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European real estate continues to offer relatively good value amidst an environment of heightened political risk and rising inflation, says Monika Sujkowska.
European real estate continues to benefit from a strengthening continental economy. Euro zone GDP expanded by 1.8 per cent year-on-year in the fourth quarter of 2016, driven by loose monetary conditions and improving business confidence. We expect the economy to grow at a slower rate of 1.7 per cent in 2017 and 1.6 per cent in 2018. This is still above the region’s potential growth rate and should be sufficient to bring down unemployment across the continent.
Property development activity is limited and occupier demand for prime real estate remains robust. Investor demand is also buoyant in most sectors, as real estate pricing still looks attractive compared with other asset classes. Transaction volumes were particularly high in Belgium, Denmark, the Netherlands, Portugal and Sweden last year, and demand is likely to remain strong in these markets in 2017.
Overall, we forecast total returns on European real estate (excluding the UK) of 5.8 per cent per annum over the next three years and 4.5 per cent over five years. Our forecasts are frontloaded because we believe bond yields in Europe will rise as the European Central Bank (ECB) phases out its monetary stimulus (see chart). Rising inflation and arbitrage effects, due to higher rates abroad, will also play a role in pushing yields higher. However, we expect yields to rise gradually and to remain below historic levels in the medium term, so the premium available on property investments will remain attractive.
Prime office rents across the euro zone rose 3.9 per cent year-on-year in the fourth quarter, largely due to constrained development activity and strengthening occupier demand in the sector. Prime offices in cities including Amsterdam, Berlin, Munich and Helsinki, where limited supply is supporting rental growth, look particularly attractive from an investment perspective.
Structural factors, along with growing consumer confidence, are driving performance in the prime high street retail sector. Euro zone prime retail rents recorded year-on-year growth of 3.3 per cent in the fourth quarter, slower than the growth in prime office rents for the first time since early 2011. Transaction volumes fell 17 per cent in 2016, largely due to a limited supply of quality assets. It is becoming increasingly important to own high-quality, centrally-located assets in retail, as properties in out-of-the-way locations are proving vulnerable to online competition.
Euro zone industrial real estate is seeing occupier demand thanks to recovering industrial production and the ongoing growth of e-commerce. However, pockets of new development have emerged across Europe, which is likely to weigh on rental growth prospects. Prime industrial rents increased by 1.1 per cent in the fourth quarter of 2016. Return-hungry investors sought out industrial properties in the euro zone last year, driving a 26 per cent rise in transaction volumes in the sector, according to CBRE.
Despite these positive signs, a series of important political events in Europe, notably the French presidential and parliamentary elections, is clouding the outlook for the European real estate sector. France’s 10-year government bond yields rose in the first two months of 2017 on the back of strong support for Front National (FN) candidate Marine Le Pen. However, we do not consider it likely that Le Pen will become president.
Nevertheless, the euro zone faces a number of other political hurdles. The possibility of a snap Italian general election before the end of the year represents a risk to the stability of the euro zone, given the country’s recent economic woes and the emergence of populist parties such as the Five Star Movement, which opposes Italy’s membership of the currency bloc. We consider the Dutch and German elections lesser threats to the region’s real estate markets, despite a similar rise in populism in those countries.
In the recent past, political risk has provided some benefits to investors in European real estate: after the UK voted to leave the European Union in June 2016, French and German bond yields fell and property assets looked relatively more attractive as a result. However, the risk of a referendum on euro zone or EU membership in one of the major continental economies is of a different order to Brexit. Such an outcome would likely damage confidence in European integration and, in a worst case scenario, lead to a fragmentation of Europe’s political institutions. The probability of such an event is extremely low, but it would have damaging implications for the region’s real estate.
Amid heightened political risk, the ECB has pledged to continue its asset-buying programme until December 2017, despite signs of resurgent inflation in parts of the euro zone.
In January, consumer prices were up 1.8 per cent year-on-year, largely due to higher energy prices. Rising inflation could lead to higher bond yields, potentially eroding the relative attractiveness of real estate. However, there is little reason to believe inflation will continue to rise at its current pace as unemployment is still high, and wage growth limited, across the continent. The ECB is also likely to focus on core inflation, which excludes more-volatile energy and food prices. On this measure, inflation in Europe remains subdued.
Nevertheless, we expect returns on European commercial real estate to soften from next year onwards as increased property development and monetary tightening combine to limit upward pressure on asset prices.
As we are nearing the late stage of the investment cycle, it is crucial for investors to avoid excessive risk-taking and to become more discerning in their choice of assets. Investors should be wary of pricing as well as income risks. It may be a good time to consider development opportunities in markets with strong fundamentals and low supply risks. Given the rise of political risk across the European Union, it would also be appropriate for pan-European funds to hold some non-EU exposure.
Source: Aviva Investors/Bloomberg, February 2017.
Unless stated otherwise, any sources and opinions expressed are those of Aviva Investors Global Services Limited (Aviva Investors) as at February 27 2017. This commentary is not an investment recommendation and should not be viewed as such. They should not be viewed as indicating any guarantee of return from an investment managed by Aviva Investors nor as advice of any nature. Past performance is not a guide to future returns. 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.