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Current conditions make these uncertain times for both UK and continental European real estate. Investors are increasingly concerned that the global economy is slowing down, with particular implications for Europe. This is, in part, driven by political events such as Brexit, the French ‘yellow vest’ movement, Italian populism and Catalan independence, all of which can weigh on demand.
In that respect, the European parliamentary elections of 23-26 May presented a key risk, and populists have made significant gains in some countries. But they fell short of securing enough votes to have a decisive say in the future direction of Europe, giving European investors some respite.
And although economic sentiment has continued to decline, first-quarter activity was surprisingly positive in Europe, supported by good performance in Spain and France and a return to growth in Germany and Italy, which should result in continued demand for real estate.
In this context, our base case is of an economic slowdown rather than a recession, supporting three key trends impacting both the UK and continental European real estate markets.
1. Lower interest rates are extending the cycle
At the end of last year, we were expecting interest rates to start rising and therefore demand for real estate to be subdued. However, fears of a potential slowdown have put rate rises on hold. For investors, the lower interest rates will extend the real estate cycle: even at their current levels, real estate yields are higher than government bonds yields offer. For instance, the forecast for the ten-year German bund yield in 2020 is 0.1 per cent, compared to a 3.2 per cent equivalent yield for Europe (ex UK) All Property. Similarly, in April 2019 Thomson Reuters Datastream’s forecast for ten-year UK government bond yields in 2020 was 1.6 per cent, compared to a 5.5 per cent equivalent yield for the UK All Property.
The pricing of real estate also remains attractive compared to a host of other income-producing asset classes. And while we anticipate lower returns in the UK and continental Europe, they should still compare favourably with other regions for investors.
Thanks to lower interest rates, investors can now find positive total returns in several areas across the UK and Europe (Figure 1). In this context of medium cyclical risk, London and Manchester appear to be in a better position than many other European cities. This is mainly because prices there paused while others were rising, giving them a comparative advantage. But we also expect Germany and the Netherlands to see a strong occupier market, especially in the office and logistics sectors.
At this stage in the cycle, debt may be more appropriate than equity for investors to capture existing opportunities. At -0.19 per cent per annum and -7.7 per cent cumulative respectively, we forecast negative rental and capital growth in the UK over the next five years. In the rest of Europe, rental and capital growth values compare more favourably at 1.6 per cent and 1.8 per cent per annum respectively over the next five years. We are adopting a defensive positioning, focusing on income-producing strategies, and generally avoiding exposure to developments that have not been significantly de-risked.
2. European retail faces headwinds
Retail is the most challenging sector as it is suffering from the structural shift to online shopping. So far the UK has been the hardest hit as e-commerce is most developed, but we expect other European economies to follow. Over recent years, robust labour market conditions and modest economic growth have supported demand for retail in continental Europe. This has generated sustained rental growth for investors, but as store-based retail sales growth starts to slow, we expect rental growth to be more modest, and investors need to be cautious.
In recent months UK retail has faced the new twin challenge of debt financing being harder to secure as well as deteriorating investor sentiment. Over the next five years, we expect rents to contract between -6 per cent and -2 per cent depending on segments, and capital values to decline by -45 per cent to -20 per cent. It is becoming ever-harder to find good opportunities.
But in the UK, as in continental Europe, this weakness hides many local and asset-specific nuances. Investors can still find attractive rents and capital rises in some types of investments even as others decline. For instance, the structural challenges are affecting low-engagement retail disproportionately, while prime locations are much more resilient. Attractive opportunities remain, including on the leading high streets of London, Dublin, Stockholm and Lyon, though investors must be extremely selective.
3. Real estate markets are increasingly polarised
In contrast, investors can benefit by allocating to other types of real estate that are poised to continue to grow strongly over the medium term. This emergence of two opposite ‘poles’ is startling – secondary location and low-engagement retail with bleak prospects at one end versus prime office space, logistics and ‘alternatives’ at the other.
Given the ongoing polarisation, investors can expect strong growth on the very best pitches in the largest cities. In most countries, solid growth can be found from rents in office and logistics sectors, especially prime office stock. For continental Europe, we expect rents to grow by 0.6 per cent to 3.5 per cent a year for offices, and by 1.3 per cent to 1.7 per cent annually for logistics, over the next five years.
European real estate investors have also started allocating significant amounts of capital to more defensive investments such as supermarkets, student housing or senior living. In addition to a lack of opportunities elsewhere, investors are allocating capital to these investments as they are becoming more comfortable with these sectors. At this stage the allocations don’t seem very driven by conviction, but such types of what some consider ‘alternative’ real estate are supported by demographic and societal changes. We therefore anticipate they will perform better than most other real estate assets over the next five years.
Finally, we expect to find opportunities for long-term growth in emerging locations set to benefit from new transport infrastructure. In Paris, the Grand Paris infrastructure development will improve transport links and promote development in areas on the outskirts of the French capital while, in London, areas surrounding the new Crossrail stations will be more connected, helping them thrive. In the long run, this type of infrastructure will support valuations and occupation, giving investors an opportunity to capture outperformance in selected areas.