Rates, retail and polarisation: three themes for UK and European real estate

Jonathan Bayfield and Vivienne Bolla discuss the outlook for UK and European real estate.

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Current conditions make these uncertain times for UK and continental European real estate. Investors are increasingly concerned that the global economy is slowing down, with particular implications for Europe. This is, in part, driven by political events such as Brexit, the French ‘yellow vest’ movement, Italian populism and Catalan independence, all of which can weigh on demand.

In that respect, the European parliamentary elections of 23-26 May presented a key risk, with populists making significant gains in some countries. But they fell short of securing enough votes to have a decisive say in the future direction of Europe, giving investors some respite.

Although economic sentiment has continued to decline, first-quarter activity was surprisingly positive in Europe, supported by good performance in Spain and France and a return to growth in Germany and Italy, which should result in continued demand for real estate.

In this context, our base case is of an economic slowdown rather than a recession, supporting three key trends for UK and continental European real estate.

1. Lower interest rates are extending the cycle

At the end of last year, we expected interest rates to start rising and therefore demand for real estate to be subdued. However, fears of a potential slowdown have put rate rises on hold. For investors,  lower rates will extend the real estate cycle: even at their current levels, real estate yields are higher than government bonds yields. In April the market’s forecast for the ten-year German bund yield in 2020 was 0.1 per cent, compared to our assumption of a 3.2 per cent equivalent yield for Europe (ex UK) All Property. Similarly, the market’s forecast for ten-year UK gilt yields in 2020 was 1.6 per cent, compared to our assumption of 5.5 per cent for the equivalent UK All Property yield.

Real estate also remains attractive compared to other income-producing asset classes such as investment-grade and high-yield corporate bonds. And while we anticipate lower returns in the UK and continental Europe, they should still compare favourably with other regions.

Thanks to lower interest rates, investors can now find positive total returns in several markets across the UK and Europe (Figure 1). In this context of medium cyclical risk, London and Manchester appear to be in a better position than many other European cities. This is mainly because price growth paused after the 2016 referendum on the UK’s membership of the European Union compared to other markets, giving the two cities a comparative advantage. But we also expect Germany and the Netherlands to see a strong occupier market, especially in the office and logistics sectors.  

At this stage in the cycle, debt may be more appropriate than equity for investors. We forecast varied negative rental and capital growth in different sectors in the UK over the next five years, from shopping centres to retail units in small and large towns. In the rest of Europe, rental and capital growth values compare more favourably.  We are adopting a defensive positioning, focusing on income-producing strategies, and generally moderating exposure to developments that have not been significantly de-risked.

2. European retail faces headwinds

 Retail continues to face challenges from the structural shift to online shopping. So far, the UK has been the hardest hit as e-commerce is most developed, but we expect other European economies to follow. Over recent years, robust labour market conditions and modest economic growth have supported demand for retail in continental Europe, generating sustained rental growth for investors. However, as store-based retail sales growth starts to slow, we expect rental growth to be more modest, and investors should be cautious.

In recent months, UK retail has faced the new twin challenge of debt financing being harder to access as well as deteriorating investor sentiment. Over the next five years, we expect rents to contract significantly depending on asset type, and capital values to decline up to 45 per cent. It is becoming increasingly difficult to find good opportunities.

But in the UK, as in continental Europe, this weakness hides many local and asset-specific nuances. Investors can still find attractive growth opportunities in some areas, even as others decline. For instance, the structural challenges are affecting low-engagement retail disproportionately, while prime locations are much more resilient. Attractive opportunities remain, including on some leading high streets in Germany, London and Dublin, though investors should be extremely selective.

3. Real estate markets are increasingly polarised

In contrast, investors can benefit by allocating to other types of real estate that should continue to grow strongly over the medium term. This emergence of two opposite ‘poles’ is startling – secondary location and low-engagement retail with bleak prospects at one end versus  prime office space, logistics and ‘alternatives’ at the other.

Given the ongoing polarisation, investors can expect strong growth on the very best deals in the largest cities. In most countries, solid growth can be found from rents in office and logistics sectors, especially prime office stock.

European real estate investors have also started allocating significant amounts of capital to more defensive investments such as supermarkets and alternatives like student housing and senior living.  In addition to a lack of opportunities elsewhere, investors are allocating capital to these investments as they are becoming more comfortable with them and because ‘alternatives’ are often supported by demographic and societal changes. We therefore anticipate they will perform better than most other real estate assets over the next five years.

Finally, we expect to find opportunities for long-term growth in emerging locations set to benefit from new transport infrastructure. In Paris, the Grand Paris infrastructure development will improve transport links and promote development in areas on the outskirts of the French capital, while in London areas surrounding the new Crossrail stations will be more connected, helping them thrive. In the long run, this type of infrastructure will support valuations and occupation, giving investors an opportunity to capture outperformance in selected areas.

Figure 1: Under/Over Pricing Analysis: 5 Year View – Europe Offices 2019-2023
Figure 1: Under/Over Pricing Analysis: 5 Year View – Europe Offices 2019-2023
Source: Aviva Investors, April 2019. A positive value indicates that the forecast total return exceeds the hurdle rate.

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