European real estate offers value despite political risk
Continental European real estate offers more value than other regions, but moderate returns are expected over the next five years, says Monika Sujkowska.
European real estate continues to benefit from rising occupier demand, underpinned by a gradual economic recovery and limited development activity.
Improving fundamentals and favourable relative pricing on the back of ultra-low bond yields have driven investor demand. Denmark, Finland, Sweden, the Netherlands and the countries of Central and Eastern Europe (CEE) have seen particularly significant rises in transaction volumes over the year to date, according to CBRE data.
We forecast total returns on European real estate of between four and five per cent per annum over the next five years, with the industrial and retail sectors likely to perform particularly well. However, our forecasts are frontloaded: we expect gradually rising bond yields to make the asset class less attractive on a relative basis as the end of the decade approaches.
Outlook by sector
European prime office occupier markets are in good health. Average euro zone office rents grew by over three per cent in the third quarter and the vacancy rate is the lowest it has been since 2009 thanks to strong leasing activity and modest new supply.
We expect office markets that attract knowledge-intensive employment to outperform. We are especially positive about Berlin, Paris La Défense, Amsterdam and Barcelona, which we expect to deliver the highest rental growth over the next five years. The office sector is likely to deliver lower returns than retail and industrial because it is more advanced in the cycle.
European prime high street retail markets are benefiting from a recovery in consumer spending and, more importantly, from a polarisation in the retail sector. In a multi-channel world, occupying the right building in the right location has become increasingly important for a company’s brand. As a result, retailers are willing to accept higher occupancy costs in the best locations. Conversely, they avoid less attractive out-of-the-way locations that are more vulnerable to competition from online retail. We expect rental growth in the most prized high street locations in Dublin, the CEE and Spanish cities to outperform in the medium term.
The prime industrial market has benefitted from the rise in online retail and performed reasonably strongly in 2016 on the back of rental growth as well as yield compression. We expect prime industrial markets in CEE, Spain and Ireland to outperform over the next five years.
Risks are on the rise
Political risk is rising in Europe. A series of crucial elections will take place over the next 10 months following the recent Italian referendum, which led to the resignation of Prime Minister Matteo Renzi. The European Central Bank (ECB) has decided to extend its quantitative easing programme until the end of 2017 in an attempt to support growth. However, the bank also signalled that it would gradually start moving away from its extraordinary loose monetary policy stance by reducing its asset purchases from €80bn to €60bn per month.
We nevertheless expect European bond yields to remain low by historical standards due to weak inflationary pressures. The ECB’s forecast is for inflation to remain below the target until at least 2019. We anticipate European bond yields will increase gradually in the medium term, remaining below historical norms. Real estate will continue to look relatively attractive in this scenario.
The risk of a correction in European bond markets due to arbitrage effects from higher yields in the US can not be discounted however. If higher bond yields are not accompanied by faster economic growth and rising inflation, and thus higher rental growth, real estate would offer a lower premium relative to bonds. This would erode the relative attractiveness of the asset class.
Given ongoing uncertainty surrounding the political situation in Europe as well as the risk of a correction in bond markets, low-yielding assets with little growth potential and secondary assets with high exposure to income risk – especially those located in peripheral economies – currently look unappealing. Good quality assets with low leasing risk and some growth potential are more attractive.
Total Return Forecasts 2017-’21 (% p.a.)
Source: Aviva Investors, November 2016. Note: CEE-2 covers Hungary and Czech Republic, CEE-3 additionally covers Poland
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