Real Estate Research

Continental European real estate market commentary - Q4 2018

Schroders forecasts that Eurozone economic growth will slow from 1.9% in 2018 to around 1.5% p.a. through 2019-2020, in line with its long-term average.

18/01/2019

Schroders forecasts that Eurozone economic growth will slow from 1.9% in 2018 to around 1.5% p.a. through 2019-2020, in line with its long-term average. Slower growth in China and the USA will weigh on exports and European manufacturers are expected to hold back on investment. We forecast that the ECB will finally begin to follow other central banks and raise the refi interest rate from zero to 1% by the end of 2020. Consumer spending should be stable, partly because most mortgages in the eurozone have fixed rather than variable interest rates and partly because real incomes will be supported by rising employment, higher pay awards and lower oil prices.

Most major European cities saw a fall in office vacancy and increase in rents in 2018. Prime rents in city centres rose by 5-10% and the shortage of space meant that rents in adjacent locations often rose in parallel. The key driver was an increase in employment in media, tech and professional services. Demand from financial services was subdued, although there were a few Brexit-related lettings in Frankfurt, Luxembourg, Dublin, Amsterdam and Paris. We believe that the upswing in office rents will continue through 2019-2020, although we expect that the rate of growth will slow, in keeping with the broader economy. While office development has started to revive, the lack of bank finance for speculative schemes is exercising a restraining influence and should prevent an over-supply in most cities.

The European logistics sector saw strong demand last year from manufacturers, third party providers (3PLs) and retailers, although total take-up was below the record set in 2017. The shortage of labour and rising labour costs in Germany and the Netherlands, and ongoing pressure on margins more widely, is encouraging occupiers to automate more tasks and to build new warehouses outside the main distribution hubs where staff are more available. In general, supply has kept pace with demand, so that prime rental growth has been weaker than in the office sector, at 1-2% p.a. We expect it to maintain that trend over the next few years. While demand from manufacturers might weaken, the growth in online retail will fuel demand for both big fulfilment centres and smaller “last mile delivery” units on industrial estates.

The retail sector is in flux. In northern Europe the main issue is the rapid growth of on-line retailing, which now exceeds 10% of total sales in France and Germany. As a result, stores sales are flat, or falling in volume terms and structural vacancy is increasing. In Italy and Spain, internet penetration is lower and stores sales are increasing, but there is growing amount of new space under construction. We believe that the most defensive retail types will be shops in big city centres and tourist destinations, convenience stores, mid-sized supermarkets and out-of-town retail warehouses selling bulky goods. We expect that department stores, shopping centres with a heavy reliance on clothing and footwear, shops in smaller cities and hypermarkets will suffer a sustained fall in rents.

Intense competition among investors has driven yields on prime assets to record low levels. Prime office yields in most central business districts (CBD) are between 2.9-3.5%, and prime shopping centre and logistics yields are between 3.5-4.25% and 4.0-4.5%, respectively. Our strategy for offices in big cities is either to add value by redeveloping older buildings in the CBD, or to invest in adjacent areas which are being transformed by a tech cluster or new transport links. These are typically available at higher yields and examples include the ArenA in Amsterdam; Kreuzberg-Friedrichshain in Berlin; Boulogne-Billancourt, Clichy and Montreuil in Paris and Solna in Stockholm. In the industrial market we favour multi-let estates and smaller distribution warehouses where it is still possible to buy good assets on yields of 5% or higher. We also see value in hotels with management agreements. We are cautious about most retail assets, because we do not believe that current yields reflect the risks of higher vacancy and lower rents.

While the increase in interest rates and bond yields will put upward pressure on real estate yields, we think that the increase in office and logistics yields over the next few years will be limited to 0.25-0.4%, assuming that the eurozone economy continues to grow. Historically, real estate yields are more strongly correlated with prospects for rental growth than bond yields. The exception is likely to be the retail sector where investors’ concerns about the challenge from online sales could prompt a sharper increase in yields.


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