Real Estate Research
Continental European real estate market commentary - September 2016
The eurozone economy has grown steadily by 1.5% p.a. since mid-2013 and we expect it to maintain that progress through 2017-2018. We do not think that Brexit will de-rail the recovery. While the boost from falling oil prices will fade, most countries look set to benefit from a virtuous circle of rising employment and higher consumer spending. Low interest rates mean that business confidence has remained strong and low / negative bond yields should cut governments’ borrowing costs and enable them to raise spending in 2017. Exports are also likely to gather momentum next year, helped by slightly faster growth in the US and a revival in emerging markets. Among the big economies, Germany and Spain should lead. France and Italy, which require further supply side reforms, are likely to lag behind.
The improvement in the economy has fed through to office demand. Agents’ data suggest that office take up rose in most European cities in the first half of 2016 with corresponding increases in prime office rents. Most of the growth has been due to professional services, technology and media, whereas demand from government and finance has been muted. Although Brexit means that Frankfurt, Paris and perhaps Amsterdam will probably see an increase in financial jobs as certain activities are switched away from London, we expect that the boost to employment will be modest and progressive in nature. In part this is because banks will probably invest more in automated trading and in part because some of the less profitable operations in London will be closed. It is also possible that tech companies will choose Berlin and Stockholm in preference to London, given the prospect of immigration controls in the UK and the need to keep data on EU citizens within the EU.
Despite the positive outlook for consumer spending in the eurozone, we are generally cautious about retail real estate. Our main concern is the rapid growth of online sales and in particular, clothing and footwear, which typically account for between 40-50% of space in shopping centres. Leading European fashion retailers (e.g. H&M, Inditex) are investing heavily in their online presence in order to compete with internet retailers (e.g. Amazon, La Redoute, Zalando) and over 15% of clothing sales in Germany, for example, are now online. Consequently, we favour mid-sized supermarkets, convenience stores and out-of-town retail warehouses, because consumers still wish to touch items like food, furniture, DIY and homewares before they purchase and because these stores typically have plenty of car parking and are convenient for click & collect sales.
The flipside of online retail has been the growth in demand for warehouses. Take up of big distribution warehouses in Europe has increased by 25% since 2013 (source: JLL), due mainly to internet retailers and third party logistics operators. However, unlike in the retail and office sectors, there has also been a jump in new supply, partly because many distribution warehouse sites are unsuitable for residential development. As a result, future rental growth is likely to be weak. We generally prefer smaller industrial estates which are benefiting from the growth in parcel volumes, but which are in built up areas where new supply is constrained.
Although this year has seen a fall in the value of investment transactions in continental Europe from the very high levels of 2015, the market remains competitive. Whereas European investors are still active, attracted by the large gap between real estate and bond yields, Asian and North American investors have been noticeably quieter, albeit for different reasons. The fall in capital from Asia appears to be driven by changes in US tax laws in 2015 which means that foreign investors are no longer subject to capital gains tax. Accordingly, this year has seen a sharp rise in purchases of US real estate by investors from Asia and the Middle East (source: RCA). By contrast, the decline in US purchasers probably reflects the fact that there are now fewer distressed sellers in Europe.
We forecast that total returns on average investment grade European real estate will be 5-7% per year between end-2016 and end-2020. The majority of performance will come from the income return of around 5%, but capital values should also be supported by a steady increase in rents. Our strategy is to focus on certain major cities which 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 these characteristics.
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