Europe real estate outlook: three predictions for 2019

Aviva Investors analysts Souad Cherfouh and Vivienne Bolla discuss the outlook for European real estate.

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A number of factors threaten demand for European real estate in 2019, not least Brexit, trade tensions and rising interest rates. However, there are some optimistic signs. Brexit talks and the US-China trade dispute could still be resolved satisfactorily. And interest rate rises will be, for the most part, gradual, which should result in continued demand for real estate assets from institutional investors. Appropriate strategies will be needed to mitigate late-cycle risks.

Against this backdrop, here are our three predictions for property markets in continental Europe in 2019, covering the key risks and opportunities.

1. We are at a late stage of the cycle…

With global monetary policy now set to tighten, the search for yield is easing somewhat – although it should be noted that property will still offer an attractive risk premium over the medium term. For example, the yield on German 10-year Bunds is expected to rise to just 1.6 per cent by the end of 2021, compared with an average of 4.3 per cent between 2000 and 2007 (see figure 1). While flows into riskier, less-established parts of the real assets universe may start to slow, prime property assets in locations supported by favourable economic conditions will remain in demand and are less likely to experience significant repricing.

Moderation in returns is expected from next year. We forecast an average annualised return of 3.1 per cent across prime European commercial real estate markets between 2019 and 2023, against an expected average return of 14.2 per cent between 2014 and 2018.

Compared to the previous cycle, we believe there are reasons to be optimistic as the risks around supply and leverage are relatively weak compared to the previous peak. Furthermore, the European economy and occupier markets are expected to remain strong.

2. …which requires an appropriate strategy

At this stage in the cycle, real estate investors in Europe are relatively poorly compensated for taking on extra risk. Positioning defensively is the most appropriate course of action. To enhance income-producing strategies, investors should look at opportunities to improve or create income growth by actively managing, repositioning and developing assets in strong locations.

Another way to play against the cycle is to look for opportunities where thematic factors are supportive. In other words, long-term structural drivers of real estate that are likely to provide opportunities include technological change, automation, shift in consumer preferences and demographics.

As direct investments become more expensive in some markets, the case for real estate debt and real estate investment trusts (REITs) is becoming more compelling in Europe. Investors in real estate debt can expect to receive income and – provided capital is sensibly lent – little capital value risk.

REITs also continue to offer good value. European REITs traded at an average discount of 10.3 per cent to net asset value in the third quarter. On this basis, REITs should offer a better entry point than direct investments next year if they remain expensive.

3. European sub-markets may offer positive risk-adjusted returns

As the macroeconomic backdrop becomes more challenging, investors are advised to focus on local drivers of demand. In Europe, emerging sub-markets in urban centres may offer a way of taking some risk to create value; fast-growing sub-markets can display significant growth and outperformance compared with the wider market, especially if they stand to benefit from urban planning or infrastructure development projects.

A good example is the Grand Paris infrastructure development, which is improving transport links and promoting development in areas on the outskirts of the French capital.

Figure 1. Property risk still offers cushion against significant yield expansion in 2019
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