Real Estate Insights
Continental European real estate market commentary: Q1 2019
Schroders forecasts that Eurozone economic growth will slow from 1.8% in 2018 to 1.25-1.5% p.a. through 2019-2020.
Schroders forecasts that Eurozone economic growth will slow from 1.8% in 2018 to 1.25-1.5% p.a. through 2019-2020. The main weak spot will be manufacturing, reflecting sluggish exports to China and the UK and slowing growth in the US. Germany, which has a relatively big manufacturing sector, is likely to experience a sharper slowdown than most countries. By contrast, consumer spending should be stable, supported by rising employment, higher pay awards low inflation of around 1.5% p.a. and some softening in austerity measures. The benign outlook for inflation means that the ECB is likely to wait until 2020 before raising the refi interest rate to 0.5%. The main upside risk is that consumer spending is stronger than forecast. The main downside risks are a disruptive Brexit and / or the USA deciding to impose tariffs on EU car exports.
Almost every major European city saw a rise in office rents over the year to March 2019. This widespread upswing reflects the sustained increase in employment in media, tech and professional services over the last five years and falling vacancy. Vacancy rates in Amsterdam, Brussels, the major German cities, Paris and Stockholm are at their lowest level in fifteen years and there is a particular shortage of prime office space. While developers are starting to respond, the reluctance of banks to lend on speculative schemes and a strong increase in construction costs is restraining new building. Consequently, while rental growth will probably slow, we expect the increase in office rents to continue through 2019-2020.
The industrial and logistics sector is also seeing strong demand and rising rents, driven by the cyclical improvement in the economy and by the structural growth in online retailing. However, the increase in rents is less ubiquitous than in the office market and big cities (e.g. Berlin, Madrid, Munich, Paris) are generally seeing faster rental growth than ports or other distribution hubs. The difference is largely due to the greater availability of land for new building in the main logistics hubs of Benelux and the Ruhr, but development in big cities is also being held back by low unemployment and a shortage of warehouse staff. This is encouraging greater automation and combined with the transition to electric vehicles, means that warehouses increasingly need to have a good power supply.
Despite the growth in consumer spending, demand for retail space in continental Europe is in structural decline. The key challenge is the switch to online retail, but the market is also being disrupted by discount retailers who are taking market share from mid-market retailers and are unwilling to pay the same level of rent. The average vacancy rate in shopping centres has risen to 8% and shopping centre rents fell in most countries in 2018, except Spain and Portugal (source: PMA). We believe that the most defensive retail types will be shops in big city centres and tourist destinations, convenience stores, mid-sized supermarkets and out-of-town retail warehouses selling bulky goods. We expect that department stores, shopping centres with a heavy reliance on clothing and footwear, shops in smaller cities and hypermarkets will suffer a sustained fall in rents.
Although the value of investment transactions in continental Europe has fallen by 10-15% from its peak in 2017 (source: RCA), there are no signs except in the retail sector that investor sentiment is cooling. While the slowdown in the economy means that prospects for office and industrial rental growth have dimmed slightly, the gap between real estate and bond yields has widened since the start of this year. As the timing of ECB’s first rise in interest rates has receded, and bond yields have fallen, we expect that the office and industrial yields will be stable over the next 18 months, before rising by 0.25-0.40% through 2021. Conversely, shopping centre yields will probably increase by 0.5-1.0% in 2019-2020 as investors price in lower rents.
In the office market we currently see most value in either redevelopment projects in central business districts, or in stabilised assets in adjacent areas where yields are higher. Examples include the ArenA in Amsterdam; most areas inside the S-Bahn ring of Berlin; Boulogne-Billancourt, Clichy and Montreuil in Paris; and Solna in Stockholm. In the industrial market we favour multi-let estates and smaller distribution warehouses where it is still possible to buy good assets on yields of 5%, or higher. We also see value in hotels with management agreements. We are cautious about most retail assets, because we do not believe that current yields reflect the risks of higher vacancy and falling rents.
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