Value remains scarce as European real estate cycle approaches its peak

3 minute read

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

References

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.