Real Estate Insights
Continental European real estate market commentary: Q2 2019
Schroders forecasts that the Eurozone economy will grow by 1.25-1.5% p.a. through 2019-2020. Spain is likely to be the fastest growing major economy, reflecting the boost to its competitiveness from supply-side reforms and a recovery in the housing market. Germany will probably lag, due to its relatively high dependence on exports as world trade slows and the structural challenges facing the car industry over emission standards (diesel) and from electric vehicles. The uncertainty over trade and lack of domestic inflationary pressures means that the new head of the ECB is unlikely to raise interest rates immediately on taking office in October. We expect the ECB to increase the main refinancing rate from zero at the end of this year to 0.5% at end-2020. The main downside risks are a disruptive Brexit, the USA deciding to impose tariffs on EU car exports and increasing geopolitical concerns.
The last three years have seen a widespread increase in European office rents. Prime rents have risen on average by 5% p.a. since 2015; in Berlin and Stockholm rental growth has exceeded 10% p.a. While office rental growth is likely to slow through 2019-2020 in line with the economy, we expect it to remain positive for two reasons. First, office rents in most cities are still affordable. In real terms rents are 15-20% below the record levels reached in 2000-2001 and the gap widens to 25-30% once the long-term decline in space per employee is taken into account. Second, and more importantly, vacancy rates in Amsterdam, Brussels, the major German cities, Paris and Stockholm are low and new building is being held back to some extent by banks’ reluctance to lend on speculative schemes and strong increases in construction costs that eat into developers profits. As a result, there is little risk of over-supply.
While take-up of industrial and logistics space in continental Europe varies from year to year, the underlying trend growth in demand is around 5% p.a. The main driver is the increase in online retail, but third party logistics operators (3PLs) are also gaining from outsourcing by retailers and manufacturers. In general, rental growth has been less uniform than in the office sector and largely confined to major cities (e.g. Berlin, Hamburg, Madrid, Munich Paris). In part this reflects the faster economic growth of big cities and in part to a tighter supply of both staff and land for new building compared with other distribution locations. The growing shortage of warehouse staff in northern Europe is encouraging logistics operators to increase training, add amenities (e.g. canteens) and invest more in automation.
By contrast, continental European retail markets are suffering from a structural oversupply of space caused by high levels of development in the run up to the GFC and by the growth in online retail. Although there are pockets of growth (e.g. discounters, organic food stores) and some vacant department stores have been converted into hotels and offices, they are outweighed by the closure of electrical stores, mid-market fashions chains and by the downsizing of hypermarkets. The vacancy rate in French and German shopping centres has risen to 7-9%, from 3-4% five years ago (source: PMA) and even large, dominant schemes are having to invest heavily in refurbishment in order to maintain occupancy. We expect average grade shopping centre rents to fall in most cities over the next three years. The most defensive retail types are likely to be shops in tourist destinations, convenience stores and out-of-town grocery-anchored retail warehouses or warehouses selling bulky goods.
Although the total value of transactions in continental Europe has fallen by 5-10% from its peak in 2017 (source: RCA), most of the decline has been due to a lack of stock and a reduction in retail transactions. Investors are holding real estate longer, limiting trading. The demand for real estate remains strong, with many investors underweight relative to target benchmarks. In general, the office and industrial sectors have remained liquid and the last three years have seen an increase in sales of other types, including apartments and full service hotels. We expect that office and industrial yields will be stable over the next 18 months, before rising by 0.25-0.40% through 2021-22, as the ECB gradually tightens policy. Conversely, shopping centre yields will probably increase by 0.5-1.0% over the next 18 months, 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 still higher. Examples include the ArenA in Amsterdam; Kreuzberg-Friedrichshain in Berlin; Valby in Copenhagen; Boulogne-Billancourt, Montreuil or parts of North-West 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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