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European real estate markets continue to benefit from improving economic confidence across the continent. But the cycle is advanced and good value is becoming harder to find, writes Monika Sujkowska.
The European economy continues to grow faster than expected, thanks to increasing investment and strengthening consumer confidence. Euro zone GDP expanded by 2.3 per cent year-on-year during the second quarter of 2017, well above trend. And unemployment fell to 9.1 per cent in July 2017, its lowest level since 2009.1
Political risk has receded somewhat after the populist turmoil of last year. Although the German Afd won enough votes on September 24 to enter the Bundestag for the first time, Angela Merkel was re-elected as German chancellor. Her position in the new, more fractious German political landscape is weakened but a continuity of political leadership both in Germany and the European Union has been ensured.
This stable macroeconomic and political backdrop is good news for investors in European real estate. Occupier markets remain robust, with rising rental growth and falling vacancy rates: only eight per cent of prime European office property lay vacant during the first quarter, the lowest level since 2008, according to CBRE. Retail and logistics markets are also building momentum thanks to a pick-up in consumer spending during the second quarter.
The cycle is turning
For now, thanks to strong fundamentals and favourable pricing compared with liquid asset classes, property continues to attract investor demand.
An all-time record amount of capital was lavished on continental European real estate in the twelve months to June 2017, according to CBRE. A hunt for yield attracted investors to industrials in particular – the sector saw a 136 per cent year-on-year increase in investment over the first half of 2017. (This figure was somewhat inflated by a single deal: Blackstone’s €12.25 billion sale in June of Logicor, a pan-European logistics platform, to China Investment Corporation, a sovereign wealth fund.)
Modest development activity and accommodative monetary conditions in the near term should prolong the current cycle into next year. However, prime real estate assets are already looking expensive on a risk-adjusted basis (see chart). According to our estimates, only 13 out of 41 prime office, retail and industrial markets included in our forecasts will offer total returns that adequately compensate investors for risk between 2017 and 2021.
Aside from aggressive pricing, there are other signs that indicate the market is nearing a peak, including high premia required on portfolios and large assets, significant merger and acquisition activity and a high share of alternative-sector investment.
At this point in the cycle, investors should be wary of taking on excessive leverage. It could be prudent for investors to reposition their portfolios towards more defensive strategies, and focus on assets with low income risk.
A few select prime high-street retail and prime logistics markets look well placed in the current environment. Industrial assets in northern Europe look particularly attractive, with Belgium expected to offer impressive average total returns of 6.5 per cent per annum.
Investors should be wary of development pipelines in the logistics sector, however, as industrial facilities are easy to build and the supply-demand dynamic can change rapidly. We are wary of investing in Berlin, for example, as there is an extensive industrial supply pipeline in the city.
Elsewhere, prime real estate looks aggressively priced. However, the gap between prime and secondary pricing is now at historically-high levels in some markets, which is opening up investment opportunities. The average spread between prime and secondary yields in the German office market, for example, now stands at 300 basis points, despite relatively strong secondary-market fundamentals in a number of cities.
Risks to the outlook
There is a risk the European bond market responds to a rise in US interest rates and increasing inflation by pricing in further rate hikes, pushing yields higher than we currently expect. This would erode the relative attractiveness of European real estate and hit investor demand. Low-yielding assets, particularly those in peripheral European economies, would be hit hardest in this scenario.
There is also a possibility that an economic slowdown could impact the region’s real estate markets, leading to heightened income risk. Our base case, however, is that the global economy continues to grow at a steady pace, with relatively loose monetary policy and moderate inflation.
With this favourable backdrop in mind, long-term investors should continue to focus on office assets in European cities that benefit from a diverse local economy, healthy demographics and a high share of knowledge-intensive employment. In retail and logistics, the focus should be on assets that are best positioned to benefit from structural changes in retail.
Five-year under-over pricing analysis over time
2 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.
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