Real Estate Market Outlook Continental Europe

September 217 Real Estate Market Outlook Continental Europe Part of the M&G Group

Executive summary Eurozone growth continues to gather momentum with recent actual data surprising on the upside Loose monetary policy and reduced debt costs has encouraged investors to take on more risk Record low yields in CBDs are likely to persuade investors to look further afield to find value A spread of up to 4bps of prime office yields over government bonds offers a healthy cushion and remains attractive 47% share of foreign capital targeting Europe in Q2 Source: CBRE 9.1% 1 European unemployment in June 2.% consensus forecast for Eurozone 217 GDP growth Source: Consensus Economics Economic Sentiment Index (rebased to Jun 16 = 1) 12 11 1 9 8 7 6 Political risks recede as fundamentals improve The populism movement appeared to be gaining momentum across the developed world earlier this year, but the Dutch and French election outcomes suggest that the Eurozone has taken a different turn. Even in Italy, where a lagging economic performance and general election next year offer the potential for an upheaval, sentiment is slowly improving. Jun 6 Fig 1: European Commission economic sentiment indicator Jun 7 Eurozone Jun 8 Source: Bloomberg. Jun 9 France Jun 1 Jun 11 Germany Italy Spain Eurozone employment levels continued to recover over Q2, with the unemployment rate in May downwardly revised to 9.2%, stabilising at 9.1% a month later. In the core countries, the unemployment rate declined in June to a record low of 3.8% in Germany, but remained unchanged in France at 9.6%. However, Macron s immediate priorities are centred on domestic policies including labour market reforms and therefore the trend is likely to improve. In the periphery, the unemployment rate in Spain fell to an 8-year low of 17.7% while in Italy it picked up modestly from 11.2% to 11.3%. 1 Jun 12 Jun 13 Jun 14 Jun 1 Jun 16 Jun 17 Meanwhile in August, French factories reported they were hiring at their fastest rate since 2 and factories in Spain at a rate not seen since before the start of monetary union in 1999, according to IHS Markit s purchasing managers index (PMI). On the region s periphery, Greece made its first sale of government bonds since 214 in July. The bond issue was an important indicator as to how Greece will cope when the bailout payments stop and the country has to meet its financial needs from taxation and borrowing from the markets. The hope must be that a return to the sovereign debt market represents a milestone on the road to recovery. The first half of the year also marked five years since Mario Draghi s now famous whatever it takes remarks. At the time, funding costs for the periphery had climbed to unsustainable levels. Spanish 1-year government bonds traded at 7.%, Italy at 7%, Portugal at 11% and Greece at 27%. By finally acting as the lender of last resort, the European Central Bank (ECB) significantly decreased this risk. Its financial stimulus alongside structural reforms and improved growth has seen funding costs fall, offering the prospect of debt sustainability for these economies. With 1-year bonds at.3%, Greece s return to market is clear evidence that the peripheral recovery is well underway. Loose monetary policy and reduced debt costs, through the ECB cutting interest rates to penalise saving, has encouraged investors to take on more risk. This has served as a supportive backdrop for improved consumer sentiment, higher asset prices and a pick-up in consumption. This helps explain why the performance of the retail property sector was the first to recover in Europe followed closely by the office and industrial sectors. 1 Source: Capital Economics, Bloomberg. 3

Economic recovery gathers pace Eurozone growth continues to gather momentum with recent actual data surprising on the upside. Q1 real gross domestic product (GDP) growth was revised up from.% to.6% q-o-q, marking the sharpest expansion since Q1 21. 2 Eurozone Q2 GDP grew in line with Q1, as suggested by the composite PMI indicator despite falling in June. The performance helped to drive y-o-y expansion from 1.9% to 2.1% the highest rate since the second quarter of 211 and now higher than the 2% UK equivalent. In terms of the year as a whole, Belgium, France, Germany, Spain and Sweden received GDP consensus forecast upgrades in August, resulting in an overall Eurozone forecast growth of 2.% for 217, up from 1.7% in 216. 3 Fig 2: 217 GDP forecasts Italy France Belgium Germany Eurozone Sweden Spain.. 1. 1. 2. 2. 3. 3. May Source: Consensus Forecasts, August 217. 217 real GDP forecast % y-o-y June July August Despite the political stabilisation seen in the Eurozone, lower borrowing costs and a generally improved economic outlook, the ECB continues to avoid breaching its inflation target ceiling of 2%. Indeed the headline rate fell from 1.9% in April to 1.3% in June while core inflation rose from.9% to 1.1%, mainly driven by the German economy already working at full capacity. Elsewhere, Spain, France and Italy all have large output gaps and so inflation there should stay lower for longer. Overall, oil prices have been ebbing, which suggests inflation will remain contained. Inflation % 3. 3. 2. 2. 1. 1... -. -1. Fig 3: Eurozone headline and core inflation Mar 11 Jun 11 Sep 11 Dec 11 Mar 12 Jun 1 Sep 1 Dec 1 Headline Source: Bloomberg. Jun 12 Sep 12 Dec 12 Mar 13 Jun 13 Sep 13 Dec 13 Mar 14 Jun 14 Sep 14 Dec 14 Mar 1 Core (Excl. Food, Alcohol, Tobacco & Energy) While central banks globally dither over interest rate changes, the Czech central bank became the first European central bank since the global financial crisis to raise rates (to.2%) in August. The ECB, on the other hand, has shown no signs as of yet of following Prague s lead. The Bank will most likely wait for further firm evidence of a sustained rise in inflation before raising interest rates. According to the August Morgan Stanley first-interest-rate-hike survey, the consensus estimates that the ECB won t increase rates during the next 2 months (until 219). Occupier markets buoyant Jun 1 Sep 1 Dec 1 Mar 16 Jun 16 ECB Target Sep 16 Dec 16 Mar 17 Jun 17 Real estate fundamentals are responding well to the improved economic environment with the office sector seeing the strongest rental growth in the year to Q2 (up to 9.7% in Stockholm followed by 9.1% in Brussels). 4 Across Europe, the supply response remains modest. Even where the largest available stock and pipelines can be found in Northern cities such as Amsterdam, Stockholm and Luxembourg, strong job creation is generating demand to absorb it. The major exception is Helsinki, where employment growth has remained tepid for the last four years, reflecting declining or flat GDP. However, the pick-up in growth to 2.3% in 217 could mark a turnaround in the Finnish market. Indeed, supported by a lack of modern space, rents grew by 4.7% in the year to June, the third highest rate in Europe. A lack of office development, coupled with a strong labour market, means that German cities, such as Berlin and Munich, have some of the tightest office markets in Europe. According to Cushman and Wakefield, these cities will have the second and third lowest vacancy rates in the world by 219 of 3.1% and 3.3% respectively, just behind Sydney. 6 2 Source: Bloomberg. 3 Source: Consensus Forecasts, July 217. 4 JLL Q2 217. JLL Q2 217. 6 Source: Global Forecast: Are we Overbuilding? Cushman & Wakefield, July 217. 4

% office stock 3 2 2 1 1 Warsaw Prague Dublin Milan Lisbon Fig 4: Prime available office space (% stock) and forecast employment growth (217-19) Amsterdam Helsinki End 216 vacancy (LHS) Barcelona Madrid Rome Frankfurt Lyon Stockholm Luxembourg Brussels Employment growth % 217-19 (RHS) Copenhagen Dusseldorf Paris Marseille Cologne Hamburg Vienna Total net additions 217-19 (LHS) Stuttgart Berlin Munich 4. 4. 3. 3. 2. 2. 1. 1.. Employment growth % 217-19 1 In the industrial sector, positive economic growth and structural changes related to e-commerce continue to support healthy demand. Logistics completions are rising, but the risk of oversupply remains concentrated in a few markets. Industrial rents across Europe remained broadly stable in the year to Q2, save in Helsinki (6.7%), Dublin (6.2%) and Italy (.8% in both Rome and Milan). 7 With the fundamentals for this sector significantly improving, we expect a pick-up in rental growth going forward. Our view is supported by the lag compared to UK and US logistics markets, which have already benefitted from e-commerce trends. Fig 6: Prime industrial rental growth Take up (s sqm) 9, 8, 7, 6,, 4, 3, 2, 1, Over the next three years, we forecast the next leg of the property cycle to be driven by Stockholm, Berlin, and Brussels with average rental growth in select submarkets exceeding 4% pa. Outside Northern cities, development pipelines are significantly smaller, with the exception of Dublin, reflecting higher existing vacancy. At c.3% pa, we expect Barcelona and Madrid to deliver the strongest rental growth over the next three years among southern markets. On the Brexit debate, Frankfurt appears to be the biggest beneficiary of financial services jobs moving out of London. In July, three Japanese banks, Nomura, Daiwa, and Sumitomo Mitsui all announced new EU headquarters in the German financial capital. In the same month, Citigroup, Morgan Stanley and Deutsche Bank also confirmed they would send staff to Frankfurt. In June, however, Colliers recorded less than 1, Brexit-related financial services job relocations across European financial centres including Paris, Dublin, and Luxembourg. With a current vacancy rate above 1%, we forecast a more modest average rental growth of less than 2% pa for Frankfurt offices over the next three years. Source: PMA Spring 217. Fig : Modern logistics stock estimated take up and availability index 29 21 211 212 213 214 21 216 11 1 1 9 9 8 8 7 7 6 6 Prime industrial rental growth (% y-o-y) Availability index (29 = 1) - -1-1 92 93 94 9 96 97 98 99 1 2 3 4 6 7 8 9 1 11 12 13 14 1 16 UK Source: JLL. Europe US We expect the European industrial cycle to be led by Dublin with an average rental growth per annum exceeding 4% over the next three years, followed by the Nordic markets of Copenhagen, Helsinki and Stockholm. Southern markets follow closely with Barcelona, Madrid and Milan expected to deliver an average rental growth of up to 3% pa over the same period. Fewer retail markets are recording increased rental growth compared to the start of the European property cycle. Notable exceptions include markets in the fast growing economy of Sweden and recovering southern markets. The strongest year to June rental growth of 8.3% was recorded in Lisbon, Portugal, while rental growth in the core retail shop markets of France and Germany remained stable over the same period. 7 Driven by private consumption underpinned by monetary policy, retail was the first sector to recover and therefore is most likely to stabilise ahead of other sectors. Nonetheless, we expect supply-constrained high streets located in established tourist destinations, such as Madrid and Milan, to continue to outperform throughout the cycle. Overall, we expect an average rental growth of 2% pa over the next three years for the combined shop, retail warehouse and shopping centre sectors. Estimated take up (s sqm) Availability Index (29 = 1) Source: PMA Spring 217 (excludes Nordic markets). 7 Source: JLL Q2 217.

Yield %.. 4. 4. 3. 3. 2. 2. 1. 1... 2 1 1 Investors targeting European property Real estate investment markets have so far not been deterred by upward movements in government bonds (up to 24bps in German 1-year government bonds over Q2), with the share of foreign capital targeting Europe increasing over the last year from 33% to 47% in Q2 217. A spread of up to 4bps of prime office yields over government bonds offers a healthy cushion and remains attractive. Singapore Hong Kong San Francisco New York Milan London: WE Madrid Paris: CBD Barcelona Washington DC Los Angeles London: City Sydney Stockholm Tokyo Seoul Berlin Melbourne Spread Prime Office Yield Government Bond Yield Source: PMA Spring 217, Bloomberg. Fig 7: Prime office spreads vs 1-year government bonds Munich Frankfurt Copenhagen Osaka Dublin Amsterdam Lyon Helsinki Brussels Overall, Europe has had a positive start to the year with Q2 investment volumes (.7bn) rising by 26% q-o-q and 1% y-o-y. On a 12-month rolling basis, Germany remains the main driver of investment activity in the region at 61.2bn. Other markets, such as Finland (+66% in Q2 y-o-y) and Spain (+76% in Q2 y-o-y), were also more active as more stock came to the market. Fig 8: Rolling annual investment volumes billion Q4 26 Q2 27 Q4 27 Q2 28 Q4 28 Q2 29 Q4 29 Q2 21 Q4 21 Q2 211 Q4 211 Q2 212 Q4 212 Q2 213 Q4 213 Q2 214 Q4 214 Q2 21 Q4 21 Q2 216 Q4 216 Q2 217 France Germany Peripherals Nordics Benelux CEE Other Source: CBRE Q2 217. Competition for the best assets remains widespread with further yield tightening of up to 2bps in Q2. The greatest yield compression took place in the logistics sector. In the office sector, yields in Amsterdam, Milan, Brussels and Stockholm fell by 2bps. Prime office yields in Paris and Berlin stand at around 3.%, with an increasing number of markets now approaching historical lows. For shops, only Brussels, Prague and Stockholm yields fell by 2bps, all to 3.%. Yields also fell by 1bps in Milan and Rome to 3.4%. 8 Record low yields in CBDs are likely to persuade investors to look further afield to find value. Edge of CBD submarkets, for example, continue to offer more attractive pricing, and also benefit from limited supply and strong prospects for rental growth. With transport links improving across European cities, as governments invest more into both digital and physical infrastructure, submarkets deemed to be core are expanding. Given the discounts on offer, non-cbd submarkets with strong occupier fundamentals and greater urban connectivity can provide opportunities to higher returns. For example, in Stockholm, the development of a subway extension from the city centre will boost the prospects for the Solna/Sundbyberg district. Equally, the Grand Paris project, with phased scheduled completions from 219 to 227, will see a number of edge of CBD submarkets, including Saint Denis, benefitting from improved transport infrastructure, such as new metro lines 14, 1, 16 and 17 as well as the extension of RER C. Looking ahead, only one in four real estate investors in Europe believes that the current market cycle will peak soon, according to the findings of the latest property investment climate study by Union Investment. Three quarters of respondents do not expect it to peak until after 218. Of that figure, 43% expect the peak in 22 or later. Conclusion In summary, the European property market continues to be characterised by ongoing economic growth, limited available supply, and attractive relative pricing. Moreover, business confidence remains undented by various political elections in the first half of the year, with the Eurozone GDP projection for 217 (2.%) now higher than the actual 216 figure of 1.7%. Monetary policy is likely to remain ultra-loose for a long while. Given the weight of capital targeting European real estate, coupled with an expected lag between government bond movements and prime property yields of between 18 to 24 months (according to Capital Economics), we expect further inward compression to continue albeit at a slower pace in the short to medium-term. Underpinned by improving demand fundamentals, we expect the European property market to continue delivering strong investment returns going forward. 8 Source: JLL Q2 217. 6

Contacts Vanessa Muscarà Senior Research Analyst +44 ()2 748 6714 vanessa.muscara@mandg.com Richard Gwilliam Head of Property Research +44 ()2 748 6863 richard.gwilliam@mandg.com Christopher Andrews, CFA Head of Client Relationships and Marketing, Real Estate +(6) 6436 331 chris.j.andrews@mandg.com Lucy Williams Director, Institutional Business UK and Europe, Real Estate +44 ()2 748 68 lucy.williams@mandg.com Stefan Cornelissen Director of Institutional Business Benelux, Nordics and Switzerland +31 ()2 799 768 stefan.cornelissen@mandg.co.uk Costanza Morea Italy +39 ()2 326 77 costanza.morea@mandg.com Florent Delorme France +33 ()1 71 7388 florent.delorme@mandg.fr Alicia Garcia Spain +34 ()91 61 27 alicia.garcia@mandg.com www.mandg.com/realestate IMPORTANT INFORMATION: For Investment Professionals only. This document is for investment professionals only and should not be passed to anyone else as further distribution might be restricted or illegal in certain jurisdictions. The distribution of this document does not constitute an offer or solicitation. Past performance is not a guide to future performance. The value of investments can fall as well as rise. Any forecasts and projections herein represent assumptions and expectations in light of currently available information; actual performance may differ from such forecasts and projections. Any expected rate of return herein is not a guaranteed rate of return. There is no guarantee that these investment strategies will work under all market conditions or are suitable for all investors and you should ensure you understand the risk profile of the products or services you plan to purchase. This document is issued by M&G Investment Management Limited (except if noted otherwise below). The services and products provided by M&G Investment Management Limited are available only to investors who come within the category of the Professional Client as defined in the Financial Conduct Authority s Handbook. They are not available to individual investors, who should not rely on this communication. Information given in this document has been obtained from, or based upon, sources believed by us to be reliable and accurate although M&G does not accept liability for the accuracy of the contents. M&G does not offer investment advice or make recommendations regarding investments. Opinions are subject to change without notice. In Australia, M&G Investment Management Limited does not hold an Australian financial services licence and is exempt from the requirement to hold one for the financial services it provides. M&G Investment Management Limited is regulated by the Financial Conduct Authority under the laws of the UK which differ from Australian laws. In Singapore, this document is issued by M&G Real Estate Asia Pte Ltd. This document may not be circulated or distributed, whether directly or indirectly, to persons in Singapore other than (i) an institutional investor pursuant to Section 34 of the Securities and Futures Act, Chapter 289 of Singapore (the SFA ) or (ii) otherwise pursuant to, and in accordance with the conditions of, any other applicable provision of the SFA. M&G Investments and M&G Real Estate are business names of M&G Investment Management Limited and are used by other companies within the Prudential Group. M&G Investment Management Limited is registered in England and Wales under numbers 936683 with its registered office at Laurence Pountney Hill, London EC4R HH. M&G Investment Management Limited is authorised and regulated by the Financial Conduct Authority. M&G Real Estate Limited is registered in England and Wales under number 382763 with its registered office at Laurence Pountney Hill, London EC4R HH. M&G Real Estate Limited forms part of the M&G Group of companies. M&G Investment Management Limited and M&G Real Estate Limited are indirect subsidiaries of Prudential plc of the United Kingdom. Prudential plc and its affiliated companies constitute one of the world s leading financial services groups and is not affiliated in any manner with Prudential Financial, Inc, a company whose principal place of business is in the United States of America. SEP 17 / W23133