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Attractive European real estate assets are becoming difficult to find, but opportunities remain for discerning investors, says Monika Sujkowska.*
We believe the future of Europe looks rosier than it has for some time. The economy continues to grow: euro zone GDP expanded at a rate of 1.7% year-on-year during the first three months of 2017, thanks to strengthening consumer confidence across the bloc. And Emmanuel Macron’s victory over Marine Le Pen in the French presidential election in May has stemmed the populist tide that had threatened to sweep the continent.
This positive political and economic backdrop is supporting the continent’s real estate markets. Strong occupier demand, coupled with limited development, has contributed to a sharp fall in the average vacancy rate on prime European office property, which stood at 8% at the close of Q1 2017. Year-on-year rental growth in the sector totaled 4.9% for the EU15 nations (excluding the UK) over the first three months of the year, up from 4.2% in Q4 2016.1
Nevertheless, increased investor demand for European real estate has driven up competition for the best assets; year-on-year transaction activity in Europe (excluding the UK) increased 12% in Q1 2017, according to CBRE. This led to yield compression in several sectors: EU15 (ex-UK) prime office yields sunk to a record low of 3.95% in Q1 2017 after falling nine basis points since the end of 2016.2
The search for value
While there remain attractive opportunities in European real estate – and the asset class still offers a healthy spread over fixed income – good value is increasingly difficult to find. Our pricing analysis suggests investors will need to become more discerning in their choice of assets, especially if they are looking to meet nominal return requirements (see chart).
Prime European real estate under/over pricing analysis 3
Source: Aviva Investors, Q2 2017
Rental growth will be a crucial factor in driving returns as capital growth is expected to slow. All prime high-street markets should see healthy rental growth over the next five years thanks to the increasing polarization of the retail sector; there is fierce competition among retailers for the best units to showcase their brands. Our forecasts show the best risk-adjusted returns will be available in Germany, the Netherlands, Belgium, Spain, Sweden and Ireland.
German prime high-street retail assets are expected to deliver total returns of 4.4% per year over the next five years, which constitutes a stable, low-risk income stream. Investors should also explore development and intensive asset-management opportunities in the German prime office market, where vacancy rates are especially low.
Industrial assets in Belgium, France, Italy and Luxembourg also offer good value. The industrials sector is benefiting from structural trends such as the ongoing boom in e-commerce – which has driven demand for warehouses and delivery hubs – and strong manufacturing growth. The Markit Eurozone Manufacturing Purchasing Managers Index registered a reading of 56.8% in May, its highest level since 2011.4 We forecast total returns of 5.2% on European industrial property over the next five years.
Late in the cycle
We are at an advanced stage of the real estate cycle when it is imperative to avoid excessive risk-taking. Investors should limit their use of leverage to aid returns, given the slowing in capital growth and expectations of a gradual rise in interest rates over the medium term.
It is inadvisable to chase yield where income risk is high. Office assets in Dublin and parts of Central Europe, for example, should be avoided in our view; these markets have experienced a flurry of development, raising the specter of oversupply. We believe now may be a good time to dispose of weak assets, given it will become more difficult to offload such properties once we enter a less favorable stage of the cycle.
Over the longer term, it will be increasingly important for real estate investors to focus on the locations that are more likely to enjoy sustained occupier demand. Cities with good demographic and economic prospects; a growing, high-quality labor force; a welcoming business environment; effective governance and cultural appeal will be best positioned, given the structural changes taking place in real estate. Even if pricing is challenging, locations with these characteristics should outperform over the long run.
3 To carry out this analysis we calculated hurdle rates (required returns) for European markets for the beginning of each year from 2001 to 2017. By comparing the hurdle rate at the start of the year with the total return over the subsequent five years for each market, we developed an over/under pricing estimate for each year for all markets. For the 2017 period we used our in-house prime total return forecasts. We assumed the property premium – which consists of the volatility, liquidity and transparency premium, and in selected markets, the currency premium – remains constant through time, so the only variable that changes in our analysis of the historic hurdle rate is the adjusted risk-free rate of return. We also incorporated in-house real estate stock estimates.
4 IHS Markit
* Investment professionals are members of AIA/AIC's Participating Affiliate, Aviva Investors Global Services Limited ("AIGSL").
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