THE INVESTMENT CASE FOR VALUE-ADDED REAL ESTATE IN ITALY COMMERCIAL-TO-RESIDENTIAL CONVERSION STRATEGIES BNP Paribas REIM July 2018 MAURIZIO GRILLI - HEAD OF INVESTMENT MANAGEMENT ANALYSIS AND STRATEGY THE INVESTMENT CASE FOR VALUE-ADDED REAL ESTATE IN ITALY COMMERCIAL-TO-RESIDENTIAL CONVERSION STRATEGIES t is easily overlooked that Italy is one of the largest and most affluent countries in IEurope. The regional differences in Italy are substantial with a clear north – south divide, where the richest areas in the North regions are on a par with the wealthiest of other countries in the North of Europe. Currently, in economic terms, Italy is possibly in the best shape ever since the GFC. Economic growth is expected to be solid over the next few years, most notably in the North of the country. The residential market seems to have bottomed and transactions are back on an upward trend for some time now. There is a notable mismatch between rising pent-up demand and scarce new, high-quality supply. Residential prices are 20% off their previous peak on average. Forecasts for house price growth in the medium term are positive, especially for the most dynamic cities in the country. The gap between residential and commercial – mostly offices but not exclusively - prices is quite large in Italy. This, along with positive and improving fundamentals for the residential sector and likely price growth, make a compelling case for refurbishing obsolete commercial buildings and converting them to high-standard residential. This type of product is particularly attractive to prospective owner occupiers and investors. Our city ranking methodology, which is based on different factors including demography, wealth, liquidity and the relative attractiveness and competitiveness of the city itself, provides us with a number of preferred markets that constitute the core of this strategy. While Milan and Rome are obvious choices as a result of their relative size, wealth and liquidity, other smaller but relatively strong markets in the North of the country offer significantly high potential returns. 2 HOW THE INVESTMENT CASE FOR VALUE-ADDED REAL ESTATE IN ITALY. WHY ITALY SIZE • It is easily overlooked that Italy is one of the largest and most affluent countries in Europe. Italy is the fourth largest economy in Europe after Germany, UK and France and is some 45% larger by GDP than the next country, Spain. Italy also has the 4th largest population in Europe with 61 million residents. • Italy is the world’s sixth largest manufacturing country, characterised by a large number of dynamic small and medium-sized enterprises, usually clustered in several industrial districts. Italy is also the world’s 8th largest exporter. Finally, Italy is the fifth most visited country in the world, with more than 50 million international arrivals. Milan and Rome are constantly within the top 5 visited cities in Europe1. • While public debt is high at more than 130% of GDP, it has recently stabilised. On the other hand, household debt at 113% of GDP is quite low in European terms and significanly lower than in the UK (171%), France (147%) and Sweden (193%)2. Moreover, Italy ranks as one of the highest economies in terms of net wealth per capita and per household (Exhibit 1). Finally, while Italian banks still need to improve their profitability, non-performing loans are declining significantly. EXHIBIT 1: ITALY : KEY METRICS REBASED ON 2017 GDP 300 250 200 150 100 50 0 GDP Public debt Private financial wealth Private wealth held in cash, deposits or bonds Source: Citi, MEF, Banca d’Italia 1- Source: Mastercard 2- Source: Eurostat. 3 • The regional dimension is very important to understand. Whilst national GDP per capita is roughly in line with the EU average, the north has wealth per capita that rivals the most affluent regions of Europe, as it is shown in Exhibit 2 (Milan, Bologna, Bergamo and Monza are some examples of very affluent cities). What is clear is that to label Italy by any single feature is flawed as the country is rich in economic diversity. EXHIBIT 2: GDP PER CAPITA AT NUTS 3 LEVEL € / capita > 33,000 25,000 - 30,000 20,000 - 25,000 10,000 - 20,000 < 10,000 Source: BNP Paribas Real Estate, Oxford Economics ECONOMIC OUTLOOK • Currently, in economic terms, Italy is possibly in the best shape ever since the GFC. While one of the drivers of the Italian economic recovery has been the acceleration in global growth, the broad-based nature of the recent upsurge in economic activity provides some assurance that growth is sustainable over the medium-term. The most welcome news has been the strengthening of investment, which fell significantly during and after the GFC. This has translated into a significant drop in the unemployment rate and considerable job creation. • There are other reasons that hint at an improving economic sentiment. Primarily, it is the improved financial profile of Italian companies as profits and margins are increasing whilst bankruptcies are at their pre-crisis level. There has been also a notable increase in lending, albeit this was mainly about residential and consumer lending. For 2018 as whole, real GDP is expected to increase by around 1.3%, according to Consensus Economics. • Over the foreseeable future, we expect the North East of Italy to record the highest growth, followed by the North West area, which should perform better in industry, while the Southern regions are expected to lag behind, penalised by more sluggish developments both in industry and services (Exhibit 3). 4 HOWHOW THE THE INVESTMENT INVESTMENT CASE CASE FOR FOR VALUED-ADDED VALUE-ADDED REAL ESTATE IN ITALY. EXHIBIT 3: GAP WITH AVERAGE GDP GROWTH – NEXT 5 YEARS 0,6 0,4 0,2 0,0 -0,2 -0,4 -0,6 -0,8 Bari Roma Torino Trento Napoli Trieste Monza Milano Verona Brescia Novara Padova Firenze Catania Cagliari Taranto Vicenza Venezia Bologna Modena Messina Palermo Siracusa Bergamo Piacenza Reggio Emilia Bolzano-Bozen Source: Oxford Economics POLITICAL OUTLOOK • The recent credit spread widening reflects an increase in worries about the political outlook rather than deterioration in fundamentals. In 2017, the country had a current account surplus of 2.8% of GDP, and since 2014 the public sector deficit has been below 3% of GDP. Most importantly, European Union data show that since 1995 the country has been running a primary fiscal surplus for 22 years. Most (65%) of public debt is domestically owned. • The source of these worries is mostly related to some uncertainty about how the new coalition- government will handle issues such as public finances. However, it is worth remembering that the new government has not expressed any will to abandon the euro. Moreover, it is also good to keep in mind the fact that around 60% of Italians are in favour of the euro3. • Uncertainty over Italy is a credit risk, not a redenomination risk, so the risk of further spread widening is more limited than in 2011. Overall, while it is not possible to make perfect predictions on how the government will act on public policy over the next few months, there is a significant chance that the ruling so-called “populist” parties will soften their approach towards Europe, once they come to terms with the management of Italian public debt. 3- Source: European Union’s Eurobarometer. 5 • Contrary to common perception, the Italian property market is quite transparent. Indeed, it ranks within the top 20 most transparent markets in the world, according WHY to JLL4. However, as many transactions take place off-market, investors that have a local presence of skilled and experienced staff have a strong advantage. • It is estimated that the Italian commercial property market accounts for 12% of the RESIDENTIAL European market and its investible property market accounts for some €700 bn, a figure lower only to economies such as the UK, Germany and France5. International investors generally focus on Milan and Rome. However, these figures exclude the REAL ESTATE very large residential market, which is generally dominated by domestic owner- occupiers and investors. • The home-ownership rate in Italy is 73%, one of the highest in Europe6. Demand for residential is driven by on-going urbanisation, changing social patterns, such as the progressive reduction of the average household size and pent-up demand for high- standard accommodation. On the supply side, until recently the construction sector has experienced only limited benefit from the recovery in the real estate sector. According to Istat data for 2017, investments in residential construction were 30% lower than in 2008 in real terms7. The prolonged period of crisis experienced by the country since 2008 has led to remarkable increase in firms exiting the construction sector, therefore providing a further obstacle to the creation of new supply. • Residential transactions are on a rising trend. Indeed, in 2017 house transactions increased for the fourth year in a row (Exhibit 4). Accordingly, the number of transactions in 2017 amounted to 542k, i.e. significantly lower than the peak reached in 2006. EXHIBIT 4: RESIDENTIAL TRANSACTIONS IN ITALY 000s 900 800 forecast 700 600 500 400 300 200 100 0 00 01 02 03 04 05 06 07 08 09 10 11 12 13 14 15 16 17 18 19 20 Source: Agenzia delle Entrate, Nomisma • The reasons for the improvement in transaction activity depend on several factors. First of all, the economic situation has improved compared to the previous year as well as confidence as shown by the Italian consumer confidence indexes. Secondly, the conditions for mortgage loans on housing purchases are favourable. Finally, house affordability is not stretched (Exhibit 5). 4- Source: JLL Transparency Index 2018 5- Source: PFR, among others 6- Source: European Mortgage Federation 7- The National Statistics Institute.