Real Estate Research
Continental European real estate market commentary – June 2017
Continental European real estate market commentary – June 2017
The eurozone economy appears to have entered a more robust recovery cycle, as faster growth leads to stronger investment.
While Emmanuel Macron’s election as French president has improved business confidence across the region, the key to increasing investment has been the steady fall in industrial spare capacity since 2013 combined with low interest rates.
There are no signs that the fall in unemployment to 9.3% is pushing up wage awards and core inflation in the eurozone, which excludes energy and food, remains around 1%.
As a result, Schroders expects the ECB to leave its refi rate at zero until 2019 and eurozone GDP to grow by just under 2% p.a. through 2017-2018.
Germany, the Nordics and Spain are likely to lead, while France and Italy will probably lag behind.
The economic recovery is reflected in the office market. In most European cities jobs in IT, media and professional services are growing and net take-up of office space is positive.
In addition, Brexit could give a boost to financial services in certain cities, assuming the UK loses its passporting rights after March 2019.
Frankfurt is emerging as the first choice for investment banks, while asset managers prefer Luxembourg and UK insurers are focusing on Brussels and Dublin.
However, it is important to put these plans in context. For example, while Frankfurt could gain 15,000 new jobs over the next five years in banking and related sectors (e.g. law, IT), that would only be equal to 4-5% of total office employment and at the same time, Deutsche Bank and Commerzbank are reducing the size of their teams.
Given the prospects for further employment growth, we expect to see a broad based increase in office rents across continental Europe over the next 3-4 years. The exceptions are likely to be Barcelona and Madrid, where a big increase in new building threatens to create an over-supply of space in 2019-2020.
In the retail sector, we generally favour out-of-town retail warehouses over town centre shopping centres, because vacancy rates are lower.
To some extent, this is a cyclical phenomenon and reflects the recovery in European housing markets and the greater bias of retail parks to household goods (e.g. DIY, furniture). For example, house prices in Germany rose by 7% in 2016 and by 2-3% in France and Spain as a result of the fall in unemployment and low interest rates.
The difference in vacancy in the retail market reflects two structural factors.
First, shopping centres are more vulnerable to internet retail, because of their greater reliance on discretionary retail such as clothing, which typically accounts for 40-50% of floor space.
Second, the lower level of rents in out-of-town locations means that retail parks are starting to attract a wider range of retailers (e.g. clothing, food, pharmacy), especially those with a discount format.
Despite good demand from online retailers, manufacturers and logistics firms, warehouse rental growth has generally been quite modest. According to CBRE, prime warehouses rents in the eurozone rose by 1.7% over the year to March 2017, compared with a 4.3% increase in prime office rents.
The slower rate of rental growth is partly because 3PLs tend to work on very thin margins and partly because of a big increase in new development of giant warehouses, albeit a lot of this space is pre-let. We prefer smaller, urban industrial estates which are benefiting from the growth in “last mile” deliveries and returned items, located in built up areas where new supply is constrained.
The favourable outlook for rental growth and the significant gap between real estate and 10 year government bond yields means that there is still a large amount of capital allocating towards real estate in continental Europe.
Eurozone REITs have raised equity and those German open-ended funds which survived the crisis of 2009-2010 are also enjoying a revival.
In addition, Brexit means that some investors who might have bought in the UK have switched their attention to continental Europe. However, despite the large amount of capital seeking investments, we think that prime yields are close to their floor, assuming that investors will now start to factor in an increase in bond yields over the medium term.
Similarly, although secondary real estate yields may fall over the next 6-12 months, the cautious attitude of banks towards lending in this segment of the market is likely to act as a brake.
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 mainstay will be an income return of 4.5%, while capital values will be driven primarily by a steady increase 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 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 Schroders communications, strategies or funds.
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