Outlook 2018: European commercial real estate

2017 was another good year for European commercial real estate. Total returns in the UK were 9% in the first 10 months of the year[1] and short-term indicators point to similar returns in France, Germany and the Nordics. Given that prices in many of Europe’s big cities have risen by 30-40% since 2013, and that real estate is notoriously cyclical, the inevitable question is are we now close to the end of the cycle?

The backdrop is encouraging…

If we look at the ways in which commercial real estate has previously contributed to its own downfall – such as a development boom or excessive borrowing – then the answer appears to be, with a few exceptions: not yet. In most European cities commercial development is still fairly modest. This is partly because new regulations mean that banks are reluctant to lend on speculative schemes and partly because high house prices mean that apartment projects are often more profitable for developers. Likewise, banks continue to take a disciplined approach to lending. Unlike in 2005-2007, the majority of recent purchases in Europe have been funded with equity, rather than debt.

We are also sanguine about the prospect of higher interest rates. There remains a large gap of 3-4% between real estate yields and most European 10-year government bonds. Assuming that the outlook for economic growth in Europe, and hence rental growth, remains favourable, this should persist. The recent experience of the US market is reassuring in this respect. While US 10-year Treasury yields have risen by 1% since mid-2016, office and industrial real estate yields have been flat, or even fallen slightly, because investors expect rents and income to continue growing.   

…but no market is perfect

However, while we believe commercial real estate capital values have further to go in most European cities, it is worth remembering that each cycle has its own dynamic. The trigger for the next downturn could be different from the past. One concern is the growth of populism in Europe over the last few years and the increase in political risk.  Brexit clearly poses a risk to financial services employment and office rents in central London. Catalonia’s declaration of independence has cast a shadow over assets in Barcelona.

In view of these uncertainties, our strategy is to focus on those parts of the European market which are benefiting from structural change and which should be relatively resilient even if the economy weakens unexpectedly. 

The spectrum of opportunity

First, the industrial sector, which is gaining from both a cyclical upturn in demand from manufacturers and third party logistics operators as well as the long-term growth in online retail sales.  Each extra €1 billion of online retail sales generates demand for an additional 100,000 square metres of warehouse space.  Online retailers require more warehouse space than traditional retailers, because they do not hold stock in store.  They have to pick and pack a high number of small deliveries and they have to process more returned items. While developers have responded by building giant warehouses, supply is generally lagging behind demand and there is a definite shortage of smaller warehouses for “last mile” deliveries in the UK, where a lot of old industrial sites have been converted into retail parks and housing.

We also like self-storage, which is still in its infancy in much of Europe. Part of the rationale is e-commerce, as people who start a business at home out-grow their garage, or shed. There are now over 150,000 professional sellers on eBay’s UK site, for example. The other key attraction is that initial yields on mature self storage units average 6.5%.

Another part of the market we like are tech clusters in big European cities (e.g. Amsterdam, Berlin, London, Stockholm) and certain smaller university cities in Europe (e.g. Cambridge, Dresden, Eindhoven, Karlsruhe, Lund & Malmo, Oxford).   IT and digital media are forecast to be one of the fastest growing parts of the economy over the next five years, but the industry is highly concentrated in certain cities where there is a pool of expertise. Once established, that pool then tends to draw people away from other places.  The challenge for real estate investors is to provide the right type of space for tech occupiers and to anticipate where the cluster will spread to, as it grows.  We are also seeing increasing demand from life-science companies for offices and laboratories close to universities and research institutes.  

Finally, we also see value in certain office markets where there is good demand from a diverse range of businesses, where there is little new office development and where yields are relatively high.  In the UK, this set of “winning cities” includes Brighton, Bristol, Leeds and Manchester.  The last two cities should also gain in the long-term from improved transport infrastructure thanks to the government’s Northern Powerhouse initiative and HS2. Similarly, we think there are opportunities in certain parts of Paris outside the central business district (e.g. Boulogne-Billancourt, Clichy, Montrouge) where office yields are 1-1.5% higher than in the centre and which stand to gain from the Grand Paris network of new metro lines.

In conclusion, it seems that after a long period when real estate cycles in Europe were converging, we are now entering a new era of polarisation, with much greater variations in returns across cities and sectors.  The rapid growth of on-line clothing sales means that the capital value of many shopping centres in northern Europe has already peaked, particularly in the Netherlands and the UK.  By contrast, we believe that office and industrial capital values in Europe’s winning cities will continue to increase.