In the latest instalment of Schroders’ series of articles looking at the outlook for the next year, we hear from Duncan Owen, Global Head of Real Estate at Schroders on the outlook for European commercial real estate:
Demand for European commercial real estate is underpinned by an increase in technology and professional service jobs.
- Length and strength of upswings differ by city and sector
- Rents are rising as occupational demand outstrips supply
- Price corrections may offer some opportunities
European commercial real estate markets have performed strongly. Prices in Europe’s major cities have risen on average by 40-50% since 2013 (source RCA) and except in southern Europe, they are now 10-20% above their previous peak before the global financial crisis (GFC).
Cycles vary enormously
Intuition suggests that markets are due a correction, but it would be wrong to assume that real estate cycles are fixed like the tides. History shows that the length and strength of upswings has varied enormously across different cities and sectors over the last 50 years. For example, e-commerce is currently driving a wedge between the retail and industrial sectors and whereas industrial capital values in the UK rose by 10% over the first 10 months of 2018, shopping centre values fell by 7% (source CBRE).
European commercial real estate faces two main risks. Firstly, the growth of populist parties across Europe has increased the chance of radical shifts in economic policy. The obvious example is Brexit, which poses a threat to financial services and office rents in the City of London and the Docklands. Conversely, this has given a modest occupational boost to office demand in Frankfurt and Paris. In addition, Catalonia’s declaration of independence has raised a question mark over assets in Barcelona, while the Italian government’s budget dispute with the EU has hit foreign investor interest in Milan and Rome.
The second clear risk is higher interest rates. Schroders expects the Bank of England and the European Central Bank to raise base rates and the refinancing rate to 1.75% and 1% respectively by the end of 2020. Yet, despite textbook theory that real estate yields should move in parallel with government bond yields, we think that the increase in office and logistics yields over the next 2-3 years will be limited to 0.25-0.4%. Retail could be the one sector where yields rise and capital values fall more sharply.
Generous yield gap
We do not expect a bigger increase in office and industrial yields, partly because there is still a generous gap of over 3% between average investment grade real estate and government bonds. The long-term average is only 2%. Globalisation, particularly at the prime end of the market is also a factor. Asian, North American and Middle Eastern investors, with varying costs of capital, together accounted for a quarter of European investment deals by value in the first nine months of 2018, compared with 17% a decade ago.
However, the key reason is that real estate is not a fixed income asset and office and industrial rents are rising, as occupational demand outstrips supply. Office rents are rising as the increase in technology and professional service jobs lifts demand and as new, tighter bank regulations introduced after the GFC hold down speculative development. UK industrial rents are growing by 3-4% p.a., supported by both the growth in online retail and loss of supply because a lot of estates have been converted into housing. There are also signs of an upturn in industrial rents in the more supply-constrained parts of France and Germany (e.g. Hamburg, Munich, Paris, Stuttgart).
The catch, however, is that yields at the prime end of the market have compressed to record low levels and all of the good news on future rental growth is in the price. In most big European cities prime office yields in the central business district (CBD) have fallen to 3.0-3.5% and prime industrial yields are between 4.0-4.5%. So where do we see value?
In the office market we have a two-pronged strategy in big cities. We seek to add value by re-developing older buildings in the CBD. We also look at adjacent areas where yields are higher and which are being transformed either by a technology, or life sciences clusters, or by new transport links, or other regeneration and new infrastructure. Examples include the ArenA in Amsterdam; Kreuzberg-Friedrichshain in Berlin; Bloomsbury and Waterloo in London; Boulogne-Billancourt, Clichy and Montreuil in Paris and Solna in Stockholm.
We also like multi-let offices in smaller “winning” cities which have good universities and a diverse economy (e.g. Cambridge, Leeds, Leipzig, Lyon, Manchester, Malmo, Mannheim and Utrecht). In the industrial market we favour multi-let estates and smaller distribution warehouses, where it is still possible (except in London and the South East) to buy good quality assets on yields of 5.25%, or higher.
Looking further afield, we also see value in other sectors such as self-storage and hotels, specifically hotels with management agreements. Both segments are benefiting from structural change – urbanisation and people spending more on experiences, respectively – and while they each involve operational risk, this can be controlled by skilled asset management and yields are relatively high.
Potential retail opportunities
Is now time to go back into the retail sector given that the transition to omni-channel retailing still has a long way to go? Projections suggest that the internet’s share of UK retail sales, for example, will almost double from 17% to 30% over the next 10 years. Unfortunately, that suggests that the recent wave of retailer failures and store closures in northern Europe will continue and that there will be a sustained fall in rents. At present, that reality is not reflected in current valuations and retail yields.
However, looking forward, if most investors shun the sector and yields jump over the next 12 months, then there could be some interesting opportunities to buy defensive retail assets (e.g. dominant shopping centres, convenience stores). There may also be opportunities in town centre buildings which can be re-modelled into mixed-use schemes incorporating apartments, offices, medical clinics, places of worship.
In conclusion, we continue to see value in parts of the European commercial real estate market. The upswing in office and industrial rents has further to go in most winning cities and some segments such as hotels where management agreements are attractive. The big concern is the current economic and market cycle. Whilst we may not be at the peak of market pricing, no one would be surprised in a year’s time if we discovered we are in reality there now. Therefore, 2019 could be a year of price corrections which may offer some good opportunity for investors who are well capitalised. There is more than one real estate cycle in Europe.
