Real Estate Strategies: Focus on the European real estate cycle
Commercial real estate markets in Europe are still in excellent shape. The economic drivers are intact, rental price growth is positive in most locations while supply risks are limited.
In addition to economic factors, the trend toward coworking is a further boost for the office real estate market. Office vacancy rates are also declining at the moment due to the demand from flexible office providers, such as WeWork and Spaces. Logistics real estate is also being supported by structural factors while the situation for retail properties has continued to deteriorate. Investor interest in real estate continues to be steady. The interest rate reversal, forecasted several times in the current cycle in Europe, has yet to materialize, as the European Central Bank (ECB) is gearing its monetary policy toward the needs of weaker countries in the Eurozone. This means that the requirements remain intact for the upswing to continue.
Real estate cycles could last longer than expected
Due to the fact that the financial market and euro crises occurred ten and six years ago respectively, some market participants wonder how long the upswing in real estate prices in Europe can continue. If we look at the history of real estate cycles over the past 40 years, we see that there is no typical duration for a real estate cycle. They last for different periods and sometimes for somewhat longer than originally expected.
Figure 1 shows the performance of quarterly overall total returns of European and US real estate funds with a core investment strategy based on the main NCREIF and INREV indices. As the European data only go back to 2001, we have also included the US data in our analysis. Since the beginning of the 1980s, real estate markets overall had downturns in the US and Europe that began in 1982, 1990, 2002, 2008 and 2012 and ended the previous upswings. The chart also clearly shows that some downturns simply go into a phase of nominal weakness of total returns and do not necessarily result in absolutely negative total returns.
If the absolute definition is taken as a benchmark, the upswings in the US sometimes lasted between 12 and 15 years, despite occasionally shorter phases. It is also the case that the strongly negative total returns during the financial crisis were more of an exception than the rule.
In light of these considerations, the current cycle in Europe that in many countries only began after the euro crisis in 2013 does not yet indicate a long upswing phase. How long it will last depends on the performance of rental and capital markets for real estate and on economic and financial conditions.
European office real estate markets with strong fundamental data in H1 2018
Office real estate markets in Europe continued their upswing in the first half of the year. Demand for office real estate is the consequence of solid economic growth and the recovery in European labor markets.
However, while economic developments in Europe have slowed down somewhat compared to the dynamic movements of last year, corporate demand for space has intensified. On a gross basis, in Q2 2018, around 3.5 million square meters (source: JLL) of office space were leased out in Europe; this is a new quarterly record figure and around 5% higher than in Q2 2017.
It also reflects the trend toward coworking as well as economic factors. Depending on the city, 7% to 15% of the space take-up was accounted for by coworking providers. In London, WeWork has now become the second-largest tenant after the UK government. In most cities in Europe, the supply of new office space cannot keep up with the high demand. The consequence was another fall in vacancy rates.
The chart illustrates trends since 2013 using important large cities as examples; vacancy rates are in the 2% to 3% range in Munich, central Paris, Berlin and Stuttgart (not shown in the figure). Large companies are finding it difficult to find additional space to suit their requirements, but even markets such as Amsterdam, Frankfurt, Dublin and Warsaw, which reported double-digit vacancies over the past few years, are seeing a significant decline in vacancies.
Aggregated over the 40 most important markets in Europe, vacancy rates over the past four years have fallen from 11.4% to 8.4%, which also means upward pressure on market rentals. JLL reports that in Q2 2018, rents in Europe rose by around 4.1% on average compared to the previous year. German and Dutch cities currently show the highest rates in rental price growth. In London however, vacancies are roughly stable and rents continue to be under pressure as tenants are still cautious. In 2018, the City of London submarket expects completions to be at a level of roughly 5.5% of overall supply of office space.
Logistics real estate as a beneficiary
The beneficiary of the weaker trends in physical retailing is logistics real estate, as the multi-channel distribution approaches in retailing are increasing the need for storage capacity. In the UK, logistics real estate has been the sector with the strongest performance since the UK’s referendum on its membership of the EU in June 2016, with the segment there recording a rise in rental prices of 6.7% p.a. on average between 2015 and 2017. In continental Europe, the rise in rents was less pronounced at 2.1% p.a. in the same period.
However, the indicators of market demand are all positive and the volume of logistics space take-up is seeing an uptrend in many European logistics hubs. In Germany, the volume of logistics space take-up since 2012 has more than doubled according to our data, but construction activity in this sector was also strong throughout Europe as a whole. There are various reasons for this. The availability of development land in semi-urban locations and the preference of online platforms such as Amazon for new build, modern logistics real estate were factors that favor this type of performance. Older and over-sized warehouse space is not a top priority for tenants. We also believe that the trend toward small urban logistics space that is close to consumers is likely to intensify due to consumers’ requirements for quick delivery of online orders. We continue to be optimistic about the logistics real estate market and anticipate rents rising between 2018 and 2020 by around 2% for logistics real estate in the Eurozone and 3% in the UK.
Risk assessment and investment strategy
The situation in European commercial real estate markets remains comfortable. The current economic upswing is likely to provide a further boost to market rents in the office and logistics real estate sectors, despite their market situations differing. In addition to cyclical drivers, both segments are also being supported by structural factors such as the trends toward coworking and e-commerce. Although property transaction prices have already risen significantly in the past few years, the high yield differentials suggest sound valuation levels. The ECB’s wait-and-see approach, which seems to rule out any interest rate hikes until at least the middle of 2019, will probably contribute little to changing this situation for the time being.
However, we would be more cautious toward, investments in retail real estate, as rents are only expected to increase in a limited number of cities, but on average, we predict a further rise in vacancies in Europe. Smaller-scale prime high street space is expected to continue to benefit from the integration of logistics and retail value chains. Modern shopping centers with entertainment facilities and retail with successful retailers can be interesting if they generate a high enough yield, but investors must take a close and critical look at the mix of tenants and business plans.
As such, we continue to view the performance of diversified core/core+ portfolios in Europe (with a strong underweight stance in retail property) in a positive light and believe that they belong in every investment portfolio due to the robust levels of distribution yields. For investors with a higher risk appetite, focused value-add strategies that exploit the low construction volume in Europe and/or the positive rental potential offer opportunities.
We see two risks to this positive scenario. One is that a rapid rise in interest rates would negatively impact real estate valuations unless it were accompanied by stronger economic growth. The structurally low wage inflation due to technological developments and the demand for income-producing assets that exists through the aging of society means that such a risk is unlikely to materialize in the near future.
The second is that an abrupt slump in global economic growth could negatively impact rental market trends and therefore price trends. We believe this is more of a realistic risk in the current environment. A trigger for this type of development could be further intensification of the trade dispute between the US and its trading partners or political risks, such as Brexit or the populist government in Italy. But even in a scenario of slower growth, we see factors such as low construction activity and the still modest use of debt capital limiting downward risk. However, this is not our main scenario, as we anticipate further solid global economic growth overall.
Investors who believe such scenarios are more likely to occur typically have a sensible investment alternative with lower-risk core strategies where around 70% of the overall returns is derived from income yields. We would recommend avoiding investments in Italy. We recommend investing in the UK within diversified European and global strategies.