3 minute read

The European economy is enjoying a relative boom, but with real estate investment markets at an advanced stage of the cycle investors must be wary, says Monika Sujkowska.

The European economy outperformed all expectations in 2017, prompting some commentators to talk of a relative ‘boom’.1 Euro zone GDP grew 2.5 per cent, the fastest annual rate since 2007; while unemployment fell from 9.7 per cent at the start of the year to 8.7 per cent in December 2017.

This economic expansion is supporting fundamentals across the continent’s real estate markets. Rental growth remains robust, especially in the office sector. Yields continue to fall, indicating ongoing strong demand for European property as relative pricing remains attractive (see figure 1). According to CBRE, prime EU-15 (excluding the UK) office yields compressed to 3.8 per cent in the fourth quarter, although yield compression is easing in many markets and absolute pricing indicators suggest we are at an advanced stage of the cycle.

The outlook appears challenging for investors seeking total returns. We expect 2018 to be the last year of good returns in the current cycle; with much weaker performance anticipated from 2019 onwards as yields normalise. However, European real estate should continue to provide attractive opportunities for income-oriented investors.

Figure 1. Relative pricing of European real estate2

Markets and sectors

European retail markets are being buoyed by increased consumer spending. Although the rate of rental growth in the sector has begun to slow, retail property remains in demand. Transaction volumes rose 10 per cent last year compared with 2016, according to CBRE, driving yield compression.

Strong economic growth is also benefiting the industrial sector. The Markit Eurozone Manufacturing PMI rose to 58.5 in February 2018 – close to its historical high. Technical improvements in manufacturing, combined with a recovery in the consumer sector and the ongoing growth of ecommerce, have resulted in solid occupier demand for prime industrial space. Investors continue to be drawn to the sector due to the wide, albeit narrowing, yield spread to retail and office property. The spread between prime industrial property and prime office property in continental Europe stands at 143 basis points; the figure is 120 basis points for prime high street retail.

There has been an uptick in development activity across different sectors; this has been noticeable in Irish shopping centres, central Paris offices and German hotels, for example. However, given the low vacancy rates in most sectors this extra space should be comfortably absorbed.

Investment implications

Almost all prime real estate markets now look expensive on a risk-adjusted basis and investors should be wary of taking on excessive leverage risk, as declining capital returns and rising borrowing costs will reduce return margins on investment. Real estate debt may offer better risk-adjusted returns than equity investments in the current environment as it gives investors more protection against capital declines.

With value becoming scarce, investors should consider selling weaker assets that are likely to underperform during the next stage of the cycle. Office assets in Ireland and Spain may be particularly vulnerable (see our over/under pricing analysis, figure 2).

With the cycle at its peak, investors should be wary of taking excessive risks. Expert operators can, however, achieve above-market returns by taking selective occupier, asset management and development risks in markets with strong occupier fundamentals.

Deep local expertise and close relationships with developers, policymakers and occupiers on the ground will be crucial for outperformance. Investors with the requisite knowledge will be able to identify mispriced assets and make high conviction calls about opportunities that may not be on the radar of other market players. They will also be able to add value through intensive asset management informed by knowledge of the occupier base and market conditions.

Risks to the outlook

Our base case is that pricing will weaken gradually as bond yields rise. However, there is a risk that a more aggressive hiking cycle by the Federal Reserve could send global bond yields rising more quickly than expected, eroding real estate’s relative attractiveness. Debt-dependent strategies and assets in peripheral Europe would be hit particularly hard in this scenario.

The increasing development pipeline should not have an effect on rental growth until 2020 at the earliest, although there is a danger a spike in supply could have an impact, especially in cities with relaxed planning regimes. Investors need to keep a close eye on new building starts to ensure they are not wrong-footed by a sudden surfeit of supply.

Figure 2. Over/under pricing analysis, 2018-‘223


  1. ‘Brussels warns of market volatility risk to euro zone boom’, Financial Times, February 2018
  2. The relative pricing analysis compares the difference between real estate yields and the yields from other asset classes in a specific quarter with the long-term average difference. A standardised score is thereby created for each quarter and the standardised scores for each asset class are separated into quintiles, with the top (bottom) quintile indicating that property is very cheap (very expensive) compared to the other asset class.
  3. The scale represents our forecast excess return (total return forecast over the outlook period minus the hurdle rate), expressed as a percentage of the hurdle rate for each sector.

Important Information

Except where stated as otherwise, the source of all information is Aviva Investors Global Services Limited (Aviva Investors) as at February 27 2018. Unless stated otherwise any view sand opinions are those of Aviva Investors. They should not be viewed as indicating any guarantee of return from an investment managed by Aviva Investors nor as advice of any nature. Information contained herein has been obtained from sources believed to be reliable, but has not been independently verified by Aviva Investors and is not guaranteed to be accurate. Past performance is not a guide to the future. The value of an investment and any income from it may go down as well as up and the investor may not get back the original amount invested. Nothing in this document, including any references to specific securities, assets classes and financial markets is intended to or should be construed as advice or recommendations of any nature. This document is not a recommendation to sell or purchase any investment.

In the UK & Europe this document has been prepared and issued by Aviva Investors Global Services Limited, registered in England No.1151805. Registered Office: St. Helen’s, 1 Undershaft, London, EC3P 3DQ. Authorised and regulated in the UK by the Financial Conduct Authority. Contact us at Aviva Investors Global Services Limited, St. Helen’s, 1 Undershaft, London, EC3P 3DQ. Telephone calls to Aviva Investors may be recorded for training or monitoring purposes. In Singapore, this document is being circulated by way of an arrangement with Aviva Investors Asia Pte. Limited for distribution to institutional investors only. Please note that Aviva Investors Asia Pte. Limited does not provide any independent research or analysis in the substance or preparation of this document. Recipients of this document are to contact Aviva Investors Asia Pte. Limited in respect of any matters arising from, or in connection with, this document.  Aviva Investors Asia Pte.  Limited, a company incorporated under the laws of Singapore with registration number200813519W, holds a valid Capital Markets Services Licence to carry out fund management activities issued under the Securities and Futures Act (Singapore Statute Cap. 289) and Asian Exempt Financial Adviser for the purposes of the Financial Advisers Act (Singapore Statute Cap.110). Registered Office: 1Raffles Quay, #27-13 South Tower, Singapore 048583.In Australia, this document is being circulated by way of an arrangement with Aviva Investors Pacific Pty Ltd for distribution to wholesale investors only. Please note that Aviva Investors Pacific Pty Ltd does not provide any independent research or analysis in the substance or preparation of this document. Recipients of this document are to contact Aviva Investors Pacific Pty Ltd in respect of any matters arising from, or in connection with, this document. Aviva Investors Pacific Pty Ltd, a company incorporated under the laws of Australia with Australian Business No. 87 153 200 278 and Australian Company No. 153 200 278, holds an Australian Financial Services License (AFSL 411458) issued by the Australian Securities and Investments Commission. Business Address: Level 30, Collins Place, 35 Collins Street, Melbourne, Vic 3000

The name “Aviva Investors” as used in this presentation refers to the global organization of affiliated asset management businesses operating under the Aviva Investors name. Each Aviva investors’ affiliate is a subsidiary of Aviva plc, a publicly- traded multi-national financial services company headquartered in the United Kingdom. Aviva Investors Canada, Inc. (“AIC”) is located in Toronto and is registered with the Ontario Securities Commission (“OSC”) as a Portfolio Manager, an Exempt Market Dealer, and a Commodity Trading Manager. Aviva Investors Americas LLC is a federally registered investment advisor with the U.S. Securities and Exchange Commission. Aviva Investors Americas is also a commodity trading advisor (“CTA”) and commodity pool operator (“CPO”) registered with the Commodity Futures Trading Commission (“CFTC”), and is a member of the National Futures Association (“NFA”).  AIA’s Form ADV Part 2A, which provides background information about the firm and its business practices, is available upon written request to: Compliance Department, 225 West Wacker Drive, Suite 2250, Chicago, IL 60606