Relative value, ‘normality’ and polarisation: The outlook for real estate in 2021

1. Hit by COVID, both UK and continental European real estate look good value; in the medium term we see greater potential for UK yield compression.

Like every other asset class, the real estate market has been impacted by the economic fallout from COVID-19. The measures taken to slow the spread of the virus have had a debilitating impact on economic activity in some areas, but others have been comparatively buoyant, making conditions as difficult to predict as any we have seen.

As interest rates have fallen, return expectations have moderated across all asset classes. Although real yields have been declining, the spread between ten-year government bond yields and initial property yields are elevated, which is supportive for both continental European and UK real estate. Even though the short-term occupier outlook is negative, the medium-term view is more encouraging.

From a relative value perspective, we believe the UK looks more attractive than Europe¹ at this point in the cycle. This is entirely driven by the Bank of England’s monetary policy; expectations of low gilt yields should be supportive of pricing. Notwithstanding Brexit risks, City of London office² equivalent yields are around four per cent, a record high compared to ten-year gilts, whereas yields on offices in Paris and core German cities are significantly lower at less than three per cent.

2. Usage of commercial property to normalise towards the end of the first half of 2021 as the need for social distancing diminishes.

In 2021, the rollout of vaccines to immunise against COVID-19 is expected to be a gamechanger, bringing relief to many people forced into isolation and to businesses that have been severely hit. While it is difficult to anticipate how effectively and quickly vaccines will be rolled out and how soon assets can return to their highest value purpose, social distancing measures are unlikely to be required to the same degree, as protection of the most vulnerable begins. 

This will open the way for potential get ‘back to school’ messaging from governments at some point after Easter, and for footfall in shops, restaurants and offices - some of the most affected sectors - to begin to pick up again.

Figure 1: Footfall across consumer consumer-led asset types

The speed of recovery will vary significantly across sectors. In retail, for instance, we remain cautious. Online sales have increased as a result of the pandemic, but sales in physical stores are expected to decline faster than previously anticipated.

Nevertheless, some successful discretionary retailers will set themselves apart through an enhanced consumer experience, blending the services offered online and offline. The most resilient high streets³ will combine shopping and leisure; places where people enjoy spending their time and where e-commerce penetration is lower. In more valuable locations, we anticipate assets being repurposed for higher value uses, such as residential and logistics.

At a sector level, those areas where footfall was more resilient from the outset – like warehousing⁴ – have less ground to recover overall.

3. Opportunities likely to appear in city centre office headquarters, urban logistics and long-lease assets.

With Europe experiencing the deepest recession in decades, we expect many employers to focus on containing costs. As COVID-19 has tested the scope of remote working more rigorously than employers could have conceived before the pandemic, many businesses will see scaling back office space as an obvious way to cut costs. This is likely to accelerate the polarisation of the office market; a trend that existed before the pandemic but has intensified.

In this environment, we still see opportunities in high-quality, city centre offices. There are many businesses where collaborative work carried out face-to-face is highly valued, and that is unlikely to change. There may well be a reduction in occupation density: the numbers utilising the space in a building on any single day might fall, while the total amount of space available per person could rise.

The valuations of city centre trophy assets with large pools of qualified labour look particularly attractive in Copenhagen, Munich, Amsterdam, Paris and Manchester⁵.

The other ongoing area of interest is urban logistics (note activity shown in orange in Figure 2, below), as the pandemic has focused minds on the need for resilient supply chains and the value of holding inventory. The extensive offshoring and outsourcing that existed before the pandemic has been curtailed. Urban locations that can serve large pools of consumers within a small radius will have continued appeal.

Figure 2: Worker presence across five major workplace sectors

In our view, the five-year total return prospects in London warehousing⁶ are more attractive now than elsewhere in Europe, although cities like Frankfurt, Munich and Paris also offer value.

From a relative value perspective⁷, we also see opportunities in UK and European long-lease real estate⁸. There is often a perception that the lower initial yields of long lease mean lower expected returns. However, our analysis suggests expected returns in traditional sectors as well as student accommodation, supermarkets and hotels are similar to industrials over a five-year horizon, and higher than the office market, but crucially offer much lower volatility.

In summary

Ultra-low interest rates contributing to the ongoing appeal of real estate, commercial property returning to its highest value use in 2021 and the most promising investment opportunities in city centres, logistics and long lease; we expect these to be some of the key themes in European real estate in 2021 and beyond.