There are encouraging signs of resilience in Europe’s real-estate occupier and investment markets, and here’s how we see the prospects for the next two years.

February 2014

We expect the Eurozone’s economic recovery to remain sluggish and forecast growth of just 0.8% this year, rising to 1.3% in 2015.

In our opinion, significant progress towards banking, political and fiscal union is required for growth to pick up meaningfully.

While the risk of the currency bloc breaking up has diminished significantly over the past 18 months or so, deflation is a growing threat, especially in peripheral Europe. Eurozone inflation dropped to just 0.7% in January while some peripheral economies are now experiencing outright deflation. If this economic weakness persists and deflationary forces become more evident, the European Central Bank (ECB) may be forced to loosen monetary policy further.

Despite the backdrop of anaemic economic growth, recent business and consumer sentiment surveys have improved. For example, the European Commission’s economic sentiment index hit a 2.5-year high in January. Sentiment improved in Germany and France while it remained close to a two-year high in Spain and Italy.

As the economic recovery slowly gains traction, Europe’s occupier markets are expected to improve. Vacancy rates are on a downward path and a lack of new supply coming onto the market is expected to boost rental growth in the second half of our 2014 to 2018 forecast period.

Rising transaction volumes

Last year saw real estate investment transactions in Europe (ex UK) rise to a six-year high of close to €98 billion n (see Chart 2 overleaf). There appears to be increased investment appetite from both domestic and international investors. While Germany made up nearly a third of all transactions last year, there was also a significant pickup in southern European transactions, which more than doubled from 2012.

According to commercial real estate advisers CBRE, prime yields fell in all sectors in the last quarter of 2013 – a fourth consecutive quarterly decline. As prime real estate is highly valued prized for its defensive qualities, we believe yields will continue to fallkeep fallingcontinue to fall in core markets. As such, the divergence between prime and secondary European real-estate values is unlikely to narrow rapidly. CBRE data shows the capital valuesthat prices at the average end of the real estate market continues to fall while values onthose of prime real estate have risen for seven consecutive quarters.

Europe’s office market

Recent quarters have seen relatively subdued conditions in office markets across much of Europe. Occupier confidence is relatively low due to economic weakness and political uncertainty and a lack of large lettings is putting downward pressure on rents.

While leasing conditions remain more resilient in German offices, a decline in large deals is also weighing on markets, most notably in Frankfurt. Prime rents in most markets have been steady of late with upward movement in a small number sufficient to drive a 0.5% quarter-on-quarter increase in CBRE’s Eurozone rent index in the last quarter of 2013.

Europe’s retail market

Retail indicators for the Eurozone have yet to show any sign of a steady recovery. Although the labour market appears to have stabilised (the unemployment rate for December was unchanged at 12% for a third month in a row), Europe’s retail sales fell 1% year-on-year – their biggest monthly fall in two-and-a-half years.

Meanwhile, prime retail rents remain resilient in most markets and even advanced in some. The CBRE reported a 0.8 % quarter-on-quarter increase in rents within the Eurozone in the last quarter of 2013. Year-on-year, the index was up 7.1% which means that prime rents have now recovered by almost 21% from their 2010 nadir.

Europe’s industrial market

The second half of 2013 witnessed an encouraging pick-up in industrial activity in both core and peripheral economies. The Markit Euro Zone Manufacturing PMI figure for January reached a 32-month high. Even so, rent increases remain very difficult to impose and aggregate rents in the sector were effectively flat in the last quarter of 2013.

Eurozone outlook

Recent months have brought relatively encouraging signs for real-estate markets across much of Europe. Evidence that the worst of the economic downturn is behind us is positive for rental prospects over the medium term, even if a pronounced rise in rents is unlikely. The investment market is also heating up.

Demand for core markets remains robust and there has also been a pronounced change in investor sentiment toward peripheral markets where a rebound in prices is set take to shape.

Weakness of financial sector a concern

Probably the most significant risk to Europe’s real-estate markets remains the weakness of the financial sector but fears of deflation are growing, too. Credit conditions remain tight and lending to businesses is still contracting.

Our current Europe (ex UK) prime all-property total return forecast for 2014-18 of circa 7% per annum is little changed from last quarter. While we anticipate a slowdown in the second half of the forecast period in the core nations of France and Germany, we expect this to be offset by strengthening returns in peripheral markets.

Focus on lower risk countries

We are maintaining a continued focus on countries where macroeconomic risks are lower such as Germany and the Nordics. Additionally, we have identified prime Irish real estate as an attractive market with the cyclical recovery well underway. With the search for yield intensifying, we believe those investors with increasing risk appetite will focus on good quality secondary assets in core markets.