Real Estate Research
Continental European Real Estate: Reasons to be cheerful
The last few years have seen a solid recovery in continental European real estate markets, echoing the improvement in the economy. The upturn in business confidence, employment and company profits has lifted demand for commercial space and almost all European cities have seen a fall in office vacancy and a rise in rents. Prime office rents in continental Europe increased by 6% on average in 2017 (source: CBRE) and prime office capital values rose more quickly, by 15%, as investor sentiment improved and real estate yields fell. Prime logistics capital values also rose strongly by 11% last year, as the growth in online shopping gave an extra boost to warehouse demand. However these same structural forces limited the increase in prime shopping centre capital values to 6%. The question now for investors is will the upswing in rents and capital values continue?
Figure 1. Eurozone GDP vs. office rental growth
Source: CBRE, Eurostat, Schroders, March 2018
If we consider the demand for commercial space then the outlook is promising. Schroders forecasts that eurozone GDP will grow by 2-2.5% through 2018-2019, its best performance since 2007. This reflects our view that the eurozone economy has now achieved “take-off velocity” and is benefiting from a virtuous circle of higher investment, falling unemployment and rising consumer spending. Unemployment fell to 8.6% in January 2018 from a peak of 12.1% in 2013. In addition, the recent acceleration in world trade should benefit export orientated economies like Germany, the Netherlands and the Nordics and several eurozone governments can now afford to either raise expenditure, or cut taxes. Although stronger growth will feed through to higher inflation, Schroders expects it to remain subdued at 1.25-1.5% p.a. over the next couple of years, with the result that the ECB is unlikely to raise interest rates until 2019 and then only gradually.
Winning cities, rather than countries, create demand
Figure 2 drills down to a city level, showing forecast economic growth in major continental European cities over the next five years (source: Oxford Economics). In most countries, the capital or biggest cities are forecast to see stronger economic growth than neighbouring smaller cities and towns. Thus Amsterdam, Berlin, Copenhagen, Helsinki, Madrid, Milan, Munich, Oslo, Rome and Stockholm are all forecast to outperform their national average. However, there are exceptions which suggest that big is not always beautiful. In France, for example, internal migration from the north to the south and west means that Lyon, Nantes and Bordeaux are expected to see faster economic growth than Paris, although the capital’s population should continue to grow thanks to international immigration. Similarly, the Brussels economy is forecast to only grow marginally faster than Belgium over the next five years, because of the high proportion of people working in the EU and government administration.
Figure 2. Economic growth forecasts by city and country: 2017 - 2022
Source: Oxford Economics, Schroders. December 2017
The fastest growing cities typically share four main attributes. First, a diverse economy with a spread of different sectors and a mix of large companies and start-ups. Cities which are dominated by one or two large vertically integrated companies are likely to atrophy in the long-term. Second and directly related to the first factor, is a highly educated labour force, which in turn usually requires a strong university and good schools. Not only do universities often act as a seedbed for new start-ups, but big companies in IT, advanced manufacturing and life sciences are increasingly seeking to collaborate with academics because new products are too complex to develop in-house. Research on US cities suggests that education is the single best predictor of urban success.
Third, thriving cities need a proactive local government with a long-term vision for housing, transport, commercial development, regeneration, schools and hospitals. Fourth, it clearly helps if a city is an attractive place to live with a mix of old and new buildings and a range of cultural attractions including sports venues, museums, theatres and restaurants. Finally, arguably a fifth factor is that in order to flourish, smaller cities need to be a reasonable distance away from a big city, because otherwise the gravitational pull of their bigger neighbour will draw businesses and people away.
Limited supply pipeline underpins real estate returns
If we turn to the supply side of the rental equation, then the outlook is also reasonably benign. While developers are coming out of hibernation, the increase in commercial building has so far been in step with demand and is unlikely to produce an oversupply in most European cities over the next couple of years (see Figure 3). Forecasts suggest that the total floorspace of offices and shopping centres in western Europe’s major cities will grow by 4% over the three years to end-2020, compared with a 10% increase during the building booms of 1990-1993 and 2000-2003 (source: PMA).
Figure 3. European office and shopping centre development pipeline
Source: PMA, Schroders, October 2017. Note data is for France, Germany, Italy, Netherlands, Spain and Sweden.
One reason for this greater discipline is that new regulations following the financial crisis mean that banks are much less willing to lend on speculative schemes. In addition, many of Europe’s big cities have a housing shortage, reflecting strong population growth and city governments are increasingly giving priority to residential schemes. However, while commercial development is generally under control, there are a couple of cities where the supply response looks excessive (e.g. Barcelona, Dublin) and it will be important to keep a close eye on building starts over the next few years.
Mind the (bond yield) gap?
Another potential concern for investors is that a lot of the good news on rental growth is already priced into real estate yields. Prime real estate yields in continental Europe have fallen by 1.5% since the eurozone sovereign debt crisis in 2010—2013 and in most cities they are now below their previous low in 2007. Furthermore, it seems inevitable that long-dated government bond yields will increase, assuming the ECB ends quantitative easing later this year and starts to gradually raise interests in 2019. Schroders expects the ECB to increase the official refi rate to around 2% in 2020-2021 and for the yield on German 10 year bunds to rise to 2.5-2.75%.
Given the likely rise in bond yields, it seems sensible to assume that real estate yields will rise at some point between 2019-2021. However, we expect that the increase in yields will be limited to between 0.25-0.5% for three main reasons. First, although real estate yields have fallen to historically low levels, they are still high relative to government bond yields, so they are unlikely to move in parallel. At present the gap between prime real estate yields and 10 year government bonds is over 3% compared with a long term average of 2%, as shown in Figure 4. Second, real estate yields are also heavily influenced by rental growth prospects and they are unlikely to rise sharply so long as the outlook for the eurozone economy is favourable and development remains measured. Third, there is a large amount of capital in Asia which is targeting continental European real estate. While some of this capital is tactical and aiming to maximise returns, quite a lot of Asian investors are taking a long term strategic view and seeking diversification away from their domestic market.
Figure 4. Real estate investment yields by sector vs. 10 year bond yields
Source: CBRE, Datastream, Schroders, March 2017. Note 10 Year Bonds are an average of France and Germany.
Structural and thematic change offers opportunity
Despite the positive outlook for the eurozone economy, our strategy is to focus on those parts of the market which are benefiting from structural change and which should be resilient through the economic cycle. A good example is the industrial and logistics sector, which is gaining not only from a cyclical upturn in demand from manufacturers, but also from the long-term structural growth in on-line shopping. The internet now accounts for over 10% of retail sales in northern Europe and in round terms, each extra €1 billion of online sales generates demand for an additional 100,000 square metres of warehouse space. Online retailers require more warehouse space than traditional retailers, because they do not hold stock in store, they have to handle a much higher number of small deliveries and they have to process more returned items. Around a quarter of online clothing and footwear orders are returned. While developers have responded by building more, supply is still lagging behind demand in most cities and we expect that both big warehouses in strategic distribution locations and smaller “last mile” warehouses close to big cities will see sustained rental growth over the next few years.
We also like data centres which are seeing very strong demand. This is primarily being driven by the explosion in data from mobiles and other connected devices – the volume of stored data is forecast to increase tenfold between 2016 and 2025 (source: IDC) – but it also reflects a switch by companies away from in-house IT to external cloud based services, which can be bought on a pay as you go basis, like electricity. While the supply of data centres is also increasing and vacancy has risen recently in Amsterdam and Frankfurt, there is a shortage of freehold sites with the necessary power supply and rates for space in colocation facilities are likely to increase over the medium term.
Another part of the market we favour are tech clusters in big European cities (e.g. Amsterdam, Berlin, Paris, Stockholm) and certain smaller university cities (e.g. Grenoble, Karlsruhe, Leipzig, Lund & Malmo, Utrecht). IT and digital media are forecast to be one of the fastest growing parts of the economy over the next five years, but the industry is highly concentrated in certain cities where there is a pool of expertise and once established, that pool then tends to draw people away from other places. The challenge for real estate investors is to provide the right type of space for tech occupiers and to anticipate where the cluster will spread to, as it grows. We are also seeing increasing demand from life science companies for offices and laboratories in city centres which are close to universities and research institutes.
Finally, we also see value in certain districts of big cities which are set to benefit from major regeneration projects and new transport links. The Grand Paris project to build new metro lines between Paris suburbs is currently the biggest transport project in Europe and we think there are good opportunities in Boulogne-Billancourt, Clichy and Montrouge, where office yields are 1-1.5% higher than in the city centre. Likewise, the new North-South line 52 in Amsterdam due to open later this year will make the Noord area much more accessible, while Stockholm has ambitious plans to extend its metro north to Hagastaden and Solna and south to Sodermalm and Nacka.
Reasons to be cheerful
In conclusion, we think there are several reasons to be cheerful about continental European real estate. Solid economic growth and rising company profits should lift demand for space; banks’ reluctance to lend on speculative schemes should keep development under control and prevent an over-supply; and real estate yields are unlikely to rise in parallel with interest rates and bond yields. We believe that office and industrial rents and capital values will continue to increase over the next few years, particularly in winning cities such as Amsterdam, Berlin, Hamburg, Helsinki, Lyon, Munich, Paris and Stockholm which have strong universities and diverse economies. The exception will be retail where demand will be undermined by the rapid growth of online shopping. We believe that the capital value of many shopping centres in northern Europe has already peaked.