Continental European Real Estate Market Commentary - September 2015
The eurozone economy grew by 0.4% in the second quarter of 2015 and Schroders expects it to continue to grow steadily by around 1.5% in 2016. Consumers should benefit from rising real wages, as inflation remains below 1% and next year should also see a rise in public spending, as low interest rates give governments a little more leeway. By contrast, the boost from exports is likely to reduce, although on balance we expect stronger demand from the USA to offset weaker sales to China and other emerging markets. Schroders forecasts that Spain will see the fastest economic growth in 2016 (3%), followed by Germany (2%), France (1%) and Italy (1%).
Although the upswing in office rents in continental Europe is still in its early stages, it is becoming more broad based. Two-fifths of cities saw an increase in prime office rents over the year to June 2015, including Amsterdam, Berlin, Madrid, Munich and Stockholm and only one fifth recorded a fall, the lowest proportion since 2012. The real driving force is the growth in employment in professional services, media and IT. In addition, office rents are being supported by low levels of new building in many cities, partly because of a lack of development finance, but also because high prices are encouraging developers to focus on apartments. The lack of a supply response, so far, is a positive surprise.
In most European retail markets big is beautiful, or perhaps more accurately, less vulnerable to on-line competition. Large shopping centres (>40,000 m2) with a range of restaurants and leisure attractions typically trade better than smaller centres and many retailers are simultaneously opening flagship stores in big city centres, but putting stores in smaller towns under scrutiny. However, there are exceptions. First, in the grocery sector, supermarkets and convenience stores are generally faring better than hypermarkets (>5,000m2). Second, a detailed analysis of Germany shows that prime retail rents in some smaller cities with a strong tourist trade (e.g. Heidelberg, Munster) have matched the rise in big city rents over the last three years (source: JLL, Schroders).
Logistics take up rose in the first half of 2015, reflecting good demand from a wide variety of car manufacturers, retailers / etailers and third party logistics operators. While some occupiers are still rationalising their warehouses, others are taking more space and relocating to modern facilities. The average vacancy rate has fallen to 9% from a peak of 13% in 2010 (source PMA). Looking ahead, one concern is the upturn in speculative building of large units in Benelux and Germany. We therefore favour mid-sized warehouses close to big cities, where supply is restricted.
The total value of investment transactions in continental Europe rose by 29% between the first halves of 2014 and 2015 to €87 billion (source: RCA). The most active investors were domestic institutions, REITs and US opportunity funds. Chinese and Russian investors only accounted for around €5 billion of deals. Another feature of the first half of 2015 was a big increase in portfolio deals, which accounted for almost one half of purchases, against one third in the first half of 2014.
In the short-term it is hard to see the investment market losing momentum, given improving prospects for rental growth and that the ECB’s QE programme is likely to keep government bond yields at very low levels through most of 2016. We expect that real estate yields will continue to compress over the next 12 months and that prime yields in many cities in northern Europe will fall below their previous 2007 lows. What then happens in 2017-18, assuming that 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 real estate fundamentals.
We forecast that total returns on average investment grade European real estate will average 6-8% per year between end-2015 and end-2019. We expect that major cities such as Amsterdam, Berlin, Madrid, Munich and Paris will out-perform thanks to stronger economic and population growth. Total returns are likely to be front loaded, assuming yields continue to decline next year, before stabilising. Capital values should benefit from steady rental growth from 2016-17.
The main upside risk is that office development is “lower for longer”, with the result the rental growth is faster than anticipated. The main downside risk is that the Chinese economy suffers a hard landing, which would not only hit exports, but also tourist spending in France and Italy and capital flows from South East Asia. Furthermore, there are various political risks, including the possibility that the latest settlement with the Greek government will unravel and the possibility that the conservative government in Spain will lose the elections in December.
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