Continental European Property Market Commentary - June 2014
The eurozone economy should grow steadily by 1-1.5% through 2014-2015, as faster growth in the USA and UK boosts exports and as households’ real disposable income benefit from higher employment, lower inflation and a halt to new government austerity measures.
The eurozone economy should grow steadily by 1-1.5% through 2014-2015, as faster growth in the USA and UK boosts exports and as households’ real disposable income benefit from higher employment, lower inflation and a halt to new government austerity measures. In addition, the upturn in business confidence should encourage companies to rebuild stocks and raise investment as the threat of a currency break up recedes. While there are concerns about deflation in the eurozone, there is no evidence that purchases are being postponed in anticipation of lower prices.
There are early signs of a recovery in tenant demand for office space, not only in the stronger economies of Austria, Germany and Sweden, but also in Benelux, France and Spain. According to Savills, the volume of office lettings is up and rent free periods are starting to shorten. Furthermore, office development remains subdued because banks are reluctant to fund new schemes and because higher residential prices in many European cities mean that developers prefer to build apartments. We expect Berlin, Hamburg, Munich, Oslo and Stockholm to lead the upturn in office rents this year, followed by Brussels, Paris Central Business District and the other big German cities in 2015-2016.
Retail sales are starting to recover across most of Europe, although much of this growth is online. Internet purchases now accounts for almost a fifth of clothing sales in Germany, compared with 4% in 2010 (source: Regio Plan). As a result, it is difficult to be enthusiastic about retail property, although certain types, such as smaller supermarkets and retail parks which focus on food or bulky goods and where rents are relatively affordable, continue to trade well. We also see growing demand for “flagship” stores over 750 m2 in big city centres from luxury goods retailers and fast fashion chains / consumer brands wishing to complement their online presence.
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.
After a prolonged hibernation, European banks are once again starting to lend internationally. The German pfandbrief banks are currently the most active, but French and US banks are also lending cross border and Deutsche Bank has recently issued a CMBS for a portfolio of Italian properties. While it is dangerous to generalise, we estimate that the margin on a good quality commercial property in northern Europe has fallen to under 1.5% on a 50% LTV, from 2.0% a year ago.
The weight of capital from both domestic and foreign investors means that prime office and retail yields have fallen to 4-5% in most major cities in northern Europe. While this pricing might be justified in a few markets which are seeing rental growth (e.g. Paris retail, Munich office), we believe that better value can be found in good quality offices which have short leases or which are on the edges of the Central Business District, or in smaller supermarkets and retail parks where yields are between 6-7%. We believe that prime office and retail yields in Spain and prime logistics yields in Germany have fallen too far and do not represent good value.
We expect total returns on average investment grade European property to average 7-9% per year between end- 2014 and end-2017. Capital values growth will be front loaded benefitting from yield compression in 2014-15, followed by rental recovery 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 in prime and secondary 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 reignite if governments fail to meet targets to cut their budget deficits.
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