Continental European Real Estate: Reasons to be Cheerful May 8 Mark Callender, Head of Real Estate Research The last few years have seen a solid recovery in continental European real estate markets, echoing the improvement in the economy. The upturn in business confidence, employment and company profits has lifted demand for commercial space and almost all European cities have seen a fall in office vacancy and a rise in rents. Prime office rents in continental Europe increased by 6% on average in 7 (source: CBRE) and prime office capital values rose more quickly, by %, as investor sentiment improved and real estate yields fell. Prime logistics capital values also rose strongly by % last year, as the growth in online shopping gave an extra boost to warehouse demand. However these same structural forces limited the increase in prime shopping centre capital values to 6%. The question now for investors is will the upswing in rents and capital values continue? Figure : Eurozone GDP vs. office rental growth - - - - - -6 6 7 8 9 6 7 8 6 - - -6-8 - - Eurozone GDP Office Rental Growth Source: CBRE, Eurostat, Schroders. March 8 If we consider the demand for commercial space then the outlook is promising. Schroders forecasts that eurozone GDP will grow by -.% through 8-9, its best performance since 7. This reflects our view that the eurozone economy has now achieved take-off velocity and is benefiting from a virtuous circle of higher investment, falling unemployment and rising consumer spending. Unemployment fell to 8.6% in January 8 from a peak of.% in. In addition, the recent acceleration in world trade should benefit export orientated economies like Germany, the Netherlands and the Nordics and several eurozone governments can now afford to either raise expenditure, or cut taxes. Although stronger growth will feed through to higher inflation, Schroders expects it to remain subdued at.-.% p.a. over the next couple of years, with the result that the ECB is unlikely to raise interest rates until 9 and then only gradually. Winning cities, rather than countries, create demand Figure drills down to a city level, showing forecast economic growth in major continental European cities over the next five years (source: Oxford Economics). In most countries, the capital or biggest cities are forecast to see stronger economic growth than neighbouring smaller cities and towns. Thus Amsterdam, Berlin, Copenhagen, Helsinki, Madrid,
Milan, Munich, Oslo, Rome and Stockholm are all forecast to outperform their national average. However, there are exceptions which suggest that big is not always beautiful. In France, for example, internal migration from the north to the south and west means that Lyon, Nantes and Bordeaux are expected to see faster economic growth than Paris, although the capital s population should continue to grow thanks to international immigration. Similarly, the Brussels economy is forecast to only grow marginally faster than Belgium over the next five years, because of the high proportion of people working in the EU and government administration. Figure : Economic growth forecasts by city and country: 7-.... Brussels Belgium Copenhagen Denmark Helsinki Finland Lyon Nantes Bordeaux Toulouse Marseille France Paris Lille Leipzig Munich Berlin Stuttgart Frankfurt Hamburg Germany Dusseldorf Cologne Milan Rome Bologna Turin Italy Amsterdam Rotterdam Utrecht NL Oslo Norway Madrid Valencia Seville Spain Barcelona Stockholm Sweden Gothenburg Malmo & Lund Geneva Switzerland Zurich Source: Oxford Economics, Schroders. December 7 The fastest growing cities typically share four main attributes. First, a diverse economy with a spread of different sectors and a mix of large companies and start-ups. Cities which are dominated by one or two large vertically integrated companies are likely to atrophy in the long-term. Second and directly related to the first factor, is a highly educated labour force, which in turn usually requires a strong university and good schools. Not only do universities often act as a seedbed for new start-ups, but big companies in IT, advanced manufacturing and life sciences are increasingly seeking to collaborate with academics because new products are too complex to develop in-house. Research on US cities suggests that education is the single best predictor of urban success. Third, thriving cities need a proactive local government with a long-term vision for housing, transport, commercial development, regeneration, schools and hospitals. Fourth, it clearly helps if a city is an attractive place to live with a mix of old and new buildings and a range of cultural attractions including sports venues, museums, theatres and restaurants. Finally, arguably a fifth factor is that in order to flourish, smaller cities need to be a reasonable distance away from a big city, because otherwise the gravitational pull of their bigger neighbour will draw businesses and people away. Limited supply pipeline underpins real estate returns If we turn to the supply side of the rental equation, then the outlook is also reasonably benign. While developers are coming out of hibernation, the increase in commercial building has so far been in step with demand and is unlikely to produce an oversupply in most European cities over the next couple of years (see Figure ). Forecasts suggest that the total floorspace of offices and shopping centres in western Europe s major cities will grow by % over the three years to end-, compared with a % increase during the building booms of 99-99 and - (source: PMA).
Figure : European office and shopping centre development pipeline Net additions, million square metres 6....... Combined % of Stock.......... Shopping Centre Office Combined as % of Stock Source: PMA, Schroders. October 7. Note data are for France, Germany, Italy, Netherlands, Spain and Sweden. One reason for this greater discipline is that new regulations following the financial crisis mean that banks are much less willing to lend on speculative schemes. In addition, many of Europe s big cities have a housing shortage, reflecting strong population growth and city governments are increasingly giving priority to residential schemes. However, while commercial development is generally under control, there are a couple of cities where the supply response looks excessive (e.g. Barcelona, Dublin) and it will be important to keep a close eye on building starts over the next few years. Mind the (bond yield) gap? Another potential concern for investors is that a lot of the good news on rental growth is already priced into real estate yields. Prime real estate yields in continental Europe have fallen by.% since the eurozone sovereign debt crisis in and in most cities they are now below their previous low in 7. Furthermore, it seems inevitable that long-dated government bond yields will increase, assuming the ECB ends quantitative easing later this year and starts to gradually raise interests in 9. Schroders expects the ECB to increase the official refi rate to around % in - and for the yield on German year bunds to rise to.-.7%. Given the likely rise in bond yields, it seems sensible to assume that real estate yields will rise at some point between 9-. However, we expect that the increase in yields will be limited to between.-.% for three main reasons. First, although real estate yields have fallen to historically low levels, they are still high relative to government bond yields, so they are unlikely to move in parallel. At present the gap between prime real estate yields and year government bonds is over % compared with a long term average of %, as shown in Figure. Second, real estate yields are also heavily influenced by rental growth prospects and they are unlikely to rise sharply so long as the outlook for the eurozone economy is favourable and development remains measured. Third, there is a large amount of capital in Asia which is targeting continental European real estate. While some of this capital is tactical and aiming to maximise returns, quite a lot of Asian investors are taking a long term strategic view and seeking diversification away from their domestic market.
Figure : Real estate investment yields by sector vs. year bond yields 9 8 7 6 Shop Industrial Office Year Bonds 6 7 8 9 6 7 8 Source: CBRE, Datastream, Schroders. March 7. Note Year Bonds are an average of France and Germany. Structural and thematic change offers opportunity Despite the positive outlook for the eurozone economy, our strategy is to focus on those parts of the market which are benefiting from structural change and which should be resilient through the economic cycle. A good example is the industrial and logistics sector, which is gaining not only from a cyclical upturn in demand from manufacturers, but also from the long-term structural growth in on-line shopping. The internet now accounts for over % of retail sales in northern Europe and in round terms, each extra billion of online sales generates demand for an additional, square metres of warehouse space. Online retailers require more warehouse space than traditional retailers, because they do not hold stock in store, they have to handle a much higher number of small deliveries and they have to process more returned items. Around a quarter of online clothing and footwear orders are returned. While developers have responded by building more, supply is still lagging behind demand in most cities and we expect that both big warehouses in strategic distribution locations and smaller last mile warehouses close to big cities will see sustained rental growth over the next few years. We also like data centres which are seeing very strong demand. This is primarily being driven by the explosion in data from mobiles and other connected devices the volume of stored data is forecast to increase tenfold between 6 and (source: IDC) but it also reflects a switch by companies away from in-house IT to external cloud based services, which can be bought on a pay as you go basis, like electricity. While the supply of data centres is also increasing and vacancy has risen recently in Amsterdam and Frankfurt, there is a shortage of freehold sites with the necessary power supply and rates for space in colocation facilities are likely to increase over the medium term. Another part of the market we favour are tech clusters in big European cities (e.g. Amsterdam, Berlin, Paris, Stockholm) and certain smaller university cities (e.g. Grenoble, Karlsruhe, Leipzig, Lund & Malmo, Utrecht). IT and digital media are forecast to be one of the fastest growing parts of the economy over the next five years, but the industry is highly concentrated in certain cities where there is a pool of expertise and once established, that pool then tends to draw people away from other places. The challenge for real estate investors is to provide the right type of space for tech occupiers and to anticipate where the cluster will spread to, as it grows. We are also seeing increasing demand from life science companies for offices and laboratories in city centres which are close to universities and research institutes. Finally, we also see value in certain districts of big cities which are set to benefit from major regeneration projects and new transport links. The Grand Paris project to build new metro lines between Paris suburbs is currently the biggest transport project in Europe and we think there are good opportunities in Boulogne-Billancourt, Clichy and Montrouge, where office yields are -.% higher than in the city centre. Likewise, the new North-South line in Amsterdam due to open later this year will make the Noord area much more accessible, while Stockholm has ambitious plans to extend its metro north to Hagastaden and Solna and south to Sodermalm and Nacka.
Reasons to be cheerful In conclusion, we think there are several reasons to be cheerful about continental European real estate. Solid economic growth and rising company profits should lift demand for space; banks reluctance to lend on speculative schemes should keep development under control and prevent an over-supply; and real estate yields are unlikely to rise in parallel with interest rates and bond yields. We believe that office and industrial rents and capital values will continue to increase over the next few years, particularly in winning cities such as Amsterdam, Berlin, Hamburg, Helsinki, Lyon, Munich, Paris and Stockholm which have strong universities and diverse economies. The exception will be retail where demand will be undermined by the rapid growth of online shopping. We believe that the capital value of many shopping centres in northern Europe has already peaked. Important Information Any security(s) mentioned above is for illustrative purpose only, not a recommendation to invest or divest. This document is intended to be for information purposes only and it is not intended as promotional material in any respect. The views and opinions contained herein are those of the author(s), and do not necessarily represent views expressed or reflected in other Schroders communications, strategies or funds. The material is not intended to provide, and should not be relied on for investment advice or recommendation. Opinions stated are matters of judgment, which may change. Information herein is believed to be reliable, but Schroder Investment Management (Hong Kong) Limited does not warrant its completeness or accuracy. Investment involves risks. Past performance and any forecasts are not necessarily a guide to future or likely performance. You should remember that the value of investments can go down as well as up and is not guaranteed. Exchange rate changes may cause the value of the overseas investments to rise or fall. For risks associated with investment in securities in emerging and less developed markets, please refer to the relevant offering document. The information contained in this document is provided for information purpose only and does not constitute any solicitation and offering of investment products. Potential investors should be aware that such investments involve market risk and should be regarded as long-term investments. Derivatives carry a high degree of risk and should only be considered by sophisticated investors. This material, including the website, has not been reviewed by the SFC. Issued by Schroder Investment Management (Hong Kong) Limited. Schroder Investment Management (Hong Kong) Limited Level, Two Pacific Place, 88 Queensway, Hong Kong www.schroders.com.hk