Continental European Real Estate Market Commentary - July 2015
While there is a strong possibility that Greece will leave the euro, we believe that the eurozone economy is a lot stronger than it was in 2010-2012 and that we won’t see contagion spread across southern Europe. Most governments have cut their budget deficits to 2-3% of GDP, the major banks have been re-capitalised and the ECB now has a range of measures to help governments caught in a liquidity squeeze, provided they agree to a bail-out. As a result, we don’t think the Greek crisis will de-rail the eurozone recovery and we expect that Spain and Germany will grow by 2.0-2.5% p.a. through 2015-2016 and France and Italy by 1.4% and 0.8% p.a., respectively.
The upturn in business confidence since mid-2014 has lifted office demand and led to a fall in vacancy rates in most European cities. Unsurprisingly, demand is stronger in the big German cities than in Paris, or Milan, but there are also clear differences across sectors. In general, banks and government agencies are focused on cutting costs, either by moving to cheaper districts, or more often, by moving to more efficient space. By contrast, IT, media and professional services firms are more concerned about attracting skilled staff and tend to favour mixed use areas with a range of shops, bars, etc. We expect Berlin, Frankfurt, Munich and Stockholm to lead the upswing in office rents through 2015-2016.Most other cities probably won’t see rental growth until next year. Encouragingly, tenant incentives have begun to fall in Amsterdam and Paris (source JLL).
The rapid growth of on-line retail means that retail rents are currently flat across much of Europe, even though eurozone retail sales rose by 2.3% p.a. in the first five months of 2015 and new supply is at a low ebb. While the major fashion chains continue to open flagship stores in city centres and large shopping centres to complement their on-line presence, they are simultaneously closing many smaller units and vacancy in mid-sized shopping centres (15-40,000 square metres) is increasing (source PMA). The strongest parts of the European retail market are big, dominant shopping centres which combine retail with leisure, tourist destinations, small centres with a strong food offer and big boxes in towns with good population growth and active housing markets.
Paradoxically, the European logistics market is enjoying the full benefit of the growth in retail sales. While pure “e-tailers” only accounted for 10-15% of logistics take-up in the first quarter of 2015, the share which was internet related was probably closer to 25%, once parcel couriers are included. Looking ahead, our main concern is the pick up in speculative building, particularly in the Benelux market. We therefore favour mid-sized warehouses close to big cities, where supply is restricted.
The investment market has continued to gather pace in 2015, with strong demand from domestic and foreign institutions, REITs and US opportunity funds. While their appetite can in part be explained by the improvement in the economy and prospects for rental growth, the real attraction is the large gap between prime retail and office yields at 4-5% and 10 year government bond yields at 0.8-2.4%. Moreover, the depreciation of the € against US$ has effectively cut capital values for US and Asian dollar-based investors by 20% since mid- 2014.
In the short-term it is hard to see the investment market losing momentum, given that the ECB’s QE programme is scheduled to run until at least September 2016. We expect that real estate yields will continue to compress and that in many cities in northern Europe prime yields will fall below their previous 2007 lows over the next 12 months. What then happens in 2017-18 when government bond yields start to rise will largely depend on the economy. History suggests that real estate yields could be stable if rental growth is accelerating. Nevertheless, we think it is sensible to assume that some of the decline in yields over the next 12 months will later be reversed and to invest in slightly higher yielding assets with good bricks and mortar.
We forecast that total returns on average investment grade European real estate will average 7-9% per year between end-2014 and end-2018. Total returns are likely to be front loaded, benefitting from yield compression in 2015-2016 and rental growth from 2016 onwards. The main downside risk is that a Greek exit from the euro escalates into a broader sovereign debt crisis, although we think that is unlikely.
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