REAL ESTATE March 2019 Europe Real Estate Market Outlook For Investment Professionals only Notice to investors in Australia M&G Investment Management Limited (MAGIM) and M&G Alternatives Investment Management Limited (MAGAIM) have received notification from the Australian Securities & Investments Commission of the Class Order [CO 03/1099] exemption and are therefore permitted to market their investment strategies (including the offering and provision of discretionary investment management services) to wholesale clients in Australia without the requirement to hold an Australian financial services licence under the Corporations Act 2001 (Cth). MAGIM and MAGAIM are authorised and regulated by the Financial Conduct Authority under laws of the United Kingdom, which differ from Australian laws.
The value of investments will fluctuate, which will cause prices to fall as well as rise and you may not get back the original amount you invested. Executive summary Economic growth softens, while macro tailwinds remain strong Emerging submarkets driven by new infrastructure offer bottom-up opportunities Defensive qualities of the residential sector creates attractive long-term potential Innovative and tourist-driven retail set to remain resilient to online competition Transport corridors between Europe and China to open up new investment Income and rental growth to drive future real estate returns Cover and this page: Greenwalk, Suresnes, France
Economic growth softens, but new trade agreements support growth Economic growth in the Eurozone softened in 2018, with initial GDP estimates indicating expansion of 1.9% down 50bps from 2017 1. Various headwinds emerged over the year resulting in negative growth in Italy, and during the third quarter. The latter countries saw a combination of slowing domestic demand, as well as the impact of car emissions testing and weaker automotive sales in China. These factors are likely to be temporary however, with the Services Purchasing Managers Index moving back into healthy expansion territory, and some of the key challenges facing the automotive sector expected to be resolved over the course of 2019. Political turmoil in Italy may also begin to moderate, with the revised budget plan now in line with EU deficit rules and endorsed by the European Commission in December. The 10-year Italian government bond, often used as a risk-free proxy for real estate, has since fallen back from its peak of 3.7% in October to 2.9% in February 2019 2. Temporary factors aside, macro tailwinds should support steady forward momentum, with Japan and the European Union agreeing to remove tariffs on goods and services from February 2019. The agreement signals a commitment to global free trade between two economic blocks that together account for around one third of the world s GDP. Figure 1: Outlook for GDP across Europe Real GDP Growth (% pa) 5.5 5.0 4.5 4.0 3.5 3.0 2.5 2.0 1.5 1.0 0.5 0.0 Eurozone Italy Belgium France Portugal Denmark Finland 2018 2019-2020 Netherlands Spain Poland Eurozone unemployment fell below 8% in December 2018 for the first time in a decade. This remains consistent with a further pick-up in wage growth, most notably in, the Netherlands and Spain, with the Spanish government recently approving a 22% rise in minimum wage. This bodes well for wider consumer economic prospects and retail sales growth. Looking at overall Eurozone prospects, GDP over 2019-20 is expected to be a softer, but still a healthy 1.5% per annum, ranging from 3.3% per annum in Poland to 0.8% per annum in Italy 3. Against this backdrop, the ECB s 2.5 trillion asset purchase programme ended in December 2018, paving the way for the inevitable but gradual process of policy normalisation. The milder economic outlook, however, leaves the door open for the ECB to delay its first interest rate hike if growth and/or core inflation remains more subdued. Estimates have subsequently been revised, with no movement forecast until the middle of 2020 4. Even with an interest rate hike, expectations are for a 20bps increase, meaning that upward pressure on government bond yields is likely to be moderate. Given the current healthy spread of European property yields over bonds, the sector is likely to remain an attractive asset class in the medium term at least. Income and rental growth to drive future real estate returns Despite expectations that the first interest rate hike is not due for another 18 months, scope for further yield compression is limited, particularly in core Central Business Districts (CBD) where prime yields appear to be more fully priced. Investors are likely to turn their attention to diverse and dynamic cities with strong rental growth prospects to support future property returns. Last year, office rents continued to improve across most European cities, with Berlin, Madrid and Lisbon all posting growth of over 10% in 2018. Across the 23 office markets covered by M&G Real Estate, headline rents saw an average uplift of 5% year on year 5. Source: Bloomberg Concensus Forecasts, January 2019 1 Bloomberg Economics, February 2019 2 Trading Economics, February 2019 3 Trading Economics, February 2019 4 Bloomberg Consensus Forecasts, December 2018 5 JLL, Q4 2018
Figure 2: European city offices well-placed to maintain and grow income 5-year cumulative rental growth CBD (%) 22 Berlin 20 18 Stockholm 16 Amsterdam 14 Munich Copenhagen Helsinki 12 Prague Madrid Hamburg Frankfurt Brussels 10 Cologne 8 Paris Dusseldorf Barcelona 6 Luxembourg Lyon Lisbon Milan 4 Vienna Dublin 2 Rome 0 Warsaw -2 0 2 4 6 8 10 12 14 16 Total city office vacancy rate at end-2019 (%) Source: M&G Real Estate forecasts as at October 2018, PMA Autumn 2018 While we expect this to moderate to 3.1% in 2019 6, as macro uncertainties taper positive occupier sentiment, upside growth potential can still be found at a submarket level. Occupier demand has moved from strength to strength, with technology, media, business services and flexible office-based companies upgrading and expanding into high-quality, modern space. At the same time, the development market has not been able to keep up. Net additions to stock averaged about 1% in 2018 and are forecast to reach just 1.2% per annum on average for the next five years 7. As such, European cities are generally well-placed to maintain and grow income. We expect higher growth cities to be found largely in the Nordics and Benelux, while the core, but more expensive markets of and France, are defensively positioned (in terms of record low vacancy rates) and offer the greatest upside growth potential. Emerging submarkets driven by new infrastructure offer bottom-up opportunities Outside of the traditional CBD, there are likely to be increasing opportunities to drive real estate performance within newly connected, emerging submarkets. Edge-of- CBD submarkets continue to offer more attractive office yields, with discounts upwards of 50bps 8 to the CBD, yet benefit from equally healthy market fundamentals. Record low vacancies have been supported by additional demand from occupiers in search of more affordable rents and larger floorplates, which have become increasingly challenging to find in CBD submarkets. Figure 3: Grand Paris Project and office submarkets 1. Saint Denis 2. Saint Ouen 3. La Defense 4. Nanterre 5. Suresnes 6. Montrouge 7. Bagneux 8. Villejuif Source: JLL, M&G Real Estate 5 4 3 6 7 2 1 With most major cities across Europe undergoing significant regeneration or transport infrastructure programmes, interesting opportunities are emerging for bottom-up investors to target alternative submarkets. The 26 billion Grand Paris Project, for example, will add a further 200km to Paris transport network by 2030, opening up and connecting new submarkets around the city. Headline rents in markets such as Saint Denis, Saint Ouen and Suresnes currently sit at a discount of nearly 60% to the Paris CBD. We expect such submarkets to appeal to more cost-conscious occupiers, particularly from the growing technology sector, which should support upside rental growth potential. Infrastructure projects such as this are not limited to Paris. Submarkets such as Cityrand Süd in Munich, Porta Nuova in Milan, and Kalasatama in Helsinki all stand to benefit from either improving transport connections or substantial redevelopment schemes in the medium term. Given the growing importance of connectivity and placemaking to occupiers, there is the potential to see a structural shift in rents in such areas over the next decade, as they begin to compete with the traditional centres as commercial districts in their own right. 8 I.N11 - lh14 - Li'lllS - i...1, i.nn - l.-.11 6 Source: M&G Real Estate office market forecast, October 2018 7 Source: Property Market Analysis, autumn 2018 8 Source: Cushman & Wakefield, Q4 2018
Defensive qualities of the residential sector creates attractive long-term potential The theme of improving connectivity and placemaking represents a key trend across the housing/living sectors in Europe and alternatives more generally. While European populations at a national level are expected to stay flat or even decline over the next decade, the opposite is true of European cities. Paris, Milan, Berlin, Brussels and Stockholm, for example, are all expected to grow by over 400,000 people by 2030 9, driven by the preference of younger, more affluent generations to live and work in vibrant, prosperous cities. The choice of the mobile urban population is increasingly centred around affordability and amenities, with green space quality, transportation and commute times now key factors in housing demand, alongside prospective job opportunities Figure 4: Residential sector offers defensive qualities versus commercial real estate Innovative and tourist-driven retail set to remain resilient from online competition The outlook remains more mixed in the retail sector, so maintaining a strict screening strategy will be essential to drive performance over the next few years. Headline rents on the high street continued to grow over 2018, with Paris, Madrid and Barcelona all recording uplifts of 5% or more 10, proving that tourist-driven markets remain resilient to online pressures. More broadly, however, consumer sentiment subsided over the last few quarters of 2018, as wider macro fears impacted retail confidence, leading to upwards pressure on yields, particularly for more secondary retail markets. Figure 5: Key attributes of retailer success Tourist destinations Food-anchored 4.0 Market Rental Value Growth, 2000-2017 (%pa) 3.5 3.0 2.5 2.0 1.5 1.0 I 0.5 Netherlands 0.0 France Netherlands -0.5-1.0 0 1 2 3 4 5 6 Standard Deviation, 2000-2017 (%) Residential Retail Offices Logistics Source: MSCI, March 2018 Netherlands France France France Netherlands Urbanisation on this scale has led to an increasing burden on Europe s housing supply, with new development in key cities failing to keep up with demand. As a result, the outlook for rental growth across the living sectors is healthy. The lack of quality, modern accommodation in central locations, for students, young renters, families and the elderly, is likely to create substantial opportunities for European investors. Coupled with the broader living sector s more defensive qualities and relative value compared to the commercial sectors, we expect it to become an increasing part of the European investment universe over the next two years. The lower volatility of rents and potential to grow income at this stage of the cycle should also prove an attractive characteristic. Experience-led Source: M&G Real Estate Highly connected Despite pressures from online retail, the physical store will remain an important touchpoint for consumer engagement. Europeans now spend a greater proportion of their income on experiences and in response retailers and landlords have been adapting, with the proportion of lifestyle and food and beverage tenants increasing across key cities. US-based lifestyle brand Anthropologie, for example, opened its first high street store in continental Europe in 2018, in the German city of Düsseldorf, having previously only been available online in the region. With future expansion plans in Berlin, Hamburg and Munich, the retailer s philosophy is to drive brand awareness through social media and in-store events. Alongside rising tourism flows across Europe, we believe that this drive to create desirable, experience-led retail locations gives certain bricks and mortar retail an advantage over online purchasing, and should support rents and values in key high streets within core destination cities. 9 Source: Eurostat 10 Source: JLL, Q4 2018
Transport corridors between Europe and China to open up new investment Performance prospects in the logistics market continue to keep the sector in vogue with European investors. Despite sentiment in the manufacturing sector falling back to 51.4 on the Markit PMI in December, from more than 60 the year before, upside rental pressure continued to build over the year, with industrial rents growing 3% on average across the continent. Even in the automotive-centric German markets, which remain most exposed to slowing car sales in China, rental uplifts as much as 10% in Berlin and 5% in Munich were recorded in 2018 11. The sector has clearly been supported by the growing need for multi-channel retailers to upgrade and expand their supply chains to facilitate quicker, more efficient logistics to service consumers and businesses alike. Figure 6: China-Europe rail routes and trip frequency (per week 2018) Global trade will continue to be a key driver of this sector despite the threat of protectionist measures impacting confidence. Transport corridors between Europe, China and other emerging economies are expected to see significant growth over the next two years. Chinese e-commerce giants Alibaba and JD.com, for example, have both begun using rail to transport high-value European goods into China. Coming back into Europe are typically cheaper electronics, clothes and homeware, to supply some of Europe s largest retailers. China has a target of 5,000 westbound freight trains into Europe over 2019, which would mean tripling the number achieved just two years ago. Increased volumes of goods on this more cost-efficient transport link are likely to drive greater demand for logistics space along core strategic networks, opening up new logistics areas and investment opportunities. Summary The prospects for European real estate remain bright, despite more limited opportunities to capture yield compression. Strong underlying macro drivers remain ever-present in the occupier markets and the significant undersupply of good quality modern space means European cities are now some of the best placed globally to maintain and grow income. Investment opportunities are likely to be both sector and city submarket specific, meaning that investors with a bottom-up approach are well-positioned to capture future upside performance. Source: Center For Strategic & International Studies, The Rise of China-Europe Railways, March 2018 11 Source: JLL, Q4 2018
Strategic themes and long-term recommendations Offices Target quality assets in supply-constrained cities to maintain and grow income Identify emerging submarkets adjacent to CBDs to capture structural upside rental potential Focus on cities with improving connectivity and highly innovative workforces Living Target markets facing structural undersupply, where rental performance prospects are greatest Focus on cities characterised by affordable living, green spaces and greater amenities Identify cities facing greatest demographic change to benefit from long-term growth Retail Maintain a strict asset screening strategy to drive future retail performance Seek out destination-led and food-anchored retail with diverse experience offering Target dominant, tourist-driven high street retail locations which remain defensive to online Logistics Focus on strategic locations along key network corridors with high cross-border activity Consider multi-unit schemes close to large, affluent populations to support last-mile delivery Take advantage of latent rental growth potential in supply-restricted submarkets
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