European Quarterly Outlook JANUARY 2012 Prudential Real Estate Investors 8 Campus Drive Parsippany, NJ 07054 USA 973.683.1745 Phone 973.734.1319 Fax www.prei.com REF: # PFIA-8QTNTF
Executive Summary Macro Themes Europe looks to be heading for its second recession in three years as industrial output and private spending growth have faltered in line with the deterioration in sentiment that began last summer. The key downside risk to growth is the ongoing delay in resolving the eurozone crisis. The early signs point to a shallow downturn. Policymakers appear to be moving in the right direction, and recent actions by the European Central Bank to ease liquidity worries have helped. The outlook remains tied to a two-tier Europe, with the highly indebted countries around the eurozone periphery expected to lag the rest of the continent. Implications for Commercial Real Estate Quarterly investment activity is expected to remain below trend throughout the first half of 2012 as the economic outlook and tougher financing conditions impact investor demand. European banks will continue to retreat from the market as deteriorating loan books and tougher regulatory controls take their toll. What s more, alternative sources of financing are unlikely to fill the funding gap. Property values are under pressure, especially outside of prime real estate in North Europe. Even so many prime markets are starting to look expensive as a result of the weak take-up of space in the fourth quarter and the subsequent downgrading of rental growth expectations. Yields nudged out in a few markets in 4Q11. A weak development pipeline remains the key upside risk to rental growth. Take-up is still mostly about occupiers cutting costs and consolidating operations. However, if firms delay taking up space, there could be a strong pick-up in demand once the economic outlook improves. Investors are set to remain cautious over the coming months with a renewed focus on income security. Spreads between prime property yields and triple-a rated bonds remain wide. Attractive options in this environment include lending on real estate and buying in the core supplyconstrained markets in North Europe. REF: # PFIA-8QTNTF 1
Economic Trends The Crisis Escalates Europe may be headed for its second recession in three years. Industrial output and private spending growth are faltering as economic sentiment deteriorates (CHART 1). Even without an escalation of the eurozone debt crisis, 2012 was going to be a year of weak growth as governments and households pay off debt. But the lack of any credible long-term solution is affecting economic activity. Adding pressure is the European Banking Authority s (EBA) ruling that banks have to have a 9% Tier 1 capital buffer by the end of June to repair their balance sheets. To try and avert another credit crunch (CHART 2), the European Central Bank (ECB) introduced a three-year unlimited loans facility. Even so, lending across the region is weakening. There are some signs of economic stability, and growth could still surprise to the upside. A weak euro might boost export growth while declining inflation could lift real incomes and make it easier for central banks to loosen monetary policy. All eyes are on the upcoming summits of European leaders to resolve the debt crisis. But the process looks to be long and drawn-out, so uncertainty and volatility are likely to persist all year. The consensus is that the European Union will register zero growth in 2012. Consensus forecasts see negative growth in the larger eurozone peripheral economies (Italy at -1.4% and Spain -0.3%), which would offset weak growth in North Europe (notably Sweden 0.9%, Germany 0.5% and the UK 0.5%). 1) ANNUAL GDP GROWTH AND ECONOMIC SENTIMENT FOR THE EU27 6% 125 4% 2% -2% -4% 115 105 95 85 75-6% 65 1Q96 1Q98 1Q00 1Q02 1Q04 1Q06 1Q08 1Q10 1Q12 GDP GROWTH ECONOMIC SENTIMENT INDICATOR (RIGHT AXIS) 2) 3M EURIBOR MINUS 3M EURO AREA WEIGHTED AVERAGE T-BILLS 250 200 150 100 50 0 Jan-05 Oct-05 Jul-06 Apr-07 Jan-08 Oct-08 Jul-09 Apr-10 Jan-11 Oct-11 EURO AREA "TED" SPREAD (BPS) Sources: Eurostat; Consensus Economics; ECB, Bank of England; Royal Bank of Scotland; Prudential Real Estate Investors REF: # PFIA-8QTNTF 2
Transactions and Pricing A Return to Safety Private investment transactions totalled 31 billion in 4Q11, according to DTZ. (CHART 3). This was only slightly higher than the third quarter, in what historically is the most-active quarter of the year. The relatively weak investment volume in the fourth quarter was caused by the retreat in bank lending and increasing caution of investors. Offices made up 48% of the fourth-quarter total. It was the sector s highest share of sales in two years, as interest in retail fell. The share of cross-border investing declined slightly in 4Q11. Investors remain focused on prime assets and income security in the better performing deep and liquid markets of North Europe. The UK and Sweden both reported higher investment volumes in 4Q11, while activity fell in Italy, Portugal, Poland and Hungary. Prime yields remained largely unchanged in most markets, according to CBRE, although there were some notable exceptions. The Netherlands reported a small outward shift in prime offices where tenant incentives remain elevated. At the same time, prime logistics yields in Brussels, Copenhagen and Milan softened slightly as trade growth slowed. The weaker outlook makes most property markets look expensive. Outside of prime offices and retail in North Europe there are growing risks that values will fall in 2012. With triple-a rated bond yields currently trading around 1.9% investors are set to keep to the major gateway cities, particularly the better-performing deep and liquid markets of North Europe (CHART 4). 3) PRIVATE INVESTMENT TRANSACTION VOLUME (BIL) 70 60 50 40 10 YEAR AVERAGE 30 20 10 0 2Q07 4Q07 2Q08 4Q08 2Q09 4Q09 2Q10 4Q10 2Q11 4Q11 FRANCE GERMANY UNITED KINGDOM REST OF EUROPE 4) PROPERTY YIELD AND 10-YEAR GOVERNMENT BOND YIELDS 12% 1 8% 6% 4% 2% 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 EURO AREA BOND YIELD GERMAN BUND YIELD EUROPE PRIME INITIAL YIELD Sources: DTZ, CBRE; OECD; Cushman & Wakefield; Prudential Real Estate Investors REF: # PFIA-8QTNTF 3
Debt Markets The Retreat of Banks European banks continued to reduce originations and tighten terms on real estate loans in the fourth quarter. Banks will only lend up to 55-6 loan-tovalue ratio on core stabilised assets, with proceeds capped at 50 million. Spreads generally range between 250-300 bps over swap rates. The retreat in lending is due largely to the deteriorating economic outlook, but banks are also under pressure from the EBA to boost their capital ratios by the end of June. Accessing debt financing will be difficult throughout the first part of 2012 (CHART 5). Germany s Eurohypo Europe s largest property lender is among the latest banks to withdraw from the market. Over the next six months, even more European banks are expected to exit the market. The retreat will add to the downward pressure on property values. That will further exacerbate the estimated 95 billion funding gap problem over the next three years that will arise from the shortfall between loan maturities and the proceeds that properties will qualify for at refinancing (CHART 6). The retreat of European banks has created interest from banks in the Middle East and Asia, as well as alternative lenders such as insurance companies. But the appetite of those lenders is small for now and there is little interest to lend outside of prime markets. Banks are reluctant to dump assets given the negative impact it produces on property values. Instead they are likely to continue to negotiate short-term extensions with property owners. 5) BANK OF ENGLAND SURVEY: CRE CREDIT CONDITIONS TO TIGHTEN 2 6) EUROPEAN REAL ESTATE DEBT AND FUNDING GAP ( BIL) 200 150 100 50 0-2 -4-6 2Q07 1Q08 4Q08 3Q09 2Q10 1Q11 4Q11 PAST THREE MONTHS EUROPEAN REAL ESTATE DEBT MATURITY PROFILE 2012 2013 2014 2015 2016 2017 NEXT THREE MONTHS 2018+ ESTIMATED EUROPEAN DEBT FUNDING GAP (2012-2014) 500 400 300 200 100 0 REFINANCING REQUIREMENT DEBT FUNDING GAP DEBT AVAILABLE CREDIT CONDITIONS TIGHTER Sources: DTZ; CBRE; Bank of England, Prudential Real Estate Investors REF: # PFIA-8QTNTF 4
Property Markets Offices: Back to 2009 Conditions Take-up declined in the fourth quarter as fears over the future of the eurozone hit office demand. Hiring intentions across Europe fell sharply towards the end of the year. Occupiers have put on hold plans to consolidate space and cut costs. Rental growth forecasts for 2012 and 2013 have weakened. Europe s prime office markets expect little rental growth for a few years (CHART 7). Differences remain. North European office markets, notably the CBDs of Stockholm, Munich, Hamburg and London West End, are expected to record some rental growth due to a shortage of prime office space. The lack of new development across Europe is making the availability of class A space a critical issue for occupiers. Demand is focused on more efficient space as occupiers look to keep overall occupancy costs low. Landlords have had to increase tenant incentives even in markets such as London City, reversing some of the recovery in effective rents since 2010. The weakness in the occupier market is significantly more pronounced across the eurozone periphery where, despite the lack of new supply, nonprime vacancy rates are still rising. The slowdown in take-up is reminiscent of early 2009, when occupiers put requirements on hold. This led to pent-up demand and a bounce in rental growth once sentiment improved. Given today s lack of new supply, a sharp pick-up in rental growth is similarly likely once economic sentiment improves (CHART 8). 7) ANNUAL HEADLINE RENTAL GROWTH AND VACANCY RATE, PRIME EUROPEAN OFFICE MARKETS, 4Q00-4Q15 3 14% 2 12% 1 1 8% 6% -1 4% -2 2% -3 8) NET ADDITIONS TO OFFICE STOCK, 1981-2016 5% 4% 3% 2% 1% 4Q00 2Q02 4Q03 2Q05 4Q06 2Q08 4Q09 2Q11 4Q12 2Q14 4Q15 FORECAST VACANCY RATE (RIGHT AXIS) AVERAGE RENTAL GROWTH FORECAST 81 83 85 87 89 91 93 95 97 99 01 03 05 07 09 11 13 15 NET ADDITIONS (% OF EXISTING STOCK) Sources: Cushman & Wakefield; PMA; Prudential Real Estate Investors REF: # PFIA-8QTNTF 5
Property Markets Retail: A Weaker Outlook Early indications are that retail sales remained weak in the fourth quarter, although there is some upside news from Christmas sales, particularly in the UK. However, the outlook remains bleak. Bricks and mortar retailers are increasingly worried that online retailing is taking business away. The aggregate rental outlook has been downgraded (CHART 9). Prime headline rents are expected to remain largely unchanged over the next few years, although rents are forecast to fall across South Europe. Rental growth is expected in the established, modern retail warehouse format in North Europe, where cost-conscious occupiers are expanding to meet growing demand from price-conscious consumers. Similarly, rents are forecast to rise in the exclusive prime high street pitches of major cities such as London s Bond Street, as high-end luxury brands continue to fight over space. Logistics: Leasing Activity Fades 9) ANNUAL HEADLINE RENTAL GROWTH, PRIME EUROPEAN MARKETS 15% 1 5% -5% -1-15% -2 3Q03 1Q05 3Q06 1Q08 3Q09 1Q11 3Q12 1Q14 3Q15 SHOPPING CENTRE HIGH STREET RETAIL WAREHOUSE 10) ANNUAL PRIME RENTAL GROWTH LOGISTICS Logistics occupiers continue to be highly selective. They are only taking space in the best locations to upgrade or consolidate operations into larger, modern facilities. Leasing momentum in Europe s main transport corridors eased by the end of the year. Rents were generally stable in most markets in the fourth quarter, with Stockholm and Frankfurt the only markets to record increases. With development activity exclusively focused on pre-lets, a number of major markets now lack available Grade A stock. Fading demand and the ability of supply to respond quickly mean that a pick-up in headline rental growth is unlikely in 2012 (CHART 10). 1 5% -5% -1 2000 2001 2003 2005 2007 2008 2010 2012 2014 2015 LOGISTICS RENT GROWTH TRADE GROWTH (RIGHT AXIS) TRADE GROWTH FORECASTS (RIGHT AXIS) 25% 15% 5% -5% -15% Sources: Cushman & Wakefield; PMA; Experian Business Strategies; Prudential Real Estate Investors REF: # PFIA-8QTNTF 6
Investment Performance Investor Caution Prevails Private real estate returns fell in the fourth quarter, largely due to a slowdown in office rental growth. The flash estimate of the European ungeared annual prime market return was 7.7%, down from 10.5% in 3Q11 and the lowest rate since 1Q10 (CHART 11). Prime market returns are typically correlated to GDP growth, which is expected to fall to zero. That suggests that capital values will be flat or decline in a number of markets in the eurozone periphery. According to DTZ, there is an estimated 120 billion of equity targeting European real estate. The property-bond yield spread remains an attractive pull for the sector. Given the economic outlook, investors are likely to concentrate on core stabilised assets in the better performing North European markets. But finding prime stock remains a challenge. Investor demand would improve if there was a marked improvement in occupier fundamentals, but that is a long shot. Demand for offices over retail is likely to remain a theme for the coming months as the consumer outlook remains poor. Investor interest in Central and East Europe could also cool, at least until the eurozone crisis is resolved, given the region s economic dependency on Western Europe. The uncertain outlook and regulatory change has given rise to increased interest in lending and operating businesses. Interest in development projects and secondary assets will remain limited, although it will grow over time, especially in early recovery markets such as Paris and London (CHART 12). 11) ANNUAL EUROPEAN REAL GDP GROWTH AND IMPLIED PRIME MARKET RETURNS, VARIOUS EUROPEAN CITIES 6% 4% 2% -2% -4% -6% 1Q00 3Q01 1Q03 3Q04 1Q06 3Q07 1Q09 3Q10 1Q12 3Q13 GDP 12) REAL OFFICE CAPITAL VALUE GROWTH AFTER 7 QUARTERS OF RECOVERY RELATIVE TO PREVIOUS CYCLES Madrid Paris CBD Stockholm London WE Amsterdam London City Dublin Milan Vienna Brussels Frankfurt Munich Lisbon Berlin TOTAL RETURNS (RIGHT AXIS) THIS CYCLE 3 2 1-1 -2-3 -4-2 2 4 6 AVERAGE PAST CYCLES Source: Cushman & Wakefield, DTZ; Consensus s; Eurostat; OECD Prudential Real Estate Investors REF: # PFIA-8QTNTF 7
Attractive Risk-Adjusted Investment Opportunities Europe THEME INVESTMENT IMPLICATIONS Wealth Preservation Due to the uncertain economic outlook, investors are focusing efforts to obtain income security in prime office and retail properties in the major cities of North Europe. Supply constrained markets offer some income protection. The threat of rising yields in the best markets remains low, thanks to the prospect of an extended period of low interest rates and the amount of money chasing real estate. Lack of Development Office and retail development has fallen to historic lows. Opportunity for core plus and value-add office and retail strategies encompassing new development and refurbishment. Focus on supply constrained and early recovery markets in faster-growing North Europe cities, such as London West End, Paris CBD and Stockholm CBD. Tougher Bank Lending Terms New debt sources are needed as traditional bank lenders reduce their exposure. Providing mezzanine debt to help deal with the expected funding gap offers attractive risk-adjusted returns in deep, liquid core European markets. REF: # PFIA-8QTNTF 8
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