Continental European Real Estate Market Commentary - March 2015
The current combination of GDP growth running at 2.8% and zero inflation is probably as good as it gets in the short-term. Schroders expects inflation to increase to 1.5% by the end of 2015, as the fall in oil prices drops out of the calculation, and for GDP growth to slow slightly to 2.6% this year and 2.0% in 2016.
After a pause in the middle of last year, the eurozone economy is gathering strength. All the major economies except Italy grew in the fourth quarter of 2014 and the recent rally in business confidence suggests that companies are coming to terms with the Ukraine crisis and the risk of Greece leaving the euro. Schroders expects the strongest levels of growth from Spain and Germany at 2% per annum through 2015-2016. Conversely, growth in France and Italy is expected to be weaker, at 1% and 0.6% per annum, respectively. The collapse in oil prices and low inflation has boosted households’ real incomes and most eurozone governments have now completed or eased their austerity programmes. In addition, the start of Quantitative Easing (QE) has cut borrowing costs in southern Europe and triggered a sharp depreciation in the euro versus the US dollar and sterling, which will benefit exporters.
Office markets in continental Europe fall into two main camps. In the big German cities and Stockholm, employment in finance, business services and new media & IT has been growing steadily since 2011, vacancy rates have fallen below equilibrium levels and office rents are rising in most locations. Conversely in Brussels, Copenhagen, Madrid and Paris a lot of recent lettings have involved occupiers rationalising their space in order to cut costs, resulting in vacancy rates above their long-term averages. However, even in these cities there are attractive sub-markets with low vacancy (e.g. southern Paris, Centre and Leopold districts of Brussels, Madrid CBD) and we expect them to lead the upswing in rents as demand recovers later this year.
On a positive note, there are no signs that deflation is leading consumers to defer purchases. Eurozone retail sales grew by a healthy 3.7% in volume terms over the 12 months to January. However, demand for retail space remains tepid, because many retailers are focusing on their online offering and improved logistics. Online accounted for 10% of German retail sales in 2014, up from 4% in 2010 and this trend is echoed in many other eurozone countries. The strongest parts of retail real estate are big dominant shopping centres, major tourist destinations, small shopping centres with a strong food offer and big boxes in towns with good population growth and active housing markets.
After a prolonged period of oversupply the logistics market has got back to equilibrium. Take up in WesternEurope rose by 10% in 2014, as retailers and logistics operators reconfigured their supply chains and prime rents rose slightly in Dusseldorf, Frankfurt and Rotterdam. Looking ahead, our real concern is that speculative development will bounce back quickly, given short lead times. We therefore favour mid-sized warehouses close to big cities, where supply is restricted.
The total value of investment transactions in continental Europe rose by 10% in 2014 to €145 billion (source: RCA) as liquidity rippled out from the core markets of France and Germany to Benelux, Italy, Portugal and Spain. The majority of capital invested was equity, but the last year has seen a definite increase in real estate lending given finance costs have fallen further to 1-2% and new entrants into the market such as insurers and debt funds.
The weight of capital means that prime office and shopping centre yields have fallen to 4-5% in most major cities in Western Europe and prime logistics yields to 6%. While this might look rational in the context of 10 year government bond yields at 0.2-1.25%, investors are concerned that pricing of prime assets has become indiscriminate. We see better value in CBD offices which have short leases, or which can be repositioned, offices in mixed-use areas with a good range of amenities, convenience retail, mid-sized warehouses around big cities and certain alternative types (e.g. hotels). Yields on these assets are typically 0.5-2.0% above those on prime assets and we expect them to outperform over the medium-term, assuming the eurozone economy continues to grow.
We forecast total returns on average investment grade European real estate will be 7-9% per year between end-2014 and end-2018. Total returns and capital growth are likely to be front loaded, benefitting from yield compression in 2015-2016 and rental growth from 2016 onwards.
The main upside risk is that the low financing costs and the weight of money targeting real estate triggers an even bigger fall in yields through 2015-2016,boosting total returns in the short-term. The main downside risks are increased uncertainty surrounding the stability of the eurozone following a potential Greek exit of the euro and elections in Spain, or deflation becomes entrenched.
The views and opinions contained herein are those of Schroder Real Estate Investment Management Limited and may not necessarily represent views expressed or reflected in other Schroder communications, strategies or funds.
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