Real Estate Research

Continental European real estate market commentary – December 2017

31/12/2017

The eurozone economy is estimated to have grown by 2.3% in 2017, its best year since 2007, and ahead of the USA.  The catalyst was an acceleration in world trade and exports, but higher investment, falling unemployment and rising consumer spending also contributed.  Schroders forecasts that eurozone growth will slow slightly to 2% p.a. in 2018-2019, mainly because higher oil prices will lead to a small pick-up in inflation.  However, inflation of 1.4% will not concern the ECB and Schroders does not expect it to raise interest rates until 2019, and then only gently.  The biggest immediate risk to the growth outlook is probably stemming from geopolitics. Political issues in Europe such as the Spain-Cataluña dispute over independency or a possible stalemate following elections in Italy remain, but will most likely only have limited impact on the eurozone’s economic momentum. 

Continental Europe is now seeing a widespread recovery in office rents, driven by the growth in employment in professional services, tech and media.  Vacancy fell and prime rents rose in almost every major city in 2017 and rents in the tech districts of Amsterdam and Berlin increased faster than in the city centre.  Oxford Economics forecast that private sector office employment in the eurozone will grow by a further 1.3% pa between end-2017 and end-2022.  The obvious concern is that the upswing will be swamped by a building boom as developers come out of hibernation.  However, while there are some examples (e.g. Barcelona, Dublin, Rotterdam), in several cities building starts are still surprisingly modest, given the low level of vacancy (e.g. the main German cities Amsterdam).  The main reason is that tighter capital requirements mean that banks are much less willing to fund speculative schemes than in the past, but it is also possible that there are now simply fewer office developers after the setbacks of 2002-2004 and 2009-2013. 

Similarly, industrial and logistics in continental Europe are seeing a broad based upswing in rents.  In part this is being driven by the cyclical recovery in retail sales, manufacturing and exports, with Rotterdam, Europe’s largest port, reporting record levels of container traffic in 2017.  This is also a function of the rapid growth in online sales as pure internet retailers like Amazon, Cdiscount and Zalando expand and as traditional retailers reconfigure their supply chains to deliver to homes as well as shops.  In aggregate the increase in prime logistics rents at 2-3% p.a. is slower than growth in prime office rents at 4-5% p.a. (source: CBRE), because the sector has seen a bigger supply side response.  However, the vast majority of new warehouse space is being built on a pre-let “build to suit” basis and vacancy in most locations remains low.

Growing competition from online sales means that the European retail markets present a more mixed picture.  Some formats which are relatively internet immune are trading well, such as mid-sized food supermarkets, bulky goods retail parks, shops in tourist locations and big shopping centres with a strong food and leisure angle which dominate their catchment.  Elsewhere, many hypermarkets and department stores which previously used to sell large amounts of clothing and electrical goods are struggling, despite repeated attempts to re-invent themselves.  Likewise, the middle and lower tiers of shopping centres in France and Germany, where internet penetration is high by European standards at 10% and 15% of total sales respectively, are having to contend with fewer shoppers and rising vacancy.

Most countries saw an increase in the value of investment transactions in 2017 compared with 2016 buoyed by strong investor interest and high pricing.  The main exceptions were France where there was a temporary pause ahead of the presidential elections in May, and Sweden where deals have been held up by government proposals to change the tax treatment of corporate structures.  Markets are however continuing to see high competition between investors and product is in some cases scarce. In general we currently see better value in assets which have good bricks and mortar fundamentals, are located close to existing or new transport links (e.g. Helsinki Länsimetro, Grand Paris), located in mixed use areas, are let at affordable rents and have short unexpired leases.  While government bond yields are expected to rise in the medium-term, it is not inevitable that real estate yields will immediately follow if the outlook for the eurozone economy remains positive.  The US market may provide a precedent where office and industrial yields have been flat since mid-2016 despite a 1% rise in 10 year government bond yields.

Assuming the eurozone economy continues to grow, we forecast potential total returns of 5-7% p.a. on average investment grade European real estate between end-2017 and end-2021.  We expect the main component part of this to be an income return of 4.5%, while capital value growth should be generated by rental growth.  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, Frankfurt, Madrid, Munich, Paris, Stockholm and Stuttgart.  We also like certain smaller university cities which share many of the same characteristics. 

 

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