Real Estate Research
Continental European real estate market commentary - June 2018
Although economic growth in the eurozone slowed in the first quarter of 2018, the main cause was bad weather and a flu epidemic in northern Europe. Italy and Spain were unaffected. Schroders forecasts that eurozone GDP will grow by 2-2.5% through 2018-2019, its best performance since 2007. Consumer spending should be supported by an increase in employment and rising real wages and the recovery in corporate profits and decline in spare capacity since 2014 should drive higher business investment. While stronger growth will feed through to faster inflation, Schroders expects it to it to stay below 2% over the next couple of years, with the result that the ECB is unlikely to raise interest rates until 2019 and then only gradually. There are two known unknowns. First, a full blown trade war with the USA, which would not only hit the eurozone directly through exports to the USA, but also indirectly, assuming weaker growth in China and elsewhere. Second, the governing coalition of far right and far left parties in Italy could unravel, triggering a new sovereign debt crisis.
The strength of the economy is reflected in continental European office markets. The majority of cities saw positive net absorption in the first quarter of 2018 and vacancy rates in Amsterdam, Brussels, the big German cities and Stockholm are at their lowest level in 15 years. Consequently, nearly every European city saw an increase in prime office rents in the year to March 2018 and in several cities the fastest rental growth is now outside the central business district in a tech hub, or area benefiting from new transport. While there is a risk that this upswing in rents will trigger a building boom and self-destruct, in most cities the upturn in office development has so far been in step with demand, adding less than 1% p.a. to total floorspace. We expect that Amsterdam, Berlin, Munich, Oslo and Stockholm will see the biggest increase in average grade office rents over the next three years.
Similarly, the logistics market in continental Europe is seeing strong demand, thanks to the rapid growth in e-commerce, the growing importance of re-cycling and the recovery in manufacturing. For example, BMW, Robert Bosch and Volkswagen all leased big new warehouses in Germany in the first quarter of 2018. However, while office rental growth is currently running at 5% p.a., logistics rental growth is significantly slower at around 2% p.a. (source CBRE). The difference can probably be explained by the higher level of building in the logistics market in recent years and last-mile logistics units, which tend to be in more supply constrained urban locations, have generally seen faster rental growth than big warehouses. Arguably another factor is that retailers, manufacturers and logistics companies have lower profit margins and are more cost conscious that the average office occupier.
By contrast, retail real estate markets are polarising as the internet captures most of the growth in sales. The trend is clearest in northern Europe where online sales now account for over 10% of total sales. The average vacancy rate in mid-sized shopping centres in France and Germany has risen to 8-9% from 2-3% ten yeas ago and structural vacancy has also increased in Benelux and the Nordics. Furthermore, the growth in prime shop rents in Paris and the big German cities appears to have stalled, as the closure of department stores creates vacant space and as some luxury retailers downsize in order to cut costs. The most defensive parts of the market are big shopping centres which dominate their catchment area and smaller supermarkets. In addition, out of town retail parks are benefiting from the growth of discount retailers (e.g. Action, Deichmann, KiK, Rossmann) who are attracted by the relatively low level of rents.
The continental European investment market remained active in the first quarter of 2018 with €35 billion of transactions, reflecting strong interest from a range of domestic, Chinese, South Korean and US investors. Looking forward, Schroders expects that the yield on German 10 year bonds will rise to 2.5% by 2022. While that will put upward pressure on eurozone real estate yields, we think that the increase in office and logistics yields between end-2019 and end-2022 will be limited to 0.25-0.4%, assuming that the eurozone economy continues to grow and prospects for rental growth remain favourable. The exception could be the retail sector where investors’ concerns about online diversion and future rental growth could lead to an earlier and sharper increase in yields.
We forecast total returns of 5-6% p.a. on average investment grade European real estate between end-2017 and end-2022. The main component will be an income return of 4%, while capital value growth should be generated by rental growth. We expect that certain major cities which have diverse economies, a large pool of skilled labour, good infrastructure and are attractive places to live will out-perform the wider market. Examples include Amsterdam, Berlin, Hamburg, Frankfurt, Madrid, Munich, Paris, Stockholm and Stuttgart. We also like certain smaller university cities which share many of the same characteristics.