described in the 1930 this importance in his “central place theory”. Usually core properties are found in metropolis areas and premium markets due to their inherent perquisites of market liquidity and attracting premium tenants.^[34]

Furthermore important for A-locations are the number, structure and quality of services as for example computer companies, advisors like tax and law firms as well as property services, media and PR-Agencies and aspects like the staff catering. ^[35] Additionally of high interest for institutional core investors is the prestige, image quality of the buildings and building cultivation of the neighborhood.^[36] The attractiveness of the surrounding has to be high in order to attract premium tenants for the premium buildings. Ideally the location is unique, well know and very attractive, in the USA these buildings would then often be called “trophy” (see aspects mentioned above).

Three other aspects should not be left unmentioned ; first, the absorption rate of the office space in the looked at location, secondly, the level of construction for comparable core properties, including the ones und construction and ideally knowing the ones shortly upcoming and thirdly, the vacancy level in the discussed location. ^[37] These aspects will be discussed in more detail under the market section of Frankfurt and London. In addition to these requirements to core real estate, three more aspects are often named that sum up as a package; the architecture, the convenience or usability request and maintenance / operating costs of a core property. Concerning the architecture, along with the mentioned aspects earlier like the image, a core property has to meet the balancing act of being unique, distributing an appealing architectural language but at the same time being plane and timeless due to the long investment periods of core real estate and the therefore changing demands and needs of the stakeholders, mainly tenants.^[38]

The Frankfurt “Silberturm”, former headquarters of Dresdner Bank and once the highest building in Germany can in this respect be seen as a good example. It is a core / trophy property built between 1975 and 1978. The property underwent different needs of tenants and market cycles through more than three decades. Since 2009 it is undergoing complete modernizations to bring it to an up-to-date market level including a sustainable modernization. Just recently it has been sold to an IVG led consortium. The tower is mostly rented out to Deutsche Bahn, a premium tenant.^[39] The usability factor is also of high importance. Since core properties as discussed earlier before they usually receive the highest rents and therefore have very solvent and often prestigious tenants. The actual fragmentation of the buildings, the floor efficiency, flexibility and level of quality for example concerning natural light, air conditioning, suspended ceilings, double floors for wiring or very important aspects such as data security systems for financial sector clients that trade and need 100% reliability are of major concern to the buildings and categorization of core properties itself.^[40]

Generally speaking the following aspects are of importance:

- Convenience of the architecture
- Flexibility of the rooms and floor efficiency
- Sufficient parking
- Sufficient lift capacities
- Sufficient sanitary facilities
- Security systems and uninterruptable power supply
- Services like representative lobbies
- Cafeteria supply and general food and beverages offers^[41]

The last aspect of operating costs has become crucial to core investments and office properties in general during the last years. Due to climate change and global warming requirements and the awareness of measures against progressively raising operating costs and additional risk (for example due to flooding) have become very important to investors. ^[42] For the London commercial property market there is for example an extra publication of the Greater London Authority making aware of potential upcoming future risks due to climate change. Here investors and owners are being informed about improvement opportunities, threats and risks to their stock as well as advice in terms of strategic operational cost savings.^[43] The topic of maintenance costs and climate change is particularly important because of the saving and prevention capabilities but as well because of the risk aversion of core investors. Knowing that roughly 80% of the life­cycle costs of a property are coming from the utilization and not the project development and construction plus the added threats of future uncertainties due to heavy climate changes give core investors a strong leverage to counter these negative measures, not only by physical implications like flood protections or solar energy on the roof but facing changes in laws, legal implications and financing issues. ^{[44] [45]} Appendix 5 shows the threats of London concerning overheating in the summers and flooding due to the surrounding water for this century.

The results of this chapter can be summarized in a core commercial office property draft, showing the demands of core office investors and their expectations to the properties. Table 5 has been divided from the “basement” to the “roof” as the two central parts. The markets and conditions as well as the locations are found on the bottom and are key to an investment, the body or stories of the building are described by the clientele, the asset type (in this thesis office being the focus but the other asset classes been very similar in their demands, just varying in their individual asset details) followed by the architecture and the whole complex running around the building most efficiently described by the usability and operation. The “roof” describes the key demands and expectations around the asset class so far.

Table 5: The “house of core”, summarized features of a core office investment

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Source: Own declination, in dependence upon Union Investment Places & Spaces Core Issue, Handbuch Immobilien-Investition, Realpoint Research, INREV, NEPC Consultants and questionnaires answered.

This core demand analysis is of major importance in order to understand the later analysis and question of improved core investments in times of crises, because if the demands are met and they fulfill their job, theoretically they should be somehow crisis resistant.

The following chapter will take the results above one step further and will try to generate a new and more detailed description of the asset investment / portfolio strategy “core” in order to get a better understanding of how the market situation in London and Frankfurt recently is and the crisis can be understood more clearly now and how the definition might be useful for future analysis.

2.4 New definition of “core”

In order to get an additional idea of the definition and ideas around core the author created a small questionnaire that can be found in the appendix. The questionnaire consisted of five questions around the topic of a core definition, risks, alternatives and the crisis. Besides the results of the scientific research and current existing material on the market, these answer provided the author with an additional understanding of the asset class core that does not come from the textbook. The companies chosen, the detailed list can also be found in the appendix, represent a profile of real estate experts from Germany, the UK and Europe being close to the topic “core”. These experts either have an agent, advisor, research, bank, investor, newspaper, developer or fund background and different experiences with the topic. Core, as discussed under the previous chapter, can be subdivided into different aspects, such as the markets, locations, clients, asset type, architecture, usability and finally the major criteria demanded by the investors towards the asset. Core, as for the results of the author could be translated as “risk averse, secure investment” which is arguing too short though. Generally, the author tries to find a generally acceptable definition, especially due to the different market backgrounds, risk attitudes of these markets, investors and globally different expectations to this asset class. It could be argued that core in Germany will always be different to core in the UK, since for example the English have a far more open attitude to Loan-To- Value levels than the Germans, or the Americans used to have a more relaxing attitude about sustainability criteria than the Germans but the international markets for core properties are more and more unifying and harmonizing in terms of the demands to the asset due to global harmonization. The major financial markets for instance, like New York, Hong Kong, London and Frankfurt are already showing tendencies to be similar, which does not mean that global office markets are completely correlated, not even close as Table 6 shows, but the core market is a much smaller and usually much more demanded market by less investors and more internationally active companies that have a high preference on a similar product (with mostly financial background) and are aiming for security in A markets, and usually not the players on heavy market circles.^[46] Table 6 displays that some markets seem to be correlated but others are not at all, diversifications are therefore not always easy (for today and the past).

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Source: Originally CBRE, JLL, taken out of Deutsch Bank Research Presentation of Dr. Tobias Just at 2.

Executive MBA Real Estate 1RE|BS, 2011

This can be read in many publications around the globe, for instance Chris Staveley, Head of EMEA JonesLang Lasalle Moscow, stating: “Overall trading levels remain influenced by limited supply of sought after prime core assets and the absence of any move into assets that are perceived to carry more risk...”^[47] Prof. Dr. Kerstin Wellner, who is researching on correlations of office markets around the globe shows that certain markets are indeed correlated but with different national yields. As seen in appendix 6 Germany is a stable and very little volatile market, which again can be another indication for the actual very strong demand on core properties in Germany as a safe haven. Prof. Wellner’s research displays some heavily correlated markets, such as the USA, Sweden and Australia and non-correlated markets in between Germany, Canada and the USA which can be seen in appendix 7. Generally these figures are correlations over the whole market and all asset strategies, such as Munich value-add up to Frankfurt core and do not say anything in detail about the core market correlation which is probably stronger due to the mentioned aspects above. Due to the analysis international diversifications are more effective than regional diversifications but at the same time overall asset type diversifications are less effective than international diversifications.^[48]

Getting back to the improved definition of core, a more detailed view on this strategy is necessary in order to understand the crisis reactions and look more skeptical on purchasing decision. When looking at most of the questionnaire’s answers to the question of what core is, for the interviewed persons mostly the answers are not detailed as such, but almost everybody demands stable cash-flows, a long term perspective and high security of the asset. Furthermore along with the literature excellent locations are demanded, as well as tenants with a high credit-worthiness, a young age of the building, meaning no upcoming modernization costs as well as a low vacancy rate and a green / sustainable standard. Additionally, demanded are mature markets, a sufficient size of the market with the necessary transparency, furthermore only quality buildings are looked at with investment strategies only investing up to a maximum of 50% LTV’s depending on the market looked at.^[49] Coming back to the problem of a non-unified core definitions and therefore difficulties in literally speaking about the same concerning correct risk allocations and investment strategies, even the rather short number of questionnaires showed sometimes vast differences. For Stefan Scholl, head of European transactions at the German fund “Deka” for example only markets can be core that are mature and bring roughly a volume of € 150 m. arguing that only in such a market the liquidity standard of the core asset can be met.^[50] On the other hand according to Uwe Schoessow, from the transactions team at “KARG”, one of Germany’s biggest family offices, it is recommendable to invest into smaller cities rather than investing into 1 В or 2 A locations ofbigger markets.^[51]

Another example of sometimes heavier differences can be derived from one of the most well- known definition of core, coming from the “European Association for Investors in Non-Listed Real Estate Vehicles” (INREV), defining the standard core for non-listed real estate vehicles such as closed-ended funds. The following table 7 shows the difference between the mostly three named investment strategies, core, value added and opportunistic (core-plus comes in many publications after core, but is not any more commonly used) strategies.

Table 7: INREV Style Classifications by 2011

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Source: INREV STYLE CLASSIFICATION pdf. 2011, Page 13

For all parts different specifications can be found. The loan-to-value amount can for example go up to 50% according to Karl-Werner-Schulte, Stephan Bone-Winkel and Matthias Thomas in their book “Handbuch Immobilien-Investition” mostly orientating their definitions towards the “National Council of Real Estate Investment Fiduciaries” (NCREIF) and American Realty Advisors, as well as Aberdeens Property investors. On the other hand other publications do even show different perquisites towards gearing in one paper, such as an internal IVG core definition document presented to the author by courtesy of Dr. Thomas Beyerle showing another INREV definition stating a gearing percentage of below 60% and another definition by BEOS, a German real estate developer and investor, naming a maximum of 30% as LTV.^[53] These differences can have major effects on the asset and can create real differences in talking about the same product. An investor from the UK can for example talk about core, when saying 60% LTV is still fine, a German fund promising their savings clientele secure 4.5% return can get difficulties in achieving this goal when gearing their product too high and therefore taking risks that might not be intended by the managers or wanted by the clients in the future. The same thought can be developed further with the INREV “Target derived from income” percentage demanded or defined by investors. A high income and cash flow, backed by secure rental contracts and strong tenants usually means low risk, and is one of the key elements of a core investment. Here the INREV demands at least 60% income, at the same time “Realpoint Research”, now “Morningstar”, demands at least 90% from income and only a maximum of 10% from appreciation in order to make the product less risky.^[54] When talking about investment decisions of for example over € 50 million the different ideas of core seem to be vast, as well as the potential outcome. Against the background of a not homogenized global market the author tries to give the investors and real estate professionals a classification of core that can widely and internationally be used.

“Core” is an international real estate asset investment strategy and style that is determined by risk-averseness and security demands. The core assets are commonly regarded as trophy, premium, Grade-A or 1-A properties. Major demands to the asset and strategy, often of the asset holding funds or being direct investments are stable cash­flows, usually and income producing percentage of between 60 and 90 percent, a high degree of liquidity and tradability, a loan-to-value (LTV) percentage of zero to a maximum of 50%, depending on the market, a stable, solvent, and a mostly well-known tenant structure, where as single-tenancy and multi-lease strategies both occur and long lease periods, easy re-letting as well as third-party usability’s are crucial. Furthermore, an internal rate of return (IRR) / yield is demanded of 4% to 11% depending on the market, country and way of internationally different calculation approaches, priorities set, international location, vehicle type or market surrounding available. Additionally, vacancies have to be very low up to fully let, the operating properties have to be of younger or youngest age, with little to no redevelopment necessity more and more bringing a high grade of sustainability and green labeling as a mandatory perquisite. Markets viewed at have to be mature, transparent, of sufficient size, little volatile and bring a secure investment surroundings that ideally provides a crisis consistency (so called “primary markets”). The investment is long term orientated, mostly 8-15 years, sometimes unlimited and is intended to be “future proven” therefore the flexibility, quality and location of the building has to be excellent.

Source: Own declination, in dependence upon Union Investment Places & Spaces Core Issue, Handbuch Immobilien-Investition, Realpoint Research, INREV, NEPC Consultants and questionnaires answered.

2.5 Potential risks to core investments

Derived from the chapters above, literature and research core can be specified as a risk­averse investment, as an investment strategy it categorizing the strategy that accepts the least yields with the highest amount of security.^[55] Since there is no risk-free investment, not even government bonds with a triple AAA rating, as the current crisis shows, investors and research have to take a closer look at potential risks to the intended little risk investment strategy of core. The author will in the following chapter make aware of a number of risks, some already generally identified, some less, shortly explain them and bring them into context. The chapter will close with a short overview of potential risks derived from the literature, research and the investor’s questionnaire answered for the author.

Risk can come from numerous sides and can bring tensions to the investment strategy and investor in a different kind of heaviness. The first theoretical question that can be asked is, if accepting a lower yield does automatically mean having less risk? Or as Prof. Dr. Wellner from the Bauhaus University in Weimar, Germany asked in a recent presentation: “What is core and are investments in these assets really less risky?”^[56] As seen in appendix 8, yields and risk are usually defined in a linear way putting them into direct connection; meaning fewer yields implicates lower risks, derived from a rational thinking that someone who is willing to accept lower yields will want a higher amount of security and vice versa. This neo-liberal thinking has been questions by economists such as Prof. Wellner, representing a “New Institutional economics” position and bringing it up in her presentation.^[57]

There is undoubted a connection between risk and return but they do not always run as smoothly as shown in publications due to the not perfect market conditions that are assumed in neo-classic teachings. That can be due to asymmetric information, transaction costs, inefficient markets, non transparent markets, external effects, moral hazards orjust a non rational behavior of market participants.^[58] When looking at investments, prices and risk information should be taking into account.

2.5.1 Geographical and market risks

As mentioned above risks can pressure core investments from various sides. By looking at the big picture, geographical and market risk can here be named first. Different regions, locations and markets do pose an opportunity to play with market cycles on the one hand but can be dangerous, even to core asset investment strategies as well. Examples that can here be named are for example the UK not being as much involved into the European Union market anymore, after not participating in a unified constitution changing of the members in order to meet the challenges of the national debt crisis, or the threat of core investments in Japan suffering from earthquakes, as well as political market hazards such as Belgium not having a government for a record time until last year posing a decision-taking threat to the market.^[59] The “big picture”, politically and economically especially now in times of crisis is here of mayor importance. DTZ for example names in the questionnaire the potential sovereign default of Greece, if orderly or not orderly as a potential hazard to watch for the core markets and Euro economies.^[60]

2.5.2 Volatility risk

Another threat to core investments poses volatility of markets, as derived from the results from the previous chapters. Having a very little volatile investment into core is one of the major perquisites to investing. Here investors can and should watch markets and future expectations carefully. Currently for example Germany is seen as “safe haven” with a comparable strong economy so far crisis resistance.^[61] Market participants can here look at volatility publications such as shown in table 8 and should watch market fundamentals closely in order to taking from them correct decisions.

Table 8: Volatility of Office Properties in Frankfurt am Main and London

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Source: Places & Spaces, The Real Estate Magazine of Union Investment - The core of a market, 2011, p.12

The timing and observation of market circles poses here a threat and opportunity at the same time. Whereas London is currently from some experts considered an overheated core market, due to the strong demand of international and national investors, Frankfurt is for instance in the questionnaire mostly rated by experts as a not overheard market, whereas the results have to be differentiated again, since and agency selling properties is probably more likely to answer positive than an insurance, seeing markets overhead.^[62] That can be illustrated by the reply of the international agency DTZ, head of Germany Timo Tschammler to the question if core is overheating, the answer is for Frankfurt: “no, in Frankfurt there are currently no overheating signs visible”, whereas Stefan Brendgen, CEO of Allianz Real Estate Germany on the German fair Expo Real replies to the core prices, saying that currently core prices were offered in certain markets, that can cause price bubbles in the future that would then burst, stating that at these prices Allianz is dropping out since they want to make long time investments with sufficient yields.^[63] Volatility and potentially overheating prices have here to be analyzed individually with the coming with risk profile and future perception. Often simplifications as indicators where markets are drifting, such as the European Property Watch by agent JLL (see appendix 9) are used to get a better idea and therefore deriving information in order to, amongst othersjudge volatility. “Core locations may change”^[64]

2.5.3 Change of location risks

An often stated risk and worry of investors is the change of locations. What has been purchased today as core does not necessarily have to be core or even a trophy property in the future. Furthermore should core investors watch long time trends and new uprising core locations, since they might pose a threat to their investment or a new investment opportunity. A famous example for this case was the land reclamation in Hong Kong and the investment of the International Finance Center Tower (IFC) by the owners Henderson Land and Sun Hung Kai Properties shifting the best core location from the decades old Hong Kong island cost line towards the water by creating a land mark high end core building (and symbol for the city) which is now attracting the best tenants and highest rental prices in Hong Kong and left other major investors literally second in line.^[65]

Other famous examples of changing or new core locations, that were not initially accepted as such but then became established are the Docklands in London or Battery Park in New York. In the case of the Docklands, called Canary Wharf, one of the biggest office complexes of the world was artificially created, constructions began in the late 1980’s when back then there were still a lot of doubts if this area could attract premium tenants and turn into a major core location. Today the Docklands / Canary Wharf is with Westend and London City one of the major office locations in London, with globally active tenants mostly from the financial sector such as Barclays, Citigroup, Clifford Chance, Credit Suisse, HSBC, KPMG, MetLife, Skadden, State Street and Thomson Reuters.^[66]

2.5.4 Illiquidity risk

The next serious risk to core investments that should be named is illiquidity. Having a property that is liquid, meaning tradable under theoretically all market conditions is one core demanded feature to the asset. For the head of European transactions of Germany based fund DEKA Stefan Scholl the size of a market and volume is therefore key. He further argues that for him a market like Munich cannot be core since a project with a sales volume of e.g. € 150 Million will not be easily resalable, whereas the same property in London will most likely find a second purchaser within a reasonable time as well.^[67] He continuous by stating that for DEKA a market starts to be core and liquid with a volume of about five million square meters.^[68] The exit opportunity is here usually crucial for major international investors, since they have to be able to react in order to meet there set requirements as well as being able to play with market cycles and shifting capital easily and ideally quickly (or parking money securely).^[69]

In general “Property is highly illiquid. It is expensive to trade property, there is a large risk of abortive expenditure, and the result can be very wide bid-offer spread (a gap between what buyers offer and sellers accept).” For that reason for core investors mostly avoiding this set factor is of major importance and one of the reasons why they invest into core, since this investment asset and style tries to purchase ‘the best real estate in the best locations, in order to ideally gain value due to scarcity and limited offer coming with a very low risk and therefore vice versa accepting lower yields and total returns. This way the risk of illiquidity should be faced by choosing sufficiently big, mature and stable markets as well as purchasing the best properties with long term perspectives and stable incomes. Basically “core” by definition worked out in the previous chapter “New definition of core”. If a core market is seen as illiquid money will either flow into liquid markets or alternative investments for institutional investors such as securities in general, government bonds or structured debts, since the risk of high transaction costs (for example in the UK 4% stamp duty, survey fees, valuation fee and legal fees, brokerage fees, initially summing up to around 6.25%, not counting in indirect costs of employees, time spend and opportunity costs of the investors) holding costs and even losing money due to different price perceptions.

[...]

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^[1] Oscar Wilde, The Picture of Dorian Gray, 1891

^[2] Cf. This time is different - Eight Centuries of Financial Folly, Reinhart, Rogoff, 2009, p.277 f.; Heuser, Jean, Bitte neu anfangen - Auch wenn die Krise mal Pause macht - das Gebot bleibt bestehen: Der Kapitalismus kann so nicht bleiben, 2012

^[3] Cf. IVG Market Tracker Europe, December 2011

^[4] cover question in I&P Magazine September / October 2011

^[5] CF. Expo Real: Weitere Polarisierung auf Europas Gewerbemärkten /2011

^[6] Bill Hughes, quoted from IP Real Estate - Global Market Intelligence for institutional real estate investors (Sept / Oct 2011)

^[7] Cf. Webster Third New International Dictionary, 1976.

^[8] Cf. Core properties, http://www.ingreim.com/reim/about_us/glossary/#C.

^[9] Cf. Defining and Determining Core and Non-Core Real Estate Investment Strategies, Real Point Research, GMAC Institutional Advisors LLC, 2005.

^[10] Cf. Der Markt für Gewerbe- und Industrieimmobilien aus Entwicklersicht, BEOS AG, 2010.

^[11] http://www.ingreim.com/reim/about_us/glossary/#C.

^[12] Cf. Commercial Real Estate Overview: Performance of “Core” & Non-Core Real Estate, The University of Chicago Booth School of Business, 2009.

^[13] Cf. INREV Style Classification, 2011.

^[14] Cf. places & spaces The Real Estate Magazine of Union Investment, The core of a market, 2011.

^[15] Cf. Erfolgreiches Portfolio- und Asset Management für Immobilienunternehmen, Lehner, Claus, 2010, p.123.

^[16] Cf. PREEF Research, RREEF Global Real Estate Investment Outlook & Market Perspective 2011,p. 1.

^[17] Commercial Real Estate Investment, Andrew Baum, 2009, p. 360.

^[18] Commercial Real Estate Investment, Andrew Baum, 2009, p. 361.

^[19] Ibidem.

^[20] Cf. Guide toUS real estate investing, 2009.

^[21] Cf. Institutional investors and corporate governance, 1993, p. 667.

^[22] http://www.ingreim.com/reim/about_us/glossary/#C.

^[23] Cf. LEED, or Leadership in Energy and Environmental Design, is an internationally-recognized green building certification system. Developed by the U.S. Green Building Council (USGBC) and The New York Time, Class-Consciousness in the Office Building Market, 2011.

^[24] Cf. Guide toUS real estate investing, 2009.

^[25] English translation: “Demands to the office asset class from an institutional investors perspective under the comprehension of energy efficiency” by Thomas Schick, 2008.

^[26] Schick, Thomas 2008, p. 23 and Handbuch Immobilieninvestition, Schulte, Bone-Winkel, Thomas, 2005, p. 32.

^[27] Cf. Handbuch Immobilieninvestition, Schulte, Bone-Winkel, Thomas, 2005, p. 30.

^[28] Cf. Anforderungen an die Assetklasse Büroimmobilie aus Sicht eines Core-Investors insbesondere unter Einbeziehung der Energieeffizient, 2008, p. 49 f.

^[29] Cf. Verordnung über energiesparenden Wärmeschutz und energiesparende Anlagentechnik bei Gebäuden, 2011.

^[30] Cf. Immobilienfonds die Zukunft ist Grün, Cleanteach Magazin, 2010.

^[31] Cf. Main Tower ist mehr als ein Leuchtturm-Project, Article Immobilien Zeitung, 8.12.2011.

^[32] Cf. Immobilienfonds die Zukunft ist Grün, Cleanteach Magazin, 2010.

^[33] Cf. Anforderungen an die Assetklasse Büroimmobilie aus Sicht eines Core-Investors insbesondere unter Einbeziehung der Energieeffizient, 2008, p. 40.

^[34] Cf. Defining and Determining Core and Non-Core Real Estate Investment Strategies, Realpoint Research,

p.5.

^[35] Ibidem.

^[36] Cf. Anforderungen an die Assetklasse Büroimmobilie aus Sicht eines Core-Investors insbesondere unter Einbeziehung der Energieeffizient, 2008, p.41.

^[37] Cf. Real property valuation in a changing economic and market cycle, Rick Peiser, 1995.

^[38] Cf. Anforderungen an die Assetklasse Büroimmobilie aus Sicht eines Core-Investors insbesondere unter Einbeziehung der Energieeffizient, 2008, p. 43.

^[39] Cf. Big Deals mit zwei Hochhäusern, 2011.

^[40] Cf. Anforderungen an die Assetklasse Büroimmobilie aus Sicht eines Core-Investors insbesondere unter Einbeziehung der Energieeffizient, 2008, p. 44 f.

^[41] Cf. Schulte/ Bone-Winkel / Thomas, Handbuch Immobilieninvestition, p. 381.

^[42] Cf. Anforderungen an die Assetklasse Büroimmobilie aus Sicht eines Core-Investors insbesondere unter Einbeziehung der Energieeffizient, 2008, p. 46.

^[43] Cf. London’s Commercial Building Stock and Climate Change Adaptation, 2009.

^[44] Cf. Anforderungen an die Assetklasse Büroimmobilie aus Sicht eines Core-Investors insbesondere unter Einbeziehung der Energieeffizient, 2008, p. 46.

^[45] Cf. London’s Commercial Building Stock and Climate Change Adaptation, 2009, p. 46.

^[46] Cf. I&P Real Estate Magazine, The core conundrum, Mansell, Greg, 2011, p. 25.

^[47] Cf. JLL, Moscow office rents are one of the highest in Europe, London, Moscow, 25th October 2011.

^[48] Cf. Immobilienportfoliomanagement (Quantitative Methoden), Prof. Dr. Kristin Wellner, 2011.

^[49] Cf. places & spaces -The Real Estate Magazine of Union Investment, Issue: The core of a market - Everyone is talking about core - but every investor defines the term differently, 2011, p. 7; Questionnaires.

^[50] Cf. Questionnaire Stefan Scholl, see appendix.

^[51] Cf. Questionnaire Uwe Schoessow, see appendix.

^[52] Cf. Handbuch Immobilien-Investition, 2nd edition, p. 32.

^[53] Cf. Spektrum: Was wollen die globalen Investoren...?, IVG, Dr. Thomas Beyerle, 2011.

^[54] Cf. Realpoint Research, Defining and Determining Core and Non-Core Real Estate Investment Strategies, 2005, p. 1.

^[55] Cf. Places & Spaces, The Real Estate Magazine of Union Investment - The core of a market, 2011.

^[56] Cf. „Impulsreferat - Was ist „Core“ und sind Investments in solche Anlagen wirklich weniger riskant?“ RealSite Forum: „Real Estate, what else?”, 2011 (translated into English).

^[57] Cf Douglass C. North, Washington Univesity, 2011.

^[58] Cf. “Impulsreferat - Was ist „Core“ und sind Investments in solche Anlagen wirklich weniger riskant?“ RealSite Forum: “Real Estate, what else?”, 2011.

^[59] Cf. A Stark Step Away From Europe, The New York Times, 2011.

^[60] Cf. Questionnaire, reply by DTZ, Timo Tschammler, 2012.

^[61] Cf. Places & Spaces, The Real Estate Magazine of Union Investment - The core of a market, 2011, p.12.

^[62] Cf. I&P Real Estate Magazine, The core conundrum, Mansell, Greg, 2011, p. 24-25.

^[63] Cf. Questionnaire reply Timo Tschammler, 2011 and „Allianz RE plant Käufe für bis zu 2,5 Mrd. Euro“, Immobilienzeitung, 2011.

^[64] Cf. Questionnaire Tino Rübsam, Pramerica, 2011.

^[65] Cf. Sun Hung Kai Propert : SHKP's Shanghai IFC and ICC win three CRIC awards, 4-traders.

^[66] Cf. Canary Wharf Group PLC official Website annual reports, 2011.

^[67] Cf. Questionnaire reply Stefan Scholl.

^[68] Ibidem.

^[69] Cf. Questionnaire, Adams, Klaus, 2012.