Real Estate Insights
Continental European real estate market commentary: Q1 2020
The lockdowns imposed by governments to slow the spread of the coronavirus have pushed the eurozone into recession. The impact will depend on how long the lockdowns last. In round terms, each month in lockdown cuts annual GDP growth by 3% (source INSEE). If the lockdowns are phased out over the summer then the second half of 2020 could see a strong recovery, as people begin to spend again in shops and on leisure activities and as businesses re-start investment. Schroders central forecast is for a V-shaped recovery, with eurozone GDP returning to its pre-virus level by mid-2021. However, a lot will depend on whether the huge package of tax breaks, loan guarantees and compensation for short-time working announced by the EU and by national governments succeed in keeping businesses afloat through the lockdowns. If they fail and there is a wave of insolvencies, then unemployment will be permanently higher and the recession will be deeper and longer. There is also a risk that the jump in government debt equal to 10-15% of GDP will trigger a new sovereign debt crisis, if investors lose faith in the ability of countries such as Italy to re-pay.
Although the lockdowns and travel bans have affected all commercial real estate, the biggest impact has been on leisure, retail and hotels. Except in Sweden, all restaurants, bars and leisure venues are shut and the only stores which are still open are banks, post offices, food stores and pharmacies. The lockdowns have also given a boost to internet sales and while part of the shift will reverse when stores re-open, not all of it will and the virus is likely to quicken the adoption of on-line shopping, including in Italy and Spain which until now had lagged behind. Some non-food retailers have deferred paying rent and despite government support and the flexibility of landlords, a number of non-food retailers will fail, particularly those mid-market brands which were already struggling financially before the coronavirus. In short, the virus is likely to accelerate the increase in structural vacancy and decline in market rents. Supermarkets, convenience stores and big box units are likely to be more defensive than shopping centres and department stores.
The lockdowns and travel bans have also hit European hotels very hard. In most cities, occupancy rates have collapsed from 60-70% in February to 5-15% (source STR) and many hotels have temporarily closed. It is possible that the hotel sector will recover in time for the peak holiday season in July and August, but a lot will depend on when governments lift border controls, on whether people can afford a holiday and feel confident to travel and on how quickly airlines resume operations.
In the industrial / logistics sector, the boost from higher on-line sales is positive, but must be put in context. The vast majority of warehouses are occupied by manufacturers, non-food retailers and logistics operators and their businesses have been seriously disrupted by the virus. All big car manufacturers have suspended production and container traffic at European ports has dropped by 20-30% compared with the first quarter of 2019. In addition, on the supply side, a significant amount of speculative space was under construction before the lockdowns and it is unlikely to let quickly, once completed. Consequently, we expect that warehouse rents in continental Europe will fall by around 5% in 2020, before stabilising in 2021. In the long-term, the virus could increase demand for warehouses, if retailers and manufacturers decide to make their supply chains more resilient by holding more stock and by re-shoring some production from Asia.
Offices will probably be the main sector which is least affected by the coronavirus, for two reasons. First, in many cities vacancy was very low at the end of 2019, so office markets are relatively well placed to cope with a demand shock. Second, a lot of office occupiers have been able to maintain operations by asking staff to work from home. Oxford Economics forecasts that collectively, output in financial and business services, IT and government will only fall by 0.5% in the eurozone in 2020, whereas output in eurozone manufacturing, retail and transport are forecast to drop by 3%, 4% and 7%, respectively. The one weak spot is serviced offices and we expect that some providers will fail, particularly those that are paying high rents. Others will very likely radically scale back their expansion plans. The big question is whether the current experiment with remote working will persuade companies to re-think their long-term space requirements and cut office demand in future. While that could happen, it is also possible that people who have been isolated at home have a greater appreciation of the benefits of being in the office in terms of communicating with colleagues, meeting clients, training and sharing values. In the short-term however, take-up and net absorption is expected to decrease significantly as companies refrain from making decisions. On a positive note, the current crisis is also likely to reduce supply volumes after 2021. While buildings currently under construction will be completed once work resumes, developers will hold back on starting new schemes.
While the value of investment transactions in continental Europe only fell slightly in the first quarter of 2020 compared with the same period of last year, the data is a lagging indicator of activity. The ban on travel and site visits means that very few new deals are being initiated and the lack of visibility on pricing has prompted valuers to add material uncertainty clauses to Red Book valuations.
Despite the low level of government bond yields, we anticipate that real estate yields will rise as investors price in potential falls in rental income - albeit those falls should be short-lived in the office and industrial sectors. There is also anecdotal evidence that banks have started to raise margins on new loans and/or reduce financing for higher risk rated assets. If our assumption on real estate yields is correct, then capital values will probably fall on average by 10-15% in the first half of 2020. Retail real estate and secondary assets are likely to be hit harder than office, industrial and prime assets. The second half of this year could then see a partial recovery in capital values, if the economy starts to improve and investor appetite returns.
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