European Market Commentary: Q1 2022

The war in Ukraine has delivered a new shock to the eurozone economy, just as it had got back to pre-pandemic levels with renewed positivity. While neither Russia, nor Ukraine are important export markets, together accounting for 5% of eurozone exports, they are major suppliers of oil & gas and grain, respectively. As a result, energy and food prices have jumped and that has added to inflation, which was already rising due to the global supply bottlenecks and pent up demand caused by Covid. Schroders now expects eurozone inflation of 7% this year and 3% in 2023. That will depress real household incomes in 2022 and the war probably also means in the short-term that consumers will be more inclined to save and businesses less willing to invest. Schroders has cut its forecast for eurozone GDP growth in 2022 from 5% to 3%. Our forecast for next year is unchanged at 2.5%. We also now expect the ECB to raise interest rates this year, although the refi rate will still be below 1% by the end of 2023.

Retail real estate continues to be challenging and a highly polarised affair. On the one hand, vacancy rates in many cities have risen to 12-15% and forecasts suggest that on-line sales in northern Europe ex. UK will increase from 14% of total sales in 2021 to 21% in 2024. On the other hand, there is good demand from discounters for food stores and big box units, spending by tourists and office workers should recover assuming Covid-19 remains under control and high residential prices are encouraging developers to convert redundant retail space. Given these trends we expect that food store and big box retail park rents will increase by 2-3% p.a. and 1-2% p.a. respectively, over the next three years. We also anticipate a recovery in prime shop rents in major tourist destinations which are supply constrained (e.g. Barcelona, Paris). By contrast, we expect that rents for non-food shops and shopping centres will continue to decline in most towns and cities coupled with an increasing move to turnover based rents.

The logistic warehouse market in continental Europe is seeing ongoing record levels of demand. The main driver is on-line retail, but another factor is that retailers and manufacturers are deciding to hold more stock as a precaution against supply disruptions. The strength of demand has pushed vacancy rates down to 3-5% in most locations and tight supply in core areas have pushed some occupiers into more 2nd tier locations. Annual rental growth is now up to 4%, from an average of 2% p.a. in the five years before the pandemic. However, although demand for warehouses is likely to remain strong, we expect rental growth to slow slightly to 3% p.a. over the next three years, as logistics developers ramp-up activity. Warehouse completions in Europe ex. UK rose to 15 million square metres in 2021 and a third of schemes were speculative. In addition, the ability of 3PL logistics firms to pay higher rents is likely to be limited given that profit margins are thin, competition is high and they are also being squeezed by higher fuel prices and labour shortages, albeit goods are being stored for longer.
Office leasing activity continues to recover with an active start to the year though it is yet to be seen if the war in Ukraine will lead to some occupiers deferring decisions given the economic uncertainty. The shift to more hybrid working has however led to a highly polarised market with occupiers focusing on top quality space with state of the art technology, strong ESG credentials and a focus on employee well-being to tempt employees back into the office, drive productivity and collaboration and cut carbon emissions. Vacancy levels have increased, but remain low in the majority of Western European markets and going forward, high construction costs are likely to impact overall construction activity. And while modern space is quickly absorbed, occupiers handing back second-hand space to the market means that vacancy increasingly consists of older and redundant stock. The ongoing tight supply and strong focus of occupiers on prime space will hence continue to support prime rents. Almost all major markets have recorded prime rental growth in the last 12 months. Conversely, secondary rents are likely to fall, or stagnate and the jump in construction costs means that some older offices risk becoming stranded assets, because it is no longer viable to refurbish them.

The impact of sanctions against Russia on investment markets in western Europe is likely to be limited. Russian cross-border investment in commercial real estate globally has averaged only €300 million per annum over the last five years (source RCA). To put that in context, there was €340 billion of investment deals in Europe in 2021.

At the margin the Ukraine crisis might lead to a slight shift in investor demand away from real estate in central Europe and towards markets which are perceived to be safer (e.g. London, Paris, Switzerland). However, its main impact is likely to be indirect via higher interest rates. Rates started to rise last year in anticipation that the ECB would tighten policy, but the further increase since the invasion began means that 10 year government bond yields and bank finance costs are now 1% and 1.5% higher than in March 2021, respectively. In addition, lenders are scrutinising LTV capacity, potentially requiring more equity or amortisation. Although the average gap between eurozone prime office yields and 10 year government bonds a year ago was exceptional (2.9%) and the current gap (1.8% ) is close its the long-term average (2.1%), we think that the era of falling real estate yields is over and that future performance will be driven by income and not capital growth. While index-linked rents mean that faster inflation will feed through to rents, albeit with a lag in countries where the increase in prices first needs to exceed a hurdle (e.g. Germany), it is possible that yields on secondary retail and office buildings will now start to increase. Logistics assets will remain sought after by investors, but the overall appetite seems to decrease over pricing. Investors are also carefully analysing the ESG credentials of their portfolios, which could lead to an increase in assets with low ESG features being disposed off. Here, potential buyers need to be careful to ensure underwriting reflects the required repositioning risk and cost.

In terms of a core investment strategy, we continue to favour Grade A offices in city centres (e.g. Berlin, Lyon, Luxembourg, Madrid, Paris, Stockholm), last mile distribution warehouses, light-industrial assets in established manufacturing hubs, food stores and residential schemes in affluent parts of Germany, the Netherlands and the Nordics. Our preferred targets for a value add strategy are office refurbishments in major cities, the conversion of vacant retail buildings to mixed commercial and residential schemes, multi-let industrial estates, big box stores let to discount, or DIY retailers and hotels with management agreements.

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