Continental European Real Estate Market Commentary - December 2015
15 January 2016
Schroders expects the eurozone economy to grow steadily by 1.5 - 1.75% through 2016-2017. Consumer spending should provide the main impetus, as low energy prices and rising employment support an increase in real disposable incomes. In addition, low interest rates should stimulate an upturn in house building and business investment and should also boost exports, assuming the euro remains weak against the dollar. Schroders forecasts that Spain will see the fastest economic growth in 2016 (3%), followed by Germany (2%), France (1%) and Italy (1%).
Most office markets in continental Europe are now seeing a revival in demand, led by professional services, IT and media occupiers. Gross take up in the 12 months to September 2015 reached its highest level since 2006 (source: JLL) and this pick up in demand, combined with low levels of new building and residential conversions, means that vacancy rates have begun to fall. We forecast that the upswing in office rents which started in the big German cities and Stockholm will spread this year to Amsterdam, Brussels, Madrid, Barcelona and Paris CBD. We also expect office rental growth in certain smaller cities with strong economies (e.g. Leipzig, Lyon, Malmo, Münster).
European retail real estate continues to be moulded by a mix of cyclical and structural forces. On the plus side, sales are growing steadily, development is at a low ebb and eating out is becoming increasingly popular. Restaurants and bars now account for around a quarter of visits to shopping centres (source: CBRE). On the downside, a lot of the growth in sales is online, particularly in northern Europe and certain countries (e.g. Netherlands, Switzerland) and cities (e.g. Helsinki, Marseille, Madrid, Stockholm) appear to have a structural oversupply of outdated retail space. We prefer large shopping centres, flagship stores in big city centres, mid-sized supermarkets and retail warehouses in areas with good population growth and healthy housing markets.
Strong demand from manufacturers, retailers and third party logistics (3PL) operators has pushed down the vacancy rate in the European logistics sector to 9%, from a peak of 13% in 2010 (source: PMA). CBRE estimates that up to one-third of recent take up has been driven by e-commerce. Turning to the future, we expect that logistics rental growth will be fairly modest at 1-2% p.a., partly because 3PL’s profits are under pressure and the sector is consolidating and partly because of an upturn in development of large units in the core markets of Germany and the Netherlands. We favour modern, mid-sized warehouses close to big cities, where supply is restricted.
Although final figures are not yet available, Schroders estimates that investment transactions in continental Europe rose by around 20% in 2015 to ca. €190 billion. That would be the highest annual total since 2006. While France and Germany were again the most important investment markets, reflecting the sheer size of their economies, a lot of the increase in liquidity was in smaller markets such as Benelux, Italy, Portugal and Spain which had previously been quite quiet. Another feature of 2015 was a rise in portfolio deals, particularly in the retail and logistics sectors.
In the short-term it is hard to see the investment market cooling, given improving prospects for rental growth and that the ECB is likely to be one of the last central banks to raise interest rates. Although the inflow of capital from Chinese insurers and oil based sovereign wealth funds could fall, the high level of real estate yields relative to bonds continues to be a major attraction for European insurance and pension funds and they are increasingly willing to look outside their home market and invest cross-border. Furthermore, both US opportunity funds and European REITs have recently raised large amounts of capital to invest in the region. As a result, we think that while prime yields are now close to their trough, yields on average grade properties could fall by another 0.25-0.5% in 2016. Our concern is that some of that decline in yields will later be reversed in 2018-2019, as government bond yields rise and we therefore think it is sensible to invest in assets with good real estate fundamentals and affordable rents with the potential for future growth.
We forecast that total returns on average investment grade European real estate should average 6-8% per year between end-2015 and end-2019. The majority of performance is likely to come from the income return of around 5%, but capital values should also benefit from a steady increase in rents. We expect the following parts of the market should out-perform: offices neighbouring the central business districts (CBD) of Amsterdam, Berlin, Brussels, Hamburg, Munich and Paris; office refurbishments in the CBDs of the same cities; flagship stores in major tourist destinations and parcel hubs / smaller industrial units in large conurbations.
The main upside risk is that strong investor demand triggers a sharper fall in yields and higher total returns in 2016 than we anticipate, although that would probably be at the expense of weaker returns in 2018-2019. The main downside risk is that an external shock forces the ECB to abandon its policy of quantitative easing and raise interest rates, which in turn would reduce economic growth and depress occupier and investor demand for real estate.
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