Spain has been viewed with suspicion since the onset of the financial crisis. Like the rest of the so-called PIIGS (Portugal, Ireland, Italy, Greece, Spain), its economy failed to recover alongside those of core Europe in mid-2009 and its GDP has only recently stabilised. The bond yield spreads between core and peripheral European economies have proved disconcerting to risk-averse cross border investors, who regard them as a signal to focus on core markets. However, prime assets in core markets are now fully priced – sometimes overly so – and investments are subject to potential price volatility at exit. Funds wishing to place capital must soon accept greater risk (location, product or tenant quality) in core markets, or target investments in markets they have previously over-looked. If the latter choice prevails and these investors expect Spain to deliver bargains, they will be sorely disappointed.

Opportunities in the core and core plus arena are few and far between. Operators with inside knowledge and good experience of asset management should be best equipped to unlock latent value and maximise returns.

Retail sector may suit cross-border investors
It is difficult to make top-down recommendations for Spanish retail investment, since deals tend to be specific to vendors, purchasers and the banks. Perhaps this is why Spain experienced hardly any increase in its retail investment volumes in 2010 compared with 2009, in contrast with major improvements in the UK, France, Germany and Sweden. Potential investors need to ditch their preconceptions of the country and approach the market from a bottom-up perspective, on an asset-by-asset basis.

Much of the shopping centre stock remains relatively illiquid and even decent quality, well-located schemes struggle to find a buyer if they do not tick all the boxes. However, unlike office investment where local players tend to dominate the scene, overseas buyers have been involved in a number of the limited retail deals conducted. This suggests the market is perhaps easier for cross border investors to access as long as the appropriate product can be identified.

Identifying good opportunities tends to require the expertise of experienced local operators, who are perhaps better able to understand why a particular centre is not performing; for example, due to its tenant mix or even the configuration of its units.

Shopping centres have experienced a wide divergence in performance. The best centres have not suffered too badly from rising vacancy and rents have held up quite well, falling by just three percent on aggregate in the recession according to JLL. The future is brighter for these schemes since multiple retailers have by and large completed their restructuring and are now considering cautious expansion. Dominant regional centre yields arguably are six percent for the very best locations. The San Cugat centre outside Barcelona is rumoured to have received three bids at six percent for a lot size in excess of €100m. The centre has a well established, good trading record and it offered the opportunity to add value in the conversion of its hypermarket, although it is not clear whether the deal with the hypermarket was formally in place. In the next tier down from the prime dominant centres, there can be quite reasonable price discounts for core plus product, where even good centres with a perceived level of threat to their dominance, or lack of an established trading record, command a discount of circa 75-100 BPS (Basis Points).

Investment market liquidity seems to fall away after this point. As a result, there is an oversupply of centres that were constructed during the development boom, many of which are competing for consumers in second tier catchments, with scant hope of finding a willing buyer. Inevitably, some of these centres will close, leaving the survivors to take the spoils.

The pricing gulf between prime and secondary should remain for years. At present good secondary offers potential for core plus investors. Further up the risk curve, the value-add space is currently vacated, suggesting equity investors with a risk appetite could negotiate more favourable terms with struggling vendors. Stock selection is critical, however, so access to local knowledge is highly recommended.

Market product?
Competition for buildings on Madrid’s prime patch is intense, especially for lot sizes under €5m. Quoting yields of 5.75 percent for a standard five year lease at market rents imply attractive capital values, but in reality many deals are sale and leaseback, offering longer leases to risk-averse investors and attracting considerably keener yields. Private investors in particular are overlooking short lease terms and heavily over-rented positions in order to access a market they were largely priced out of during the boom. Overseas institutional investors are unable to compete, a situation that is unlikely to alter much in the near term.
There is little future development to further frustrate levels of new supply. Prime rents are notoriously volatile and could potentially deliver attractive growth from their current low base. In view of this, quoting yields of 5.75 percent off current market rents appear attractive, which is probably why the market is so much more expensive in reality.

To tempt institutional and cross-border investors to shift their focus away from the CBD, vendors of stock on out of town business parks have constructed sale and leaseback deals that offer long income security to risk averse investors. A few deals have been secured on quality products either located in consolidated business areas or close to the M-30 inner ring road where public transport connectivity is good. These deals have been agreed at yields of between 6.25-6.75 percent. However, with low growth prospects and potential yield drift at exit, these can hardly be classified as bargains.

While investment volumes were low in Madrid in 2010, they at least represented an improvement on 2009. This cannot be said of Barcelona, where relatively few deals completed last year, the overall total amounting to just €236m according to CBRE. Over-renting is a serious deterrent for potential investors who are unclear how much further market rental values have to fall. Banks are unwilling to finance anything with perceived risk and there have been no deals completed in the value-add space. Realia is rumoured to have sold its prime CBD office to Deka for a yield of close to six percent.

The lease offered a decent income profile, although not the typical 10-year sale and leaseback. Arguably, the same deal would have attracted a keener yield in Madrid. The
rationale for investing at current yields depends on your view of rents. The recession produced record levels of vacancy and prime rents have already fallen by over 30 percent, more than anywhere in Europe except for London and Dublin. Oxford Economics estimate Madrid has lost 31,000 office jobs (-3.5 percent) and Barcelona 28,000 (-6.5 percent) since the onset of the crisis. Future jobs growth, when it gets underway, will be restrained
and net absorption of space will be sluggish. Prime CBD rents are now close to the bottom of the cycle but rents on secondary buildings, and even prime buildings on some parks
with high vacancy, may experience further declines. However, vacancy is not high everywhere, as Fig. 1 illustrates. Central areas are less badly affected and prime rents may begin to recover from 2012 as the supply of new space evaporates.

Getting it right
It can be difficult to project beyond current perceptions of Spain. Economy-wise, there is no denying the short term picture is hugely challenging, particularly given the extent of private sector de-leveraging and the challenges that need to be overcome in the banking system. Acquisition yields should not necessarily be judged in the context of Spain’s bond yield, which incidentally is predicted to converge with the UK bond yield by 2013. Spain merits attention as a destination for cross-border capital. However, the investment terrain is full of potholes; there are no bargains and value has to be identified and extracted. Market rental growth will eventually evolve from current troughs, although investor nerves could be tested in the earlier years of the holding period. Opportunities should be considered on an asset by asset basis. Good local knowledge and proven asset management skills will be paramount to success.