Continental European Property Market Commentary - December 2014
We expect the eurozone economy to continue to grow in 2015, although growth will be modest and uneven. Several countries have high levels of outstanding government debt, and France and Italy need to implement further supply-side reforms to improve their competitiveness, tempering growth prospects. Moreover, the Ukraine crisis and political uncertainty in Greece have depressed business confidence and investment. However, there are also several positives. Consumers are benefiting from the fall in energy and food prices, exporters should start to gain from the euro’s depreciation, the eurozone’s big banks have been re-capitalised and Portugal and Spain are now seeing growth in employment following earlier supply-side reforms. We expect Germany and Spain to grow by 1.0-1.5% p.a. through 2015-2016, while growth in France and Italy is likely to be weaker at 0.5-1.0% p.a.
After a strong first half, office take-up in most European cities weakened in the third quarter of 2014, as the Ukraine crisis hit business confidence. The exception was Brussels which was insulated by a number of lettings to the EU and to embassies. While office demand will probably stay subdued in the early part of 2015, we expect it to revive later this year as employment in TMT and professional services in the big cities expands. Furthermore, office rents in many cities will be supported by low levels of new building and by the conversion of obsolete space into apartments and hotels. We expect Berlin, Frankfurt, Munich, Oslo and Stockholm to lead the upturn in office rents this year, followed by Brussels, Paris CBD and the other big German cities in 2016.
The boost to real incomes from marginal deflation has lifted retail sales across the eurozone. However, demand for retail space remains patchy, because many retailers are focusing their investment on their on-line services. The strongest parts of the market are flagship stores in big cities and large dominant shopping centres, which continue to attract those chains that are in expansion mode (e.g. Desigual, Primark). In addition, some small centres with a strong food and convenience offer and certain big box schemes continue to trade well. By contrast, many medium sized centres and smaller towns are struggling, as multiple retailers close under-performing stores.
The upturn in retail sales and rapid growth in on-line sales and parcels has sustained demand for big warehouses in western Europe. However, development is now picking up and while most of this space is pre-let, the transfer of occupiers is likely to mean that quite a lot of older distribution units fall vacant. Accordingly, we favour smaller units close to big cities, where supply is restricted.
Provisional figures suggest the value of investment transactions in continental Europe grew by 15% last year to around €150 billion (source: JLL, Schroders). While Germany and France were once again the biggest investment markets in absolute terms, the biggest percentage growth was seen in the Netherlands and Spain which had previously been relatively illiquid markets. Although the fall in oil prices is likely to restrain Middle Eastern and Russian buyers, the most active foreign investors over the last twelve months have been from Asia and the US.
The weight of capital means that prime office and retail yields have fallen to 4-5% in most major cities in northern Europe. While this might look reasonable in the context of 10 year bond yields at 0.9-1.2%, we see better value in secondary assets in big cities with good bricks and mortar fundamentals which perhaps are just outside the central business district, or have a short lease, or are multi-let, or are in a complex legal structure. Yields on these assets are typically 0.5-1.5% higher than on prime properties and we expect them to out-perform over the medium-term, assuming the eurozone economy continues to grow and rental growth becomes more widespread.
We forecast total returns on average investment grade European property will average 7-9% per year between end-2014 and end-2017. Capital values should benefit from yield compression in 2015 and from steady rental growth from 2015/2016 onwards.
The main upside risk in the short-term is that the inflow of capital from Asia and the USA could trigger a widespread fall in property yields, which would push annualised total returns over 10% per year for a limited period. The main downside risk is that the sovereign debt crisis could re-ignite, either because the next Greek government decides to re-negotiate its debts, or because deflation in the eurozone becomes entrenched.
The views and opinions contained herein are those of Schroder Real Estate Investment Management Limited and may not necessarily represent views expressed or reflected in other Schroders communications, strategies or funds.
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