Real Estate Research
Continental European real estate market commentary, July 2016
By Schroder Real Estate Research Team
The eurozone economy exceeded expectations in the first quarter of 2016, growing by 0.6% compared with a previous trend rate of 0.3%-0.4% per quarter. The main driver was consumer spending reflecting a favourable combination of low inflation, rising real wages and higher employment. Unemployment in the eurozone fell to 10.1% in May 2016 from a peak of 12.1% in mid-2013. While the UK’s vote to leave the EU may dent business confidence in the eurozone in the short-term and lead some companies to temporarily freeze recruitment, or delay new investment, we doubt whether it will halt the recovery. The biggest impact will probably be on certain smaller countries such as Ireland and the Czech Republic which have particularly strong trade links with the UK. By comparison, exports to the UK account for only 2-3% of French and German GDP and Schroders expects both countries to continue to grow by 1.0-1.5% through 2016-2017.
The improvement in the economy combined with limited development has led to a widespread fall in office vacancy and in several European cities it is now at its lowest level for more than a decade. By the end of March 2016, the overall office vacancy rate was below 7% in Berlin, Hamburg, Luxembourg, Munich, Paris CBD, Stuttgart and Vienna (source PMA) and in some sub-markets it was as low 2-3%. As a result, office rental growth in these cities has started to spill over from the central business district and in Berlin and Munich the fastest increases have recently been in emerging locations such as Freidrichshain and Arnulfpark. It seems likely that Brexit will prompt some London based investment banks, insurers and asset managers to switch certain operations to the eurozone. Frankfurt and Paris La Défense are the obvious locations given their scale, but we suspect that some jobs will also be relocated to Dublin and Luxembourg. It is also possible that tech companies will start to choose Berlin and Stockholm in preference to London.
In general we remain cautious about the retail sector, partly because some cities and countries are over-built (e.g., Marseille, Finland, Netherlands), but mainly because of the rapid growth of on-line sales. The internet now accounts for 8-10% of retail sales in both France and Germany and earlier predictions that the growth of on-line sales would moderate have, so far, proved to be wrong. The most resilient parts of the sector are city centre tourist destinations and large shopping centres which offer an array of retail and leisure attractions. In addition, we believe that mid-sized supermarkets and retail warehouses have a future in an omni-channel world, partly because food and bulky good (e.g. DIY, furniture) are reasonably internet immune, partly because out-of-town space is relatively affordable for retailers and partly because plentiful car parking means that retail warehouses are convenient for click & collect orders. The upswing in the housing market triggered by low interest rates has given a further boost to the retail warehouse market in Denmark, Germany and Sweden.
In the investment market, there are some signs that activity is moderating. In most big cities prime retail and office yields levelled off in the first quarter of 2016, following sharp falls in 2014 and 2015 and the total value of deals in continental Europe was 40% lower than in the first quarter of 2015 (source RCA). However, while this could signal a negative shift in sentiment, we think it is more likely that investors are simply taking stock, after a hectic 2015. Despite the recent compression in yields, real estate is still priced relatively attractively, given the large yield premium over government bonds of 3-4%, the recent volatility of equities and given the prospect of steady rental growth over the next few years. Moreover, while Brexit means that investors will definitely pay more attention to political risk in future, we doubt whether it will reduce their appetite for real estate in core eurozone countries. Indeed, it could increase it, if some of the capital which was earmarked for the UK is now switched to the continent.
We forecast that total returns on average investment grade European real estate should average 7-8% per year between end-2015 and end-2020. The majority of performance should come from the income return of around 5%, but capital values should also be supported by a steady increase in rents. We currently see most value in: offices in the inner city sub-markets of Amsterdam, Berlin, Brussels, Hamburg, Munich and Paris; office refurbishments in the central business districts of the same cities; modern, centrally located offices in university cities; mid-sized supermarkets and convenience stores in areas with growing population and mid-sized logistics units which are suitable for on-line fulfilment.
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