Real Estate Research

Continental European real estate market commentary - March 2017

19/04/2017

The eurozone economy is currently ticking all the right boxes. GDP is growing slightly above trend, business confidence is strong, unemployment fell to 9.6% in January and core inflation, excluding energy, is steady at 1%. As a result, the ECB is becoming less concerned about deflation and has trimmed its programme of quantitative easing, marking the first step towards an eventual increase in interest rates, probably in 2019. Schroders expects the eurozone economy to grow by 1.5%-1.8% p.a. through 2017-2018. While higher energy prices will curb consumer spending a little, the improvement in the world economy and last year’s depreciation of the euro against the dollar should help exports and that in turn, should support an increase in business investment. Germany, the Nordics and Spain are likely to lead, while France and Italy will probably lag behind.

Most European cities saw a fall in office vacancy and a rise in prime rents last year. The key driver has been the sustained growth in the eurozone economy over the last 3-4 years, so that a lot of the office space which was vacant in 2013 has now been re-occupied. Office markets have got back to equilibrium.  The other supporting factor has been low interest rates and high residential prices. This encouraged developers to convert obsolete office space into apartments, particularly in Amsterdam and Frankfurt, and discouraged them from building new offices. It is no coincidence that, so far, the increase in office development has been strongest in cities like Barcelona, Dublin and Madrid where house prices are still well below their pre-Lehman peak. By contrast, in most German cities, where house prices have risen by 30-40% since 2008, office development is still fairly muted.

While almost every European city saw a fall in office vacancy in 2016, the picture in retail is more mixed. In Italy and Spain, the recovery in consumption has encouraged retailers to expand and shopping centre vacancy has fallen since 2014, albeit from high levels. By contrast, in France and Germany, which historically have had tight retail planning controls and little empty space, vacancy rates have risen over the last couple of years. This difference is largely due to online retail, which now accounts for 9-13% of total sales in northern Europe, but only 3-4% in southern Europe (source: Centre for Retail Research), reflecting the greater reluctance of consumers there to use credit cards and on-line payments. However, although online diversion is less of a threat in Italy and Spain, the direction of travel is clear. Our strategy across Europe is to focus on mid-sized supermarkets, convenience stores and retail warehouses selling goods which are relatively internet immune.

The rapid growth of online retailers such as Amazon and Zalando, coupled with good demand from manufacturers, 3PLs and conventional retailers has pushed warehouse demand in continental Europe to record levels. However, rental growth has remained fairly modest, partly because many occupiers work on very thin margins and partly because of a big increase in new building. We therefore prefer smaller industrial estates which are benefiting from the growth in “last mile” deliveries and returned items, but which are in built up areas where new supply is constrained. 

Turning to the investment market, last year saw a further significant fall in yields across continental Europe, reflecting strong competition between domestic and foreign investors. As a result, prime office yields in many major cities now stand at 3.0-3.5%, half a percent lower than in mid-2007. While that might suggest that European real estate is now expensive, the investment market is different from 2007-2008 in several key respects. First, prime yields are currently 2-3% above 10 year government bond yields, whereas in 2007 they were 0-1% below. Second, investors have not bought indiscriminately and whereas the gap between prime and secondary office yields narrowed to 0.3% in 2007-2008, it is currently around 1.25% (source: CBRE). These differences can in turn largely be explained by the fact that gearing is generally a lot lower now than in 2007-2008, when banks could syndicate loans on the CMBS market and LTV ratios of 75% were commonplace.

We forecast total returns of 5-7% p.a. on average investment grade European real estate between end-2016 and end-2020, assuming the eurozone economy continues to grow. The mainstay will be an income return of 4.5%, while capital values will be driven primarily by a steady increase in rents.  We think that the era of yield compression is now over. Our strategy is to focus on certain winning cities which are benefitting from urbanisation, have diverse economies, a large pool of skilled labour, good infrastructure and are attractive places to live. Examples include Amsterdam, Berlin, Hamburg, Madrid, Munich, Paris, Stockholm and Stuttgart. We also like certain smaller university cities which share many of the same characteristics. While there is a growing degree of political uncertainty in the EU, we think that real estate in growth cities should be relatively resilient.

 

 

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