Real Estate Research

Continental European real estate commentary December 2016

15/01/2017

The eurozone economy is steadily returning to normal. Total GDP is now 3% above its previous peak in 2008, net bank lending has turned positive, unemployment fell below 10% in September and core inflation, excluding energy, has settled at 1%. As a result, the ECB is becoming less concerned about deflation and has trimmed its programme of quantitative easing, marking the first step towards an eventual increase in interest rates, probably in 2019. Schroders expects the eurozone economy to continue to grow by around 1.5% p.a. through 2017-2018. While higher energy prices will curb consumer spending a little, a number of governments are planning to increase spending and eurozone exports should also gain from stronger growth in the USA and emerging markets. Among the big economies, Germany and Spain should lead, while France and Italy are likely to lag behind.

The benign outlook for the economy is reflected in the growing demand for office space in continental Europe. Take-up is benefiting from rising employment in media, tech and professional services and a lot of the expansion is in cheaper locations adjacent to city centres, where there is modern office space and good infrastructure (e.g. City Sud in Hamburg, the inner southern periphery of Paris, Solna in Stockholm). Almost every European city saw a fall in office vacancy in 2016 (source PMA) and the recovery in prime rents which started in 2014 is now feeding through to rents on average grade space. Looking forward, the upswing in rents should also be supported by relatively modest levels of new office building. In part this is because banks are still reluctant to lend on speculative projects and in part it is because residential schemes are generally more profitable for developers.

By comparison, the main issues for retail real estate are structural, rather than cyclical. In the non-food sector, the big challenge is the rapid growth of online sales, particularly of clothing and footwear, which typically account for 40-50% of shopping centre space. In the food sector, the key challenges are the switch by consumers away from hypermarkets and the simultaneous growth in discount stores, organic / craft food and eating out. Consequently, retailers’ profit margins are under pressure and we expect that, on average, retail rents will lag behind office rents over the next couple of years. We favour mid-sized supermarkets, convenience stores and out-of-town retail warehouses, because consumers still wish to touch items like food, furniture, DIY and homewares before they purchase and because these stores have plenty of car parking and are convenient for click & collect sales.

The growth in online retail has generated record demand for warehouses in continental Europe (source JLL). However, unlike in the retail and office sectors, there has also been a jump in new supply and some developers are starting to build multi storey warehouses, which are already common in Asia. We therefore prefer smaller industrial estates which are benefiting from the growth in “last mile” deliveries and returned items, but which are in built up areas where new supply is constrained.

Turning to the investment market, we think that the era of yield compression in continental Europe is now largely over and that real estate yields will be broadly flat over the next couple of years, for two reasons. First, despite the favourable outlook for rents and the large gap of 3-4% between real estate and government bond yields, we expect that the recent upturn in eurozone bond yields will draw some capital back to fixed income. Second, we anticipate that certain investors who entered the market in 2012-2014, such as the US opportunity funds, will now start to sell and take profits.

We forecast total returns of 5-7% p.a. on average investment grade European real estate between end-2016 and end-2020, assuming the eurozone economy continues to grow. The bedrock will be an income return of 4.5%, but capital values should also increase on the back of a steady rise in rents. Our strategy is to focus on certain major cities which have diverse economies, a large pool of skilled labour, good infrastructure and are attractive places to live. Examples include Amsterdam, Berlin, Hamburg, Madrid, Munich, Paris, Stockholm and Stuttgart. We also like certain smaller university cities which share many of the same characteristics.

The obvious downside risk is politics. This year will see a number of general elections in Europe and we cannot rule out the possibility that populist parties opposed to membership of the euro will take power in France and the Netherlands. The election of Marine Le Pen in France could be particularly disruptive, given the size of the French economy. In addition, there is a lot of uncertainty over Donald Trump’s economic policy and a move towards greater protectionism would particularly hit export orientated economies like Germany and Sweden. The USA accounts for 15% of eurozone exports.


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