Prudential Real Estate Investors European Quarterly October 2005 Market Perspective Europe s economic recovery remains slow and fragile, but despite this, conditions in property leasing markets are improving. Increases in energy prices, however, have pushed inflation well above target in most of Europe, and this has raised expectations of a tightening of monetary policy. Were it to materialize, a period of significant and sustained interest-rate increases would stifle rental growth, much needed to underpin current pricing, and would reduce the volume of capital targeting the market. As of yet, capital flows to the sector show no signs of abating, but significant monetary tightening remains the key risk facing European real estate markets. Economic Context The sluggish and fragile economic recovery continues to stifle a more rapid improvement in Europe s property leasing markets. Recent data indicates the European Union s (EU) GDP grew by 0.4% in 2Q and by 1.3% over the same quarter one year earlier. The contribution of domestic demand to real growth continues to be weak. In particular, the contribution of private consumption was just 0.1% in 2Q, which may partly reflect the impact of rising oil prices on real income. Net export growth also remained weak: its contribution to real GDP growth declined to almost zero in 2Q. Nevertheless, economic growth could pick up in the second half of 2005. During 3Q, all components of the European Commission s Economic Sentiment Index (consumer, industrial, service sector, retailer and construction sector confidence) improved, although most remain below their long-run averages. Improved consumer sentiment along with recent developments in retail sales and new car registrations provide modestly positive signals for consumption dynamics in 3Q. Prudential Real Estate Investors 8 Campus Drive Parsippany, NJ 07054 USA Ph +1 973.683.1745 Fax +1 973.734.1319 Web www.prudential.com/prei E-mail prei.reports@prudential.com Labor markets conditions, one of the main drivers of consumer confidence, are also improving. The EU unemployment rate fell from 8.9% at the end of 1Q to 8.7% at the end of August. This modest tightening is likely to result in some convergence in regional unemployment rates in the EU, which, at the end of last year, ranged from 2.4% (in Dorset and Somerset, UK) to 32.8% (in Réunion, France). Two successive quarterly rises in EU-wide employment have also occurred, and employment expectations for the industry and service sectors improved in 3Q.
Despite the substantial scope for productivity improvements in many European nations, these developments are likely to result in improved real income growth during the first half of 2006. The European economy continues to feature an underperforming core (particularly Germany, Italy and the Netherlands) and an outperforming periphery (the Nordic region, Central Europe, Spain and the UK). Although this pattern of growth is expected to persist over the next five years, the extent of the underperformance of Europe s core, and Germany in particular (which accounts for about one-third of euro-zone GDP), is likely to diminish over this period. While the German government s ability to force through much-needed economic reform has been limited over the last few years, the corporate sector has been more successful in restructuring and reducing its cost base. Increased labor market flexibility, including decentralized pay bargaining, longer hours and wage cuts, have sharply decreased unit labor costs relative to many of its neighbors. This growing competitiveness has helped Germany recently regain its position as the world s leading exporter and has led to sharp rises in corporate profitability and stock market valuations. More importantly, recent surveys of business confidence have been encouraging, which should help boost investment expenditure and enhance firms willingness to raise headcount. The latter should help to improve consumer confidence. Given the latent spending capacity of German households, due to several years of excess saving, a significant revival in domestic demand could occur. Consensus GDP growth forecasts for Germany remain weak (0.9% this year and 1.3% next), and the results of Germany s recent election will do little to encourage forecasters to revise expectations upward. Legislative change and much-needed reform of public finances are likely to be more difficult under the new administration. However, after several years in which growth has failed to match expectations, the restructuring of corporate Germany and the revival in business and consumer confidence may well provide the foundations for economic performance to surprise on the upside. Not only would this give impetus to property leasing markets in Germany, but it would also provide a much-needed boost to the economies and leasing markets of its neighbors, not least the Netherlands, where fundamentals remain very weak. Conditions for an increase in European economic growth over the medium term remain in place. On the external side, ongoing growth in global demand should support euro-area exports. Domestically, the favorable financing conditions prevailing in most of Europe and the robust growth of corporate earnings should encourage investment growth. Consumption should expand gradually, in line with the expected moderate growth of real disposable income. Overall, more positive fundamental factors may shape economic developments. However, the outlook for economic activity remains subject to downside risks, relating mainly to the need for fiscal tightening in many countries, given the constraints of the Stability and Growth Pact, concerns about global imbalances, weak consumer confidence and oil prices. Oil price increases have already contributed to inflation now being above-target in the UK and the euro zone. At a time when the UK economy is showing signs of weakness and the euro-zone economy is trying to gain momentum, the last thing central bankers want to do is stifle growth by raising base rates prematurely. Consequently, recent weeks have seen central bankers begin to 2
manage inflation expectations and interest rates by warning of the risks of inflation rather than by explicitly changing policy. Capital Markets Inflationary pressures and more hawkish talk from central bankers in recent weeks have impacted interest rates in Europe. In the UK, monetary authorities cut rates by 25 bps in August in response to a weakening growth profile. At that time, financial markets were pricing in a further fall in base rates by year-end. Following recent data and comments from the Monetary Policy Committee, financial markets now expect the next move in rates to be upward. Expectations of rate increases in the euro zone have been brought forward relative to three months ago. The markets now expect a 25 bp increase by year-end and a 50 bp rise by next spring. Longer-term interest rates have also risen in response to these dynamics. Five-year swap rates and 10-year government bond yields in the UK and the euro zone have risen by 20 to 30 bps since the start of September. Despite these increases, the interest-rate environment remains supportive of real estate investment, especially in the euro zone. The arbitrage opportunity afforded by property s yield premium over finance costs remains wide in the euro zone and still supports demand for real estate from highly leveraged private investors and opportunity funds. Despite the fact that this premium is much thinner in the UK (and negative for better-quality property), yield shift continues to drive performance: the all-property initial yield fell 20 bps to 5.37% in 3Q, according to IPD. This highlights the current strength of demand from equity-oriented investors, such as institutions. The fact that new funds, created by experienced managers with good track records, are greatly oversubscribed with institutional capital also highlights the strength of demand. Moreover, pension fund and insurance company demand for direct and third-party managed real estate is likely to remain strong for some time. In addition, it is expected to remain relatively insensitive to modest increases in bond yields over the short term for several reasons. First, the high level of institutional demand is to some extent a function of a long-term strategic shift to real estate. Second, unspent capital already allocated and committed to real estate remains significant, which will delay the response of real estate pricing. Third, real estate yields have not compressed to the same extent as bond yields over the last three years. Fourth, institutional investors are equity investors and tend not to leverage their directly held portfolios. They are, therefore, indifferent to changes in interest rates, as long as the relative pricing of property and bonds remains unchanged. Although a big increase in real long-term bond yields remains the principal risk to real estate pricing, these factors are likely to ensure that any correction occurs slowly. As a result of the volume of capital that has targeted real estate over the last few years, yields have fallen significantly in all sectors in almost every European country. The main exception to this has been Germany, where office and retail yields have risen marginally over the last few years. Some of the reasons for this are economic stagnation in recent years, very weak property market leasing fundamentals, overbuilding, concerns about the integrity of valuations and the 3
well-documented problems of German open-end funds, which have resulted in more product coming to the market. As a result of this repricing of German real estate (and perhaps a belief that the performance of the German economy will surprise on the upside), many international investors are increasingly aware of the value in German real estate. Opportunity funds and private equity groups have been capitalizing on the bad news story for some time now with big sale-leaseback transactions, and large acquisitions of residential property and nonperforming loan portfolios. Recent months, however, have seen increased interest in German real estate from investors operating at the lower end of the risk spectrum. This interest has focused primarily on retail investment. However, with office rents having bottomed out in many markets and the leverage potential offered by the office yield premium over finance costs now wider than at any time since the 1980s, international investors are starting to turn their attention to the office sector. Although recent weeks have seen some speculation on the introduction of REITs in Italy, the timetable is difficult to predict, given the political volatility and parliamentary elections, which are expected before May of next year. The dominant issue in real estate equity markets, therefore, remains the possible introduction of REITs in Germany and the UK. As a result of the recent election in Germany, greater uncertainty surrounds the introduction of a REIT structure. A few politicians in one of the leading parties in the grand coalition have recently voiced opposition to it. While most politicians in both main parties remain in favor of the structure, there exists a small possibility that REITs might be abandoned as part of wider political and economic negotiations. The ramifications of abandoning the introduction would go far beyond impacting the valuation of German real estate stocks. Several international investors have increased their exposure to Germany s private real estate markets over the last few years in the hope that REITs will form an important part of their exit strategy. Moreover, several German open-end funds are looking at the potential for REITs to help with the problems in their domestic asset portfolios. In the UK, the uncertainty surrounds what kind of REIT structure will be created, which has implications for the timing of the introduction. If the UK Treasury adopts a company-exempt structure, UK REITs likely will be introduced sometime next year. If, on the other hand, the UK Treasury opts for a more complex structure that taxes non-domestic investors more effectively, a date in 2007 is likely. More news on the UK governments preferred route is expected before year-end. The French REIT sector continues to trade at a substantial premium to net asset value (NAV), with most companies share prices currently between 20% and 40% above NAV. These premiums are supported by robust investor demand and strong expected NAV growth as new development is completed. These vehicles, however, have not been as successful as originally envisaged in terms of encouraging the transfer of assets to the public markets. Even the introduction of SIIC 2, which, for a limited period, allows property to be transferred into REIT vehicles at half the usual rate of capital gains tax, has had a limited impact. However, following the publication of the Tron report, speculation is increasing that a substantial volume of 4
government-owned real estate could be transferred into REIT vehicles. The report points to mismanagement, lack of accountability, absence of cost awareness and structural underutilization of government office stock. In addition to forcing down yields, the weight of capital now pursuing real estate is affecting transaction activity. CB Richard Ellis estimates that 55.2 billion of real estate was transacted in the EU15 in the first half of 2005. This level of activity, which shows no sign of abating, is a rise of more than 20% over one year ago. As anticipated, excess capital in the market is resulting in increased sale-leaseback activity, higher levels of cross-border investment and greater interest in nontraditional sectors and locations. The market is also seeing more development activity. A byproduct of these trends is an increase in joint-venture arrangements as investors/managers team up with local or specialist partners to manage risks more efficiently. Competition for stock in direct markets is also encouraging some managers to invest in funds managed by other managers. Property Markets While investor demand remains strong across all real estate sectors, current and prospective leasing market conditions continue to vary considerably. National and local economic and property market dynamics ensure that the prospects for rental growth differ enormously across countries and sub-sectors. On the whole though, early recovery office markets and modern retail formats will see a greater share of total return from rental growth over the short to medium term. Retail Although improving in recent months, consumer and retailer confidence in Europe remains weak. Also, growth in the volume of EU retail sales remains sluggish, at an annualized rate of 1.4% in the three months to the end of August. While falling unemployment rates are expected to lift consumer confidence and result in a slight rise in real income growth next year, any improvement in conditions confronting retailers is likely to be modest. Trading conditions vary greatly across countries and formats. Retail sales growth remains weaker in Germany, Italy and the Netherlands than in peripheral countries, notably Spain and Scandinavia. This is likely to continue over the short to medium term. At the same time, modern retail formats, such as shopping centers and retail warehouses are, in general, trading better than city- and town-center retail. Even in Germany, data from the retail trade federation suggests that retailers in shopping centers and retail warehouses are more optimistic about future sales growth than those in city-center shopping streets. The same applies to France, where turnover in retail parks increased by 4% in the first half of this year, while aggregate retail sales growth was marginally negative. These figures underscore consumers increasing appetite for shopping in out-of-town locations in many parts of Europe. Given this trend and the advantages that out-of-town shopping centers and retail warehouses offer retailers in terms of rental discounts to city-center locations and larger, more flexible unit sizes, their popularity among retailers is expected to grow. Due to strong retailer demand and enhanced active management potential, income growth from these formats is 5
likely to be superior to that of the retail sector as a whole. Indeed, these characteristics have contributed to outperformance of shopping centers over the last few years. In all but two of the European countries monitored by IPD, shopping centers outperformed all retail by at least two percentage points between 2001 and 2004. Investors have noticed these characteristics. As a result of the better rental growth prospects and the difficulties of buying high-street retail in parts of Europe, investor attention in the retail sector has focused on shopping centers and retail warehouses. This has driven yields down faster than for other retail segments, thus boosting relative returns. A combination of the need to meet rapidly changing space requirements of retailers and a strong investment market is resulting in increased development activity. The stock of shopping center space in Europe is expected to grow by about 7% per annum over the next few years. Property Market Analysis (PMA) estimates that currently about 15 million square meters of shopping center space is under construction or has full planning permission in Europe. More than half of this is in Spain, Italy and Poland. Strong consumer demand in Spain and low per-capita supply of shopping center space in Italy should result in space being more easily absorbed there than in some other markets. While the relatively full development pipeline is likely to have a slightly negative impact on rental growth across Europe as a whole, the fact that only 20% of retail sales in Europe derive from shopping centers, compared with about 50% in the U.S., implies that further scope exists for new shopping center development in many markets. The aggressive expansion plans of major international fashion retailers should help drive rental growth for prime high-street shop units. Like-for-like sales among major fashion chains have held up well, and new store openings, not just in emerging markets but also in more mature ones, such as France and Spain, have boosted overall sales growth. The large international fashion chains still view expansion as a main source of revenue growth, while many high-street retailers are suffering from weak consumer demand, imports from China and other countries with low labor costs, and giant supermarket chains expanding into more product areas. While these trends will help push up rents for prime space over the short to medium term, high vacancies and rising deflationary pressures in the goods sector will still put downward pressure on rents for secondary space. Office The recovery in the office market continues to progress. Against a background of improved business confidence and increasing profitability, the European corporate sector is moving into an expansionary mode: business investment and employment growth are becoming more robust. While the pattern of growth is far from uniform across countries, in aggregate, conditions in the European office leasing markets are improving. According to JLL, the average vacancy rate in Europe fell from 9.7% to 9.4% during 3Q. Although rates are now declining in most office markets, a fall of one percentage point in the London market (to 8%) explains much of the European-wide decline. The recovery in the London market has now been under way for several quarters. Improving employment growth and slow development activity have resulted in a faster than expected tightening of supply. This has 6
led to significant prime rental growth in the West End, where the availability of good-quality space is very low. In the City, headline rental growth has been much more modest, but incentives for prime space are starting to decline, leading to stronger rates of effective rental growth. At the other end of the spectrum, those markets with the highest vacancy rates in Europe, Frankfurt and Amsterdam, saw modest increases in vacancy in 3Q (to 17.5% and 20.5%, respectively). Supply conditions in these markets are beginning to stabilize, but rental growth over the next few years is likely to be modest. PMA estimates that by the end of 2009, prime rents in these markets will only have recovered to about 70% of their previous peaks. The return to rental growth in the early-recovery markets of London, Paris and Madrid is likely to occur at least two years before it happens in Germany and the Netherlands. Despite this, vacancy cycles across Europe are now more highly synchronized than in the last cycle. As a result, the overall vacancy rate in European office markets may well fall more quickly this time, despite weaker economic growth and scope for productivity improvements resulting in more modest growth in occupier demand. This year will represent the low point in the development cycle. Net additions to office stock are expected to rise steadily until 2009, averaging about 1.2% of stock per year. One of the principal threats to the office market recovery, however, remains an earlier than usual increase in development activity. The first six months of 2005 saw the volume of space under construction as a share of stock increase in most of Europe s main office markets (except in Dutch and German cities, where demand for space remains very weak and vacancies are rising). While developers continue to monitor leasing market fundamentals carefully, they are also very much aware of the strength of investor demand. The prospect of strong rental growth in some markets over the next few years and the lowinterest-rate environment is encouraging some investors to pay exceptionally low yields for the best-quality stock, reportedly as low as 4.5% in Paris, less than 4.5% in Madrid and Barcelona, and less than 4.0% in London s West End. These markets are all close to the bottom of their rental cycles, have relatively low vacancy and are expected to see strong demand growth over the next few years. As future rental growth on these assets is realized, their acquisition yields likely will gradually rise. Further compression in acquisition yields is not expected from these levels, but valuation yields used by appraisers could fall further over the short term. Rapid yield compression has not been limited to markets with strong rental growth prospects. Even Dutch and Italian cities, which tend to occupy positions toward the bottom end of league tables of future rental growth, have seen yields fall slightly since the start of 2005. A bit further up the tables, in Central European markets, particularly Warsaw and Prague, yield compression remains rapid as the large volume of capital earmarked for these markets gets invested. A well-located prime office asset in Prague with a long-term, secure income stream might command a yield close to 6% today. This represents a significant premium over Paris at between 4.5% and 4.75%, but with prime office yields in Germany at 5.5% to 5.75%, it may not be too 7
long before the German office markets begin to look more attractive to international investors on a risk-adjusted basis. Industrial According to JLL, leasing activity picked up slightly in the first half of 2005. Three pan- European trends, in addition to many local factors, have increased leasing demand. First, logistics firms continue to benefit from more outsourcing from retailers and manufacturers seeking to streamline their overheads. Second, the expansion of the EU last year means more intra-eu trade and higher demand for storage and distribution facilities. Finally, the admission of 10 Central European states with lower unit labor and property occupation costs has also encouraged many distribution and production firms to relocate to Central Europe. As well as varying by country, demand for space continues to vary by unit size. Demand for larger units remains strong, driven by retailers seeking to consolidate existing distribution operations into one bigger center. Demand for smaller units also remains robust, but low finance rates over the last few years have encouraged more owner occupation. JLL reports that units from 5,000 to 10,000 square meters continue to see lower, but improving, levels of activity. While several countries saw more activity in the first half of 2005 (most notably France, Spain and the UK), few markets saw increases in prime rents. Across Western Europe, rents remained stable during the first half of the year, while rental growth increases for prime space in Central Europe averaged 2.9%, according to JLL. Higher transport prices, driven largely by higher energy prices, and more competition among logistics operators have put pressure on operators margins. At the same time, development activity, some of which is speculative, is increasing the supply of modern facilities. In a strong investment market, developers have been offering shorter leases at lower rents to secure tenants before selling to investors. The European industrial market is now at the bottom of the rental cycle, but these trends will continue to limit the capacity for rental growth. Improved economic (and export) growth and more business formation, however, should raise rents slowly over the next few years. However, the principal appeal of the sector to investors will remain its relatively higher income return. Strong investor demand continues to drive industrial yields down rapidly. Across Europe, prime industrial yields averaged about 7.5% at the end of 3Q, according to CB Richard Ellis, which is a fall of 50 bps over the same time one year earlier. The spread over prime office yields has also narrowed and is now lower than ever, at about 170 bps. Part of the explanation lies with investors search for yield and the limited supply of good-quality industrial product in Europe. The institutionalization of the sector and the greater understanding of the risks of ownership of industrial investments also provide a partial explanation. The last few months have seen several investment managers launch funds to capitalize on these dynamics. Given a lack of good-quality stock in parts of Europe and strong investor demand, some of these funds intend to engage in build-to-suit development activity in joint ventures with experienced local developers or through forward commitments. 8
Summary The last three months have seen a significant improvement in the prospects for rental growth in many European office markets. On the whole, the prospects for retail rental growth are more limited, but good-quality space in a number of key markets and segments will continue to see rental increases. These trends will be very welcome to those investors who, even after having greatly reduced total return expectations, are increasingly underwriting rental growth to justify current pricing. These investors are particularly exposed to rises in interest rates. Although the interest-rate environment remains highly supportive of real estate investment, at least in mainland Europe, inflationary pressures are building, and policy makers are becoming more vigilant. Financial markets now expect the next move in interest rates to be upward, and although central bankers are keen not to raise rates prematurely, a sustained increase remains the key risk to the health of Europe s property markets. 9
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The Investment Research Department of Prudential Real Estate Investors publishes reports on a range of topics of interest to institutional real estate investors. Individual reports are available free of charge in hard copy or via the Web at www.prudential.com/prei. Reports may also be purchased in quantity for use in conferences and classes. To receive our reports, change your contact information or to be removed from our distribution list, please e-mail us at prei.reports@prudential.com, or telephone our New Jersey office at +1 973.683.1745. Prudential Real Estate Investors 8 Campus Drive Parsippany, NJ 07054 USA Tel +1 973.683.1745 Fax +1 973.734.1319 Web www.prudential.com/prei E-mail prei.reports@prudential.com Copyright 2005, Prudential Real Estate Investors Prudential Real Estate Investors is a business unit of Prudential Investment Management, Inc., a registered Investment Adviser and indirect wholly owned subsidiary of Prudential Financial, Inc., Newark, New Jersey.