European Market Commentary: Q4 2021

Europe continues to be affected from the Covid-pandemic with infections caused by the new Omicron variant dwarfing any previous waves. Yet, cases seem to be much milder with hospitalisation rates and deaths significantly lower then in previous waves, driven largely by the continued progress in  the vaccinations campaigns. The rapid spread, high case numbers and need for people to isolate is however a risk for the workforce and countries across Europe have introduced some renewed measures to contain the spread. This will likely decelerate the pace of economic recovery at the start of 2022 and growth forecasts have been slightly downgraded. Schroders now forecasts that the eurozone economy will grow by 5% this year and by 2% in 2023, assuming current Covid restrictions are relaxed in the Spring.  Initially, the main driver will remain consumer spending, but exports and investment should see a stronger contribution again later this year, once supply chains normalise. In addition, southern Europe should benefit from a recovery in tourism. The main downside risk is that inflation gets stuck at 5% and the ECB is forced to hike interest rates.  However, Europe’s furlough schemes mean that, unlike in the USA, few people have left the labour force and upward pressure on wages is lower, with some exceptions.  We therefore expect eurozone inflation to slow sharply in the second half of 2022 and that the ECB will not start to raise interest rates until 2023 and then only gradually.

Unfortunately, on-line competition means that shops and shopping centres are unlikely to benefit from the forecast growth in consumption.  On-line’s share of total sales in northern Europe ex.UK is forecast to rise from 14% in 2021 to 21% in 2024 and in-store sales are likely to fall by 3-5% in volume terms and flatline in cash terms.  While discount retailers will continue to expand and some vacant stores in city centres will be redeveloped into apartments, or other uses, this will be insufficient to stop a further increase in vacancy.  We expect that shop and shopping centre rents in continental Europe will continue to fall significantly over the next two years.  By contrast, out-of- town big box units and food stores are likely to see rental growth of 1% p.a. and 2% p.a., respectively.  Both types are less exposed to on-line retail, rents and service charges are generally deemed affordable and they are easily accessed by car.

Warehouse take-up in continental Europe hit a new record in 2021 and is likely to remain strong in 2022.  The main driver is on-line retail as both pure internet and conventional retailers increase their on-line sales and reduce delivery times.  On-line retail requires 2-3x times more warehouse space than conventional retail.  In addition, the sector is benefiting from a recovery in demand from 3PLs and manufacturers which is partly cyclical, but also partly structural as the recent disruption of supply chains has encouraged companies to hold more stock and move away from just-in-time inventory management.  However, strong demand has been matched by a big increase in development and while vacancy rates in most big cities are low at 4-6%, some occupiers are willing to take new warehouses in smaller towns, where costs are lower.  Consequently, we expect logistics rental growth to continue at 2-3% p.a. through 2022-2023. Urban logistics is expected to see stronger rental growth of 5%+ over the medium term.

The second half of 2021 saw a strong rebound in office demand in continental Europe, but take-up remained 20-25% below pre-pandemic levels.  Although this year should see a further recovery, we think that the shift to more hybrid working means that take-up will remain 15% below its 2019 level.  Looking further out, demand should grow however in line with the increase in jobs in tech, media and professional services.  The market is seeing a huge acceleration in the polarisation between prime and secondary offices.  Demand for modern offices with cutting-edge building technology and strong ESG-credentials is growing fast as companies look to tempt staff back into the office and cut carbon emissions.  In Germany “green” offices accounted for 31% of city centre take-up over the 12 months to June 2021, despite accounting for only 9% of floorspace.  Given also the low level of supply, we expect that prime rents in e.g. Berlin, Luxembourg, and Stockholm will increase by 3% p.a. over the next three years. Conversely, secondary rents are likely to fall, or stagnate and the recent jump in construction costs means that some older offices in secondary locations  risk becoming stranded assets, because it is no longer viable to refurbish them.

The eurozone investment market gathered momentum through last year and the total value of transactions in 2021 was close or even above to pre-pandemic levels especially when taking into account the number of entity-level transactions.  The most liquid parts of the market were apartments, food stores, life sciences, logistics / industrial and prime offices, whereas there was only limited interest in hotels, shopping centres and secondary offices.  So far there have been few distressed sales of hotel and retail assets, although this is expected to change as banks look to limit non-performing loan exposure.

The last seven years have seen a continuous compression in food store, prime office and industrial/logistics yields in continental Europe, as investors have re-allocated capital from sectors such as retail, but also from e.g. bonds to private assets including real estate.  Although logistics could see a further fall in yields this year, given the weight of capital targeting the sector, we think the probability that the ECB will raise the refi rate in 2023 means that real estate yields will generally be flat in 2022.  Government 10 year bond yields have already risen by 0.5% over the last 12 months in anticipation of the ECB’s move, so the real question now is how much further would bond yields have to rise before they put upward pressure on real estate yields?  That will depend on two factors.  First, the gap between real estate yields and 10 year bonds which have narrowed, but are still above their long term average of c.200 bp.  Second, prospects for future rental and income growth.  Assuming that rents increase in line with our forecasts, we estimate that 10 year bond yields could increase by another 0.5-0.75% before prime yields react.  The threshold for secondary assets is probably slightly lower, reflecting the lower potential for rental growth and capital expenditure concerns.

In terms of a core investment strategy, we currently favour Grade A offices in city centres (e.g.  Berlin, Lyon, Luxembourg, Madrid, Paris Stockholm), last mile / urban distribution warehouses, 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 alternate uses such as mixed commercial and residential schemes, multi-let industrial estates, big box stores let to discounters, or DIY retailers and hotels with management agreements.

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