Continental European Property Market Commentary - September 2014
Although the eurozone economy stagnated in the second quarter of 2014, we believe that this marks a growth pause, rather than a relapse into recession. Schroders believes that the eurozone started to grow again in the third quarter and we expect it to achieve annual growth of 0.75% this year and 1.25% in 2015.
8 October 2014
Although the eurozone economy stagnated in the second quarter of 2014, we believe that this marks a growth pause, rather than a relapse into recession. Schroders believes that the eurozone started to grow again in the third quarter and we expect it to achieve annual growth of 0.75% this year and 1.25% in 2015. Low inflation is boosting households’ real incomes and while there are concerns about deflation, there are no signs yet that consumers are deferring purchases in the expectation that prices will fall. Furthermore, faster growth in the USA and UK should lift exports and more than offset the impact of Russia’s trade embargo on EU food. In addition, the ECB has cut its main interest rate to 0.05% and started buying asset backed securities to encourage bank lending. We expect Germany to continue to be the strongest major economy with growth of 1.5-2.0% per year through 2014-2015, followed by Spain. France and Italy will lag in the short-term, but could accelerate in the medium term if their governments implement thorough labour market reforms, similar to those in Spain.
Most office markets in western Europe saw a fall in vacancy in the first half of 2014. In part this reflected an upturn in demand, particularly from large companies, but in part it also reflected low levels of new building and the conversion of obsolete offices into apartments and hotels. Indeed, estimates suggest that the total stock of office space in Amsterdam and Frankfurt fell marginally in the first half. We expect Berlin, Hamburg, Munich, Oslo and Stockholm to lead the upturn in office rents this year, followed by Brussels, Paris CBD and the other big German cities in 2015-2016.
Despite the recovery in retail sales in the eurozone in 2014, demand for retail space remains patchy. At present the key priority of the big fashion chains in Europe (e.g. H&M, Inditex) is to build their online presence and in the last year they have closed almost as many stores as they have opened (source: PMA). As a result, while most big shopping centres are trading quite well, many medium sized centres (20-40,000m2) are suffering from rising vacancy and falling rents. Our retail strategy is therefore to focus on either dominant centres, small centres with a strong food and convenience offer, or furniture and DIY warehouse units, which are relatively internet immune
The rapid growth in international trade which went hand in hand with the transfer of manufacturing to Asia over the past two decades appears to be over. While we still see opportunities in logistics around Europe’s major ports and airports, we expect the main area of growth will be online retail. Accordingly, we favour smaller warehouses close to big cities, where supply is restricted.
Most countries in western Europe saw an increase in investment transactions in the first half of 2014, reflecting growing demand from both domestic and foreign investors (source: RCA). While prime assets in major cities are still the main focus of attention, liquidity is deepening and we have also seen a definite upturn in deals in Tier II cities and in secondary assets. The only markets where liquidity is still uncertain are: Italy, due to investors’ concerns about the economy; Poland due to tensions with Russia; Finland, where both factors have depressed investor appetite.
The weight of capital means that prime office and retail yields have fallen to 4-5% in most major cities in northern Europe. While this might look reasonable in the context of 10 year bond yields at 0.9-1.2%, we see better value in secondary assets in big cities with good bricks and mortar fundamentals which perhaps are just outside the central business district, or have a short lease, or are multi-let, or are in a complex legal structure. Yields on these assets are typically 0.5-1.5% higher than on prime properties and we expect them to out-perform over the medium-term, assuming the eurozone economy continues to grow and rental growth becomes more widespread.
We expect total returns on average investment grade European property to average 7-9% per year between end-2014 and end-2017. Capital values should benefit from yield compression in 2014-15 and from steady rental growth from 2015/2016 onwards.
The main upside risk in the short-term is that the inflow of capital from Asia and the USA could trigger a widespread fall property yields, which would push annualised total returns over 10% per year for a limited period. The main downside risk is that the sovereign debt crisis could re-ignite if deflation takes hold and governments fail to meet targets to cut their budget deficits.
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