Eurozone Real Estate Outlook Edition 1H18 Robust demand as economy holds strong UBS Asset Management
Economic environment & expected occupier demand Figure 1: GDP growth forecasts 2018-20 Economic growth was strong during 2H17 and for the year as a whole. The year ended well with robust growth of 0.6% in 4Q17. GDP growth reached an exceptional decade high of 2.5% in 2017 and according to survey data, it seems the eurozone economy got off to a good start this year. There was some strong survey data from the services sector which recorded the services PMI rising to its highest level in a decade. The labor market also appears fairly solid and survey data suggests that employment intensions are positive. Also in support, the unemployment rate is at a nine-year low and workforce participation rates are rising, signaling a healthy recovery of markets. Although to date, we have not seen any signs of strong wage growth despite the improving labor markets but they are expected to support consumer spending this year. The near term outlook for the eurozone is for a period of steady, above trend GDP growth. Consumer income growth is expected to rise this year as inflation moderates to 1.4%. As a result, consumption is forecast to increase by a solid 1.8% in 2018. In addition, investment is forecast to be strong given sentiment, tight capacity, easing political fears related to populism and the continued strength of bank lending to firms. Growth this year is expected to be largely driven by the domestic sector, with net trade providing a small contribution. Exports are expected to slow this year as the euro continues to rise. The strengthening value of the euro coupled with slowing global growth are expected to moderate export growth from 5.1% in 2017 to 4.5% in 2018. In terms of the outlook beyond this year a mild slowdown in the rate of growth is anticipated with 1.8% and 1.5% forecast respectively in 2019 and 2020 (see figure 1). The main downside risks to the outlook are political risks surrounding the Italian elections, the possibility of a hard Brexit or the Catalan independence crisis and stronger than expected monetary tightening, although these are certainly not consensus. However, political uncertainty declined in the region over the course of the year, providing much needed respite. It seems that Brexit negotiations have progressed to discussions surrounding trade, whilst both sides appear to agree on the need to a transition period. Source: Oxford economics, MapInfo February 2018 Looking to the office market, the positive momentum behind the eurozone economy has filtered through into exceptionally strong levels of demand, aggregate take-up in the fourth quarter reached 3.1 million sq m not just setting a new quarterly record but exceeding the previous from 2007 by 8%. This exceptional transactional volume was helped by some of the key eurozone markets delivering a record, or close to, level of demand namely Paris, Frankfurt, Munich and Madrid. Paris is perhaps the most interesting, as this has been one of the most sluggish core markets over the past few years as corporate demand has been driven by consolidation and churn, rather than expansionary net absorption. There are signs however that the emergence of a more business friendly approach from Emmanuel Macron could stimulate real jobs growth sentiment indicators for France are around the highest levels in a decade and this appears to be reflected in a re-emergence of an expansionary agenda amongst Paris based corporates. During 2017 we have seen the emergence of the service office sector in continental Europe, with markets including Madrid, Munich, Frankfurt, Amsterdam and Berlin reporting an increase in activity from this Ftype of operator. Previously, their focus of expansion had been heavily centered on central London, to the extent that in 2017 take-up from serviced office providers accounted for 15% (183,000 sq m) in the market. Whilst we acknowledge the underlying trends towards more flexible demand from office occupiers, it remains to be seen whether the penetration already achieved in central London will be replicated across continental Europe. Page 2 of 8
One of the key differentials being the lease structure in central London typical leases are longer than Europe (c. 10 years rather than 3-5 years), which has encouraged the attraction of the type of flexibility provided in the serviced office model. Even in central London, however, there are concerns that the expansion of these providers has been too aggressive and it is very difficult to assess how much space is actually occupied once the operator signs a lease. For the sector as a whole, the challenge of how to maintain occupancy levels during a downturn in the economy, when occupiers will be reducing their floorspace and intuitively coming out of the most flexible and short-term leases first, and continue to meet their cash flow liabilities, has not yet been answered. On the retail side, consumer confidence was strong during 2H17. In December, the GfK Consumer Climate Index for the EU 28 reached the highest value in ten years at 21.1 points. It seems the strong recovery staged in recent years has translated into improving confidence on the state of the economy. In December 2017, economic expectations increased to 17 points for all EU countries, indicating a clear 5 point increase compared to 3Q17. In particular, France, Germany and Austria all showed significant gains on this measure. As such, consumer income expectations increased slightly on average in Europe from September to December 2017 by 2 points, reaching 15 points. Higher wage expectations were particularly positive in Austria after a period of relative weakness. Overall, it appears the impact of political uncertainty in Europe waned and consumers now feel much more positive about the outlook for the economy and their own personal financial situation, which is great news for retail spending. This year, households are expected to benefit from a robust job market and lower inflation than the recent past. Despite the improving consumer outlook there is a growing mismatch between consumer and retailer prospects. Retailer margins remain under pressure and are expected to do so in the near term due to the impact of growing e-commerce activity. Whilst in-store demand in the eurozone still accounts for over 90% of retail sales, the amount generated online continues to rise and this is placing increasing pressure on store profitability and viability. As a result, retailers are focused on the most successful dominant retail offers. This is reflected in new store demand levels where interest remains fairly robust in major eurozone high streets, shopping centers and retail parks but is much thinner in second and third tier centers. The polarization between the performance of dominant and non-dominant retail will remain a key feature of the eurozone retail market. Generally speaking, prime retail continues to attract a greater share of reducing demand and have a stronger rental growth story as a result. The industrial sector continues to benefit from disruption in the retail sector, as growth in online retail continues to fuel demand for distribution warehouses. Net absorption in Europe is looking to be around 50% higher than the previous years, with various centers seeing higher levels of stock taken up. The story is not only about ecommerce either, as a recovery in European manufacturing has driven demand from the production sector. As a result, take-up has risen strongly over the past few years and European prime logistics rents rose by an annualized 2.4% in 2017. Prime rental growth in city centers tends to be less centralized for logistics assets, as location choices for large format warehouses are dictated more by infrastructure and road connections. Nonetheless, Italian cities saw a big pick-up in rents over the course of the year, with Milan seeing growth of 10% and Rome 6%. Amazon recently announced they will develop a robotic warehouse in Italy, indicating a big vote of confidence in the market. This strong performance indicates there could be greater development of online retail in Italy going forward. Rental growth continues to be especially strong for smaller light industrial units, particularly those 'last mile' units located within urban areas. There are two macro-drivers which could pose an upside risk to demand for European logistics assets. Firstly, the TEN-T 1 infrastructure program is set to invest EUR 700 billion in improving connections on nine cross-border network corridors by 2030. This could obviously be a game-changer for international logistics operations. The second is another EU-led initiative to create a 'digital single market' and reduce national obstacles to consumers buying products outside their home market. This could be a big boon for European 'E-tailers' who with the exception of larger operators like Amazon and Zalando are largely domestic enterprises at the present moment. Supply As demand has increased, the aggregate European vacancy rate dropped below 7% at the end of 2017 for the first time in over a decade. The German cities are seeing an especially pronounced squeeze on office space as Munich (3.2%), Berlin (3.2%) and Cologne (3.9%) have the lowest vacancy rates in Europe. The Netherlands certainly wins the title of most improved country as Amsterdam, Rotterdam, The Hague and Utrecht all had vacancy rates around 2-2.5% below the level recorded at end-2016. In Amsterdam, careful town planning and successful conversion of vacant office stock to other uses has reduced vacancy from a peak of around 20% to just 6.6% in 4Q17. Although we are starting to see some more speculative schemes start in certain European cities (namely Dublin, Paris, Madrid and Barcelona) development levels generally remain well below historic norms. Even in the main German markets, where demand has been consistently strong for several years, we are not seeing the start of any meaningful supply response. Unsurprisingly the positive demand and supply dynamics across the eurozone are translating into positive prime rental growth. The strongest annual growth in 2017 came in Amsterdam (12.5%), whilst other markets including Berlin, Madrid, Brussels, Dublin, Milan and Helsinki all recorded growth in the 8-9% range as the positive dynamics are increasing tenant competition for the best available spaces. In markets where CBD vacancy is particularly tight we are also seeing rental growth 1 Trans European Transport Network Page 3 of 8
spreading to the fringe submarkets, as well as some very selective peripheral markets as occupiers become priced out, or forced to look outside of the CBD due to an absence of suitable available space. Whilst there are opportunities to capture this rental growth in the strongest performing markets, we would remain solely focused on the micro-locations with a very strong local growth story, and crucially excellent public transport infrastructure. In the retail sector, vacancy rates for major cities and prime dominant shopping centers across the eurozone remain fairly low, whilst rates are under pressure in smaller less dominant centers. However, development is now generally modest and considered across the eurozone as investors become more concerned about the impact of structural changes occurring in the sector, particularly the impact of ecommerce. As such, brand new shopping center development is anticipated to be fairly muted in most eurozone countries, although Finland is expected to see the greatest increase in stock over the next 5 years (+3%). However, extension and refurbishment activity is expected to remain elevated as investors attempt to enhance and /or protect retail catchment areas by enhancing the overall center offer, especially in terms of food and beverage and leisure which is becoming an increasingly important driver of footfall in shopping centers. The outlook for average retail rents is for moderate growth in the eurozone with slightly stronger growth anticipated in prime cities. We have started to see the strengthening of consumer confidence in the Netherlands starting to feed through to improving rental growth prospects over the next 5 years for the overall market. We have already seen demand pick up for prime properties in the major cities, resulting in very low vacancy levels but stable rents. However, robust confidence in Spain last year has already translated into good rental growth in Barcelona (+4.1%) and Madrid (+4.2%) during 2017. Whilst for other major retail high street destinations in the eurozone, there was evidence to suggest that retailers were becoming more sensitive to prime rental levels as growth in all other major cities was zero with the exception of Vienna (+4.3%) and Milan (+3.3%). Increasingly, major retailers are more prepared to consider slightly off pitch retail units in the largest, most dominant retail centers for a more modest rent than they would be to open a store on prime pitch in a less dominant retail center. We expect retailers will remain cost sensitive in the near future and this is reflected in our moderate rental growth forecasts for average quality (MSCI) retail property next year. As outlined previously, there has been an upswing in demand for industrial real estate and, while pipeline data for industrial assets is somewhat lagging, there are now signs that there has been a pick-up in development in most European countries. PMA 21 estimated every major region in Europe saw completions rise in 2017, though this has not made much difference to availability as the vast majority are design and build schemes. As a result, vacancy remains low although the industrial sector is very prone to supply shocks due to relatively cheap and rapid construction periods. Urban Poland and CEE are seeing a significant amount of space come online for instance, as high 2 Property Market Analysis availability and a relaxed planning regime has seen a significant amount of space developed. Urban logistics has a degree of protection from increased development as competition for land in and around cities make industrial schemes challenging to underwrite. As a result, 'last mile' facilities favored by retailers and 3PL operators for online fulfillment are in especially short supply at present. Speculative development has been very low compared with previous cycles, though 2017 has seen a slight uptick in activity due to high levels of demand. In contrast to 2006-07, however, developers are generally adding units at already established industrial locations rather than developing out from scratch in untested locations. Considerations of increased obsolescence are being factored in to development decisions particularly in terms of power supply. As automation and electric vehicles are becoming a part of the industrial landscape, power requirements have surged; it is estimated that a modern large format warehouse requires the same levels of power as 10,000 three-bedroom houses. This will most likely push developers and occupiers to look beyond the traditional prime areas and ultimately locate closer to urban centers, which have superior electrical infrastructure. Capital flows Investment volumes in 2017 hit a record high for European real estate (See figure 2). Over EUR127 billion was invested in the eurozone during 2017, a 15% increase on the same period last year. However, this outperformance was largely driven by investor interest in industrial, with total volumes ending the year 91% above 2016 levels. This surge is partly explained by an increase in M&A activity as several multi-billion deals closed for industrial entities over the course of the year. Offices also saw a slight increase as well, 11% above 2016, while retail volumes fell by 5% underlining a general cautiousness surrounding the sector. A closer look at the retail sector will show that shopping center transactions were much weaker, declining by around 16%. There were some strong performers within the eurozone. At a country level, the Netherlands in particular benefitted positively from the improving economic and consumer outlook with a significant increase (+41%) in commercial investment volumes totaling EUR 19.7 billion. Similarly, investment volumes increased substantially in the smaller markets of Portugal (+107%) and Italy (+23%). Investors were attracted to the recovering occupational market in Portugal, whilst investors started to respond to the improving economic outlook (albeit from a low base) and market sentiment in Italy. At a sector level, the greatest increase in investment volumes during the year was recorded in the industrial sector (+91%), although transaction volumes were much smaller at EUR 22.2 billion than the office segment (EUR 74.1billion) due to the total investable market size. Overall, at a sector level the industrial sector attracted a substantial uplift in attention across the Eurozone without exception. The smaller markets of Portugal Page 4 of 8
and Finland saw the greatest increase in investment volumes at +267% and +814% respectively. Demand was also strong in the Netherlands and Spain, although the continued shortage of good quality stock and competitive pricing constrained volumes. Whilst, in contrast to the continued strong performance in the industrial sector, investment volumes fell (-4.9%) in the retail sector to c. EUR 13.2 billion. In terms of demand, investors continue to be focused on core and core plus assets, particularly in major cities. Investors are increasingly more willing to take on measured risk where there is a robust local supply and demand story. However, prime product remains in short supply in major cities and demand remains elevated. In most eurozone markets, prime yields have now fallen below, or are very close to, record low levels. Figure 2: Eurozone investment volumes (EUR '000) 180'000 150'000 120'000 90'000 60'000 30'000-2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 Office Retail Industrial Hotel Other Source: CBRE, 4Q17 Outlook Over the next three years, we expect a total return for all property of c.5.8% p.a. This forecast is slightly stronger than our expectations six months ago (5.1%). This is being driven by a more robust outlook on capital growth. The industrial sector shall remain the strongest performer, with a total return of 6.8% and is followed by the retail sector (5.9%) and then office (5.3%). The industrial sector benefits from both higher yields and strong occupier demand as supply chains are overhauled to deal with the ongoing developments in e-commerce. Over the next three years, the Netherlands is expected to be the strongest performer with Portugal a close second as shown in figure 3below. Both markets are expected to benefit from strong capital growth as a result of strong rental growth while the income return component remains comparatively high. Portugal and the Netherlands are expected to see above average returns supported by front loaded inward yield compression and strengthening rental growth as a result of improving occupational market conditions. Figure 3: Total return forecast 2018-20 (% annual average) Netherlands Portugal Finland Spain France Eurozone Belgium Italy Germany 0.00 1.00 2.00 3.00 4.00 5.00 6.00 7.00 8.00 Income Return Capital Return Source: UBS Asset Management, Real Estate & Private Markets (REPM), February 2018 Page 5 of 8
Office Retail Returns for all the eurozone office markets between 2018-20 have been upgraded in the new forecasts, mostly to reflect the improved economic outlook for the eurozone which as noted earlier is starting to translate into some really positive occupational demand, and rental growth. During this period the Netherlands, France and Portugal are expected to outperform the eurozone average. Netherlands is benefiting from one of the strongest trend rates of rental growth, while Portugal has lagged in the cycle and is set to benefit from slightly higher yields. But perhaps the most interesting is France which has jumped up the rankings reflecting the markedly improved occupational demand in Paris, and continued strong levels of investor appetite which has also spread to the regional centers. Ireland sits at the bottom of the pack as this is the only eurozone market where we can observe a serious supply response taking place which is forecast to deliver a negative rental impact over the three year period, whereas the impact for all other markets is positive to varying degrees. Chart 4: Relative peformance of office markets against the eurozone average 2018-20 (EZ average = 5.3) Netherlands France Portugal Belgium Spain Finland Germany Italy Ireland -1.5-1 -0.5 0 0.5 1 1.5 Source: UBS Asset Management, REPM February 2018 Over the forecast period 2018-20, Portugal, Spain, Italy and France are all expected to outperform the eurozone average while the Netherlands, Germany and Belgium are forecast to underperform due to lower capital growth prospects as shown in the chart. France is also expected to outperform due to improving investment sentiment translating into capital growth. Strong rental growth has been seen in prime high street and shopping center markets in recent years and this is expected to filter through to the average (MSCI) retail market as occupier and consumer conditions continue to improve, although growth will be moderate due to the ongoing impact of e-commerce. Retailers remain committed to their bricks and mortar stores although they continue to 'fine tune' their portfolios to match changing retail dynamics. In general terms, retailers are gravitating toward larger units in dominant retail locations and moving away from less dominant retail offers. This has already translated into store closures in less dominant retail locations. For example, in a recent 4Q17 company report for Inditex (incorporating brands - Zara, Pull&Bear, Berhska, Stradivarius, Oysho and Uterque), negative net store openings (-29) during the quarter were reported across their store network but they only registered a marginal reduction in total retail floor space occupied (-0.4%). This is largely because store closures were located in smaller, less dominant retail markets in mature European markets and new openings were generally twice the size of store closures. This example clearly illustrates the ongoing trend of polarization in the retail sector and we expect this will to be a key feature of the eurozone retail market in the near term. Chart 5: Retail total return forecast 2018-20 (% average annual) Portugal Spain Italy France Finland Eurozone Netherlands Germany Belgium 0.0 2.0 4.0 6.0 8.0 Income Return Capital Return Source: UBS Asset Management, REPM, February 2018 Page 6 of 8
Industrial / Logistics Viewpoint Over the period 2018-20, we expect Spain, Finland, France and Netherlands F to outperform the eurozone average with Ireland performing in-line. Italy, Belgium, Germany and Austria are expected to lag. Industrial forecasts have been upgraded across all countries over the last six months, representing the continuing strong performance and investor enthusiasm surrounding the sector. Germany is perhaps one that stands out, as it is a highly industrial economy and has strong economic fundamentals. However, Germany has seen significant yield compression as a result of its safe haven status, while rental growth has been harder to achieve due to the predominance of design and build and high land availability. Finland's returns are largely driven by relatively high yields following a period of soft performance, while the Netherlands is enjoying a period of recovering fundamentals as well. The distribution sector continues to benefit from the growth in private consumption and online retail. The pace of development is relatively uneven, however with, Germany and Nordic countries seeing very high penetration with southern Europe lagging behind. Nonetheless, there has been a significant uptick in requirements, particularly modern cross-docked warehouses in the vicinity of urban areas. It is likely that this area of logistics will evolve at a rapid pace as occupiers are struggling to deal with the demands of ecommerce in a cost-effective manner. As a rule we would therefore expect urban logistics to significantly outperform out of town stock both in terms of rental growth and capital appreciation. Chart 6: Industrial/logistics total returns forecasts 2018-20 (% average annual) Spain Finland France Netherlands Ireland Eurozone Italy Germany Belgium Austria 0.0 2.0 4.0 6.0 8.0 Source: UBS Asset Management, REPM, February 2018 Will Europe see supply chains 'localized'? Having already benefitted from the growth of ecommerce the industrial sector may be about to see a second tailwind- this time in the manufacturing sector. Rising wage costs in key developing economies have begun to erode the cost benefits of outsourcing production and have prompted European producers to consider 're-shoring operations. CEE locations, particularly Poland and Czech Republic have already benefitted from significant relocations, especially from the automotive sector and are expected to see manufacturing GVA as a share of GDP continue to rise significantly over the next 10 years. In the fashion industry as well, many operators have begun to realize that speed to market and customer service are worth paying for; Zara produces 60% of its products in Europe and North Africa, while online retailers ASOS and Boohoo source around 50% of products in their home markets. There are two catalysts to this process. Firstly, the TEN-T program will allocate significant capital to developing and bolstering physical and digital infrastructure within the EU. Secondly, improved technology will provide opportunities for streamlining processes. Driverless cars have the potential to boost drive times, while robotics and 3D printing in factories have the potential to reduce labor costs significantly. These gains, if realized, may further reduce the comparative cost benefits of locating in Asia. There are already tentative signs of development in this direction. Ocado and Amazon have already implemented robotic systems in their distribution warehouses, while on the production Adidas have just opened a fully automated robotic factory near the German town of Ansbach. Both Adidas and competitor Nike have announced their intentions to re-shore as much production as possible over the next five years in order to be closer to the end consumer. From the outset, it's important to emphasize that we are not expecting a wholescale 'reindustrialization' of Europe. While some cost benefits of manufacturing in emerging markets are falling, such areas still have advantages in producing less complex, mainstream products. However, there are indications that production is becoming more customer-centric. Just as the online consumer expects rapid fulfilment of online retail orders, they will increasingly have similar expectations of production meaning global supply chains will not be optimal for all operators. A growth in reshoring will create new challenges for occupiers and landlords, however. As technology will most likely play a key role, electrical infrastructure will need to improve due to the power intensive nature of the new automated systems. We are already seeing evidence of occupier decisions being influenced by this factor, and this could potentially re-shape how we think about prime and secondary locations. Going forward, a welllocated high spec warehouse will not be able to command top rents unless it has a sufficient power supply as well. Page 7 of 8
Real Estate Research & Strategy Team Europe Gunnar Herm Zachary Gauge Melanie Brown Sean Rymell For more information please contact UBS Asset Management Real Estate & Private Markets, Research & Strategy Gunnar Herm +49-69-1369 5317 gunnar.herm@ubs.com Follow us on LinkedIn www.ubs.com/realestate This publication is not to be construed as a solicitation of an offer to buy or sell any securities or other financial instruments relating to UBS AG or its affiliates in Switzerland, the United States or any other jurisdiction. UBS specifically prohibits the redistribution or reproduction of this material in whole or in part without the prior written permission of UBS and UBS accepts no liability whatsoever for the actions of third parties in this respect. The information and opinions contained in this document have been compiled or arrived at based upon information obtained from sources believed to be reliable and in good faith but no responsibility is accepted for any errors or omissions. All such information and opinions are subject to change without notice. Please note that past performance is not a guide to the future. With investment in real estate (via direct investment, closed- or open-end funds) the underlying assets are illiquid, and valuation is a matter of judgment by a valuer. The value of investments and the income from them may go down as well as up and investors may not get back the original amount invested. Any market or investment views expressed are not intended to be investment research. The document has not been prepared in line with the requirements of any jurisdiction designed to promote the independence of investment research and is not subject to any prohibition on dealing ahead of the dissemination of investment research. The information contained in this document does not constitute a distribution, nor should it be considered a recommendation to purchase or sell any particular security or fund. A number of the comments in this document are considered forward-looking statements. Actual future results, however, may vary materially. The opinions expressed are a reflection of UBS Asset Management s best judgment at the time this document is compiled and any obligation to update or alter forward-looking statements as a result of new information, future events, or otherwise is disclaimed. Furthermore, these views are not intended to predict or guarantee the future performance of any individual security, asset class, markets generally, nor are they intended to predict the future performance of any UBS Asset Management account, portfolio or fund. Source for all data/charts, if not stated otherwise: UBS Asset Management, Real Estate & Private Markets. The views expressed are as of February 2018 and are a general guide to the views of UBS Asset Management, Real Estate & Private Markets. All information as at February 2018 unless stated otherwise. Published March 2018. Approved for global use. UBS 2018 The key symbol and UBS are among the registered and unregistered trademarks of UBS. Other marks may be trademarks of their respective owners. All rights reserved. Page 8 of 8