European Market Commentary – Q2 2020

Most countries have allowed building sites, cafes, hotels, non-essential shops and schools to re-open, but have kept limits on public gatherings and restrictions on travel from non-EU countries.  Anecdotal evidence such as Google’s mobility data suggest that the economic recovery in Germany, Netherlands, the Nordics and Switzerland is more advanced than in Belgium, France, Italy and Spain which had longer and often stricter lockdowns.

Although Schroders forecasts that eurozone GDP will grow through the second half of 2020 and 2021, we do not expect it to return to its pre-virus level until 2022 and GDP forecasts for 2020 have been revised further down in recent weeks by a number of institutions. Some sectors such as aviation, business travel, entertainment, hotels, restaurants, sports and tourism will not fully recover until people feel comfortable being in a crowd.  In addition, the hit to cashflows during lockdown means that businesses will probably cut investment and staff in the short-term and concerns about job security will discourage households from making major purchases such as cars and homes.  Eurozone unemployment is forecast to increase from 7% to 10% and that means that inflation is likely to remain low at 1% through 2020-2021 and that the ECB will leave the refi rate at zero.  The upside risk is that scientists succeed in developing a vaccine, or effective treatment for Covid-19 before the end of this year.  The main downside risk is that there is a widespread second spike in infections, which forces governments to re-impose national lockdowns.

The closure of non-essential shops during lockdown has speeded up the shift to on-line shopping in continental Europe.  In Germany the market share of on-line sales is expected to jump to 20% in 2020 from 15% last year and there has been a parallel advance in most other countries, albeit from a lower base.  In part this is driven by a change in consumer habits and continuing anxiety about visiting stores, but it also reflects greater investment by retailers in on-line delivery.  For example, Inditex / Zara plans to raise on-line from 14% of total sales to 25% by 2022.  As a result, we expect the increase in structural vacancy to accelerate as more retailers either close stores, or fail and prime retail rents in continental Europe are likely to decline by 15-20% over the next three years.  The drop in tourism means that even prime pitches in Barcelona, Milan and Paris will probably struggle.  The most defensive retail types are likely to be food supermarkets, convenience stores and big box units, which are out of town and where on-line sales penetration is low.

In general most warehouses have been able to keep operating through the pandemic by adopting new safety protocols.  While the jump in on-line retail will boost demand, the vast majority of warehouses are occupied by manufacturers, traditional retailers and logistics firms.  Eurozone manufacturing output is currently 25% below normal and container traffic at European ports is forecast to drop by 10-15% this year and not fully recover until 2022. Consequently, we expect that prime logistics rents in most locations will fall by 1-3% this year, before recovering in 2021-2022.  One of the main constraints facing the sector in the Netherlands and Germany through 2016-2019 was a shortage of staff in major cities and that led logistics occupiers to develop new warehouses in towns and smaller cities where labour was still available.  It is possible that this trend will now reverse, if unemployment rises significantly because of Covid-19.

While Covid-19 has halted the upswing in European office rents which began in 2013/14, we do not think it will trigger a major downswing.  Instead we expect that prime office rents in most cities will  probably fall by 2-5% between end 2019 and end- 2021 and then increase from 2022 onwards though incentives might become somewhat more generous.  This modest fall reflects the very low level of vacancy in many cities before the virus and despite the increase in completion in 2020 and 2021, overall supply is moderate. Total office floorspace in continental Europe will grow by 2% over the next two years, compared with 3% during the global financial crisis and 5% following the dotcom crash.  We also expect supply from 2022 onwards to be lower then previously anticipated given the lack of new schemes to be started in the coming 12 months. Furthermore, we also doubt whether many companies will now decide to switch permanently to remote working.  Working from home might become more common than in the past, but it will not be the norm and happen on a occasional level and not permanent.  The office still offers many advantages in terms of productivity and communicating with colleagues, sparking ideas, training staff and meeting clients and it is notable that big tech firms (e.g. Apple, Google) have invested heavily in new offices in order to attract and retain skilled staff.

Real estate investment markets in continental Europe are opening up again, led by Germany and Sweden.  In part this reflects the economies of the two countries, but it may also be because cross-border investors generally play a smaller role than in other markets. And while overall volumes for Europe have not shown a severe decline in volume terms, the number of transactions has in some countries declined dramatically. And although deals are starting to happen, investors are very selective and are focusing on assets with secure income, including sale and leaseback deals with major corporates.  Therefore, while yields on prime office and industrial assets will probably be stable over the next 18 months, yields on secondary assets could rise by 0.25-0.5%, as investors factor in potential tenant failures and longer re-letting periods. Assets facing capital expenditure and heightened obsolescence will face larger yield deterioration given investors preference for lower risk and long term income.  In the retail sector, both prime and secondary yields are likely to rise by at least 1%, although a lack of investment deals may hamper price discovery in the short term. Further rental uncertainty and retailers capacity to pay is a factor in the larger yield deterioration.

Assuming that the eurozone economy grows from the second half of 2020 onwards, we should see an upturn in office and industrial capital values in most European cities in either 2021, or 2022.  The recovery will be gradual as higher levels of vacancy will initially hold back rents for 12 to 24 months.  By contrast, retail capital values are likely to decline continuously over the next three years, as the increase in structural vacancy undermines open market rents and as banks lose patience and force sales.  The exception should be food stores.  We also expect to see some distressed sales of hotels, although that could create attractive investment opportunities, given the strong long-term prospects for the sector.

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