European Market Commentary – Q4 2020

We expect that these restrictions will be lifted from March onwards as vaccines are rolled out and that the second quarter of 2021 will mark the beginning of a period of sustained economic growth.  The main driver will be consumer spending as non-essential shops, bars, restaurants and hotels re-open.  In addition, the new €750billion EU Recovery Fund should start to boost government spending from the second half of the year onwards and the European Central Bank (ECB) is likely to keep the refi rate at zero through to the end of 2022.  There are also signs that exporters are starting to benefit from China’s recovery.  That will benefit export-led economies in particular alongside the EU-UK trade agreement. Schroders expects Germany to be the first of the big four eurozone countries to get back to its pre-virus level of GDP, followed by Spain, France and Italy.

The pandemic has seriously disrupted non-food retail real estate in Europe.  The growth in on-line retail sales meant that many department stores and shopping centres were struggling before Covid-19 and the further loss of revenue during lockdowns has added to the pressure.  Several fashion and restaurant chains failed in 2020 and the lack of tourists means that there are now empty shops even on prime pitches in Paris, Rome and Madrid.  We expect prime shop and shopping centre rents to fall by 20%  over the next three years.  By comparison, the big box sector has been more resilient, partly because some stores (e.g. DIY) have been allowed to stayed open, partly because bulky goods are more immune to on-line competition and partly because social distancing is easier out of town.  Some retailers have launched “drive-thru” services, whereby shoppers can buy goods on line and then pick them up without leaving their car. Consequently, we expect big box rents to be flat over the next three years.

Most European office markets experienced a very slow summer with regards to leasing volumes as occupiers adopted a wait-and-see attitude over the ongoing uncertainty.  Leasing activity in Q4 picked up, but is likely to be 35-40% down in 2020 compared to a buoyant 2019.  Leasing activity was severely hit in London, which was not only hit hard by lockdowns and lower mobility, but also uncertainty about the end of the transition period and the future EU-UK relations. In Paris, leasing volumes were down 45%, while they held up somewhat better in the Big7 German markets (-35%), where employees were in many cases also quick to return to their offices. While demand was subdued, office schemes started before the pandemic continued to complete, leading to vacancy on a European level to increase for the fourth consecutive quarter.  At the same time, space offered for sub-letting continued to increase. The renewed lockdowns at the end of 2020 in most European countries will likely lead to low occupier activity at the start of the year while vacancy will continue to sneak up from low levels given further completions. Leasing activity should however increase from late spring alongside the roll-out of vaccines. Prime rents have so far proven resilient though effective rents have decreased slightly. Rents for secondary space have decreased and remain under pressure. We expect prime rents to remain robust, but effective rents to soften further while rents for secondary space should stabilise in 2022/ 23.   

Most warehouses have kept operating through the pandemic, albeit with extra safety precautions and take-up last year was only slightly lower than in 2019.  While demand from manufacturers fell in 2020, this was broadly offset by good demand from on-line retailers (e.g. Amazon), food retailers (e.g. Aldi, Lidl, Rewe) and third partly logistics firms.  On-line retailers typically need around twice as much warehouse space per € of sales, as traditional store based retailers.  Furthermore, the disruption caused by Covid-19 has encouraged companies to increase stocks of key products and that helped to increase demand around Rotterdam and Europe’s other big ports.  However, while demand is stable, there is also significant new supply and that combined with the intense pressure on retailers’ and logistics firms’ profit margins are likely to moderate rental growth.  We expect logistics rental growth in most locations to average around 2% p.a. over the next three years.   

European investment markets started to re-open in Q3. However the renewed lockdowns impacted the usual Q4 rally. Nevertheless, Q4 was in most markets again the strongest quarter of the year. Investors and lenders continue to remain  very selective and focusing on assets with secure incomes.  As a result, the investment market is polarising and while prime office, prime logistic and supermarket assets are highly liquid and prime yields are stable, or even falling, investors are much more hesitant about assets with risk (e.g. location, leasing, use).  In Q4, yields e.g. for prime offices saw further compression between 5 and 25 basis points at the end of 2020, particularly in the large and liquid markets like Germany and Paris. In Zurich, the prime office yield dropped below 2%. Logistic assets remain most sought after and yields for prime logistics assets dropped in almost every larger European logistics market by 10 to 40 basis points. At the same time in the retail sector, volumes for non-food assets like shopping centres and unit shops as well as hotels continue to be subdued. Yield forecasting for these sectors remain a challenge given no clear transaction evidence and concerns around sustainable income.

Although the outlook for ultra low interest rates and bond yields makes it possible to justify prime office yields below 3% and prime logistics yields below 4%, we currently see more value in other parts of the investment market.  In particular, we favour office refurbishments in major city centres where there is a shortage of Grade A space and high quality offices in emerging locations with good transport links.  We also like food anchored retail schemes, DIY and light industrial units where yields are typically around 5%.  In the hotels market, we expect that this year will see a number of distressed sales which will provide the opportunity to acquire good quality assets at a discount.

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