Sunnier times ahead for Spain?

As featured in this month’s Master Investor Magazine.

A 12-part series of articles by Swen Lorenz, reporting on easy-to-access investment opportunities in high quality real estate around the world.

This series looks at investments on a country-by-country basis. The truth is, however, that it should really be done on the basis of regions or even cities. Most countries we have looked at so far are fairly big, and even the property market of a medium-sized country is usually split into different regions, some of which couldn’t possibly be any more different from each other in terms of price, quality and prospects.

Take Germany as a prime example. In the West, booming prices across the board; in the East, one bright spot (aka Berlin) combined with depopulated regions where tens of thousands of apartments are being torn down because they are deserted and essentially worthless. Investors who got into Germany in 2005/06, when the country’s real estate was priced even below its replacement value, made a fortune if they invested in the right region, but only very modest returns (if any) if they put their money into the wrong part of the country.

There are currently a lot of similarities between Germany back in 2005 and present day Spain. Germany’s real estate boom started with the introduction of REITs, or Real Estate Investment Trusts, i.e. publicly listed investment trusts that offers investors different tax advantages and the ability to buy and sell their investment on a daily basis through an exchange. With the introduction of REITs came large private equity groups that bought up portfolios of tens of thousands – sometimes even more than a hundred thousand – apartments. Foreign capital sparked the turnaround of the German market and Germany turned into a property market juggernaut from there onwards.

Spain also recently introduced REITs, as one of the measures aimed at injecting life back into the Spanish property market. Between 2007 and 2013, prices in Spain fell 35% across the board, according to the official statistics of the real estate registrar. Take into consideration that in some regions transactions essentially stopped happening, and it is likely that the aforementioned figure is an understatement. Some statistics speak of a “real” loss in value of Spanish property of 58%, which is nothing short of extraordinary. The most famous example for the kind of bloodshed that happened in Spain is the sale of Ciudad Real passenger airport, which was built for €1.1 billion and subsequently sold for a ridiculously paltry €10,000 (with the new investors agreeing to invest €100 million into getting the dormant airport relaunched as a cargo hub). Major cities weren’t protected either, and prices for prime real estate in Madrid also fell by 30% to 40%. Imagine that kind of fall in a place like London!

A slow recovery

The good news is that since 2014, prices have been rising again. So far, they have recouped one fifth of the losses incurred during the bust. In other words, whereas London, Berlin and a few other markets have long reached entirely new highs, Spanish prices still have a lot of catching up to do before they even reach their pre-crisis levels.

Some regions though may never again see those pre-crisis prices, at least not in our lifetime. Spain has regions where supply and demand is so out of whack, and the quality of real estate so questionable, that prices are unlikely to go anywhere. Also, the economy has a long way to go before it truly shakes off some of its structural issues, such as the high youth unemployment; in 2013, a staggering 56% of Spain’s young were unemployed. That figure is now down to 49.2%, but it’ll be years before the country has a chance to get back to anywhere near normal. Even the high percentage of young people working in the informal economy doesn’t change that.

There’ll be a number of other regions though where the recovery is likely to continue, and might even gather pace. The two economic centres of the country, Madrid and Barcelona, are where things are likely to stabilise and move forward the fastest. Cities adapt faster to changing economic environments, and they are also the first place where foreign investment gets washed ashore once the initial panic is over. It’s actually already evident in the case of Spain: private equity firms like Cerberus and Blackstone started moving into the country in 2013, and sovereign wealth funds from the Middle East have also been buying up Spanish assets, including retail and hotels.

Barcelona is increasingly turning into Europe’s no. 1 “urban resort” and will continue to be seen as an attractive place to make a long-term investment. Madrid, as the country’s capital and with more than 5 million inhabitants, will also naturally remain one of Spain’s powerhouses. There are also certain coastal regions where demand has picked up again. However, these areas tend to be more attractive to investors looking to buy their holiday home rather than for investors who are purely looking for a financial return and a low-risk, liquid asset.

The recovery is also being driven by a number of macro factors. Following years of contraction, Spain’s economy is currently up 2.7% over the past 12 months. Banks have begun lending again, and the return of local buyers has led to new mortgage approvals growing by 27% compared to a year ago. Whereas before the crisis close to 40% of all the mortgages in Spain were taken by foreigners speculating with properties that generally they hardly ever lived in (if at all), now overseas buyers account for just 3% of outstanding mortgages. The increase in demand is currently mostly due to people buying property for actual use or for renting instead of merely looking for capital gains, which gives the market a much stronger foundation to stand on.

There has also been a trend of new groups of buyers moving into some markets. British and German buyers used to dominate foreign purchases in the residential market before the crisis, but now there is also a much larger contingent of Asian, Middle Eastern, American and Swiss buyers – buyers that generally pay in cash and don’t require a mortgage. A newly introduced visa scheme helped, too. Launched in September 2013, a “Golden Visa” scheme that offers residency to foreigners who invest more than €500,000 led to nearly 500 transactions during the first year. Not enough to make a difference to the overall market, but following the kind of bust the Spanish market experienced, every incremental improvement helps to build new momentum.

REITs already playing a major role

During 2014, more than €10 billion of investment found its way into commercial real estate in Spain. Of that, a quarter came from the “Socimis”, as the REITs are called in Spain. Their funding in turn is heavily based on foreign investors looking for an easy, liquid way to grab a piece of the action. As ever, buying a listed security is much easier than purchasing and managing an actual piece of real estate.

For those who are looking to invest with a view to an attractive financial long-term return, rather than wanting a place in the sun or the trouble of managing individual tenants themselves, the obvious answer is to look at REITs with heavy exposure to Barcelona and Madrid. Incidentally, this leads us to one very obvious candidate: Merlin Properties, the new giant in the Spanish real estate industry.

Having listed on the Spanish market just last year, Merlin quickly rose to become the country’s largest property holding company. It made headlines by buying a minority stake in Testa, the property holding of a financially stricken Spanish construction firm, Sacyr. Two months ago, in a transaction valued at €1.8 billion, Merlin purchased all remaining shares of Testa. What’s noteworthy about the transaction is not just the size, but also the fact that Testa was widely known as the highest quality portfolio of real estate in the country.

With a portfolio worth €5.5 billion, the company is now the single largest investment entity in the Spanish real estate market. It’s portfolio is focussed on Madrid (71%) and Barcelona (11%), the two powerhouses of Spain. The majority of its investments are in office buildings (53%), with hotels (12%), retail (11%) and residential (8%) adding to the mix. Currently, 98% of the available space is rented (or 92% if space that is currently out of commission because of refurbishments is counted as empty). The Madrid and Barcelona office portfolio is recognised as virtually irreplicable, with many international firms and corporate headquarters as anchor tenants.

The next largest Spanish property company has €1.3 billion in Spanish real estate, leaving Merlin towering over the rest of the industry. Foreign investors – i.e. investment funds, hedge funds and private investors – are likely to favour investments into Merlin because of the liquidity its shares offer and the high quality of the portfolio. Once the transaction to purchase Testa has been executed, the company will be financed with 50% equity and 50% debt, i.e. the company is not highly geared and therefore particularly suited for long-term investors who want to put the investment aside and sit tight for three, five or ten years. The dividend yield is currently around 2.5%.

Having a player like Merlin emerge is also a clear sign that Spain’s property market is going through a process of globalisation and is becoming more integrated with the financial sector – just as Germany did 10 years ago! The data clearly indicate that the worst of the real estate crisis is behind the country, and Spain is now entering a two speed recovery where Barcelona and Madrid will lead the way.

The shares of Merlin listed in June 2014 at €10, and are now trading virtually unchanged at €10.25. Those seeking to squirrel away some money into relatively cheap real estate and not have to worry about its management could do worse than take a closer look at Merlin Properties. Once the market has digested the Testa-transaction, and the significant issue of new shares that was necessary to fund it, the price for Merlin-shares should improve. Longer-term, getting in on the Spanish opportunity could turn out to be as good a decsion as investing into Berlin a decade ago.