REAL ESTATE October 2018 Europe Real Estate Market Outlook For Investment Professionals only
Executive summary Economic growth softens, but macro tailwinds still strong Majority of European markets now firmly in expansion mode Record low vacancies and rising flexible office demand driving office rents Consumer demand driven by Chinese tourists, supportive of dominant high street retail Spanish and Nordic logistics expected to deliver above-average property returns in the short term
Economic growth softens, but macro tailwinds still strong Economic growth in the Eurozone has softened in 2018 with trade uncertainties, but a number of macro tailwinds should support steady momentum going forward. GDP grew in Q1 and Q2 by 0.4% and 0.3% respectively, down from the 0.7% quarter-on-quarter growth seen over the second half of 2017. Weaker data has been attributed to growing concerns over global trade, primarily in relation to newly imposed US tariffs on Eurozone exporters, with automotive manufacturers a key target. Confidence in the Eurozone s manufacturing sector has fallen as a result, but the Markit Manufacturing PMI remained at 54.6 in August, well above the average for the last five years and still supportive of healthy, albeit more muted, expansion. In an effort to ease tensions, the US and European Union have since agreed to negotiate a new phase between the two economies, with zero tariffs likely to be implemented across a number of major sectors including chemicals and pharmaceuticals. This should support a pick-up in both manufacturing and services confidence over the remainder of the year. Overall, Eurozone GDP is expected to grow at a healthy rate of 2.2% pa on average over the 2018-19 period, in line with 2017. The recovery is forecast to be led by Spain (2.5% pa), Finland, the Netherlands and Sweden (all 2.4% pa). Figure 1: GDP outlook remains healthy across the Eurozone Average Real GDP Growth (% p.a.) 3.5 3.0 2.5 2.0 1.5 1.0 0.5 0.0-0.5-1.0 UK Belgium France 2011-2016 2017 2018-2019 Source: Bloomberg, July 2018. Germany Portugal The political picture remains typically transient, with Italian government bond yields climbing to 3.1% in August, following concerns over the newly formed coalition and their impending first economic budget. Elsewhere, more positive news came in the form of a smooth transition to a new Spanish government, reinforcing the strength of their economy. As of June, Spain and Italy also have Eurozone Sweden Finland Netherlands Spain new reasons to warm to the EU, as Brussels announced that it was shifting 30 billion of its cohesion funding away from central and eastern Europe in favour of the South. A number of key metrics continue to suggest domestic demand will support GDP growth. The Eurozone unemployment rate has fallen to 8.4% so far in 2018, the lowest since December 2008. Many countries still have scope to improve, particularly Italy and Spain, but also France, where Macron s labour reforms aim to cut unemployment from 9.1% today down to 7% by 2022. By comparison, a number of markets, including Germany and the Netherlands now boast unemployment rates of less than 4%. With inflation rising to 2.1% in August, in line with the ECB s target figure, it is likely that policymakers will look for sustained upwards pressure on inflation before implementing monetary policy changes. As such, the ECB is not expected to begin raising interest rates until the latter part of 2019. Most European markets now firmly in expansion mode While the interest rate cycle in Europe now lags both the US and UK, the potential for further prime office yield compression across core European Central Business Districts (CBD) remains relatively limited. We do not expect property yields to increase significantly in the medium term either, as a rise in the bank rate and bond yields does not automatically have a linear impact on property yields, with the relationship between the two much more nuanced, according to our research. A healthy risk premium of around 270bps on average is still being priced in when looking at the spread between prime office property yields and 10-year government bond yields (based on 23 office markets). 1 This spread is likely to narrow when interest rates rise, but we believe bond yields would need to increase significantly before European real estate becomes unattractive. Figure 2: The European property cycle Correcting Recovering Expanding Peaking German retail, Dublin offices Paris offices, retail, German logistics Warsaw offices Source: M&G Real Estate. Lisbon offices, Nordic logistics Berlin, Stockholm, Amsterdam offices Nordic retail, Brussels offices Helsinki offices, Spanish logistics 1 Source: JLL Q2 2018.
The region s strong economic backdrop and rental growth prospects can also lend support to property values. With most European cities still in expansion mode, our expectation is for all-property rental growth to see 2.5% pa over the next three years, which should boost property values in the medium term. This is in line with our expectation that income, rather than capital growth through further yield compression, is likely to be a key driver of future European returns. Record low vacancies and rising flexible office demand driving office rents Across the major sectors, office markets continue to see healthy performance, with 13 city markets recording rental growth over the first half of 2018. Milan (6.4%), Madrid (5.6%) and Copenhagen (5.3%) 2 top the ranking on a cumulative annual basis, reflective of accelerating GDP rates in the Southern European and Nordic economies. With future net additions in these markets forecast to be just 1% of stock pa over the next five years, 3 upwards pressure on rents is likely to remain. Occupier demand continues to strengthen, with technology and media-based firms comprising an increasing percentage of the market. Serviced and flexible office providers in particular have grown in importance. Having accounted for just 1% of annual take-up since 2011, they now typically comprise between 5% and 15% dependent upon location (2016-17), 4 with more than 70 major operators across the Continent. We expect this share to continue growing, with expanding companies increasingly in need of more flexible terms and additional amenities to attract and retain staff. Stronger demand has seen vacancy rates in a number of CBD markets drop below 3%, including Stockholm and Berlin where rents continue to improve. 5 Even in Paris, where prime office rents ( 760 psm pa) are nearly double the European average, the prospects for renewed rental growth appear imminent, with a vacancy rate in the CBD of 3.1% and incentives across the region reducing for the last three quarters. 6 Figure 3: Greater Paris region office incentives Incentive rate % 23 22 21 20 19 18 17 16 15 Q4 2012 Q1 2013 Q2 2013 Q3 2013 Q4 2013 Q1 2014 Q2 2014 Q3 2014 Q4 2014 Q1 2015 Q2 2015 Q3 2015 Q4 2015 Q1 2016 Q2 2016 Q3 2016 Q4 2016 Q1 2017 Q2 2017 Q3 2017 Q4 2017 Q1 2018 Q2 2018 Source: Immostat, Q2 2018. Demand from Chinese tourists supportive of dominant high street retail Following a quiet first quarter, rental growth in the retail sector accelerated in Q2, led by Paris (6.8%) Prague (5.0%) and Madrid (3.7%). 7 Record forecasts of arrivals in established tourist destinations including Milan should continue to deliver healthy growth, with consumer sentiment across much of the continent running above historic averages. Tourists remain a significant contributor towards Europe s consumer catchment. The region has the largest inbound tourism market globally, attracting over 670 million international tourists in 2017. This accounted for half of the world s total, with international arrivals growing by over 5% y-o-y, despite the maturity of the market. Urban areas, in particular, have seen stronger tourism inflows, accounting for almost two-thirds of the total number of tourist nights spent in the EU-28. The top three cities to attract both domestic and international overnight stays have been Milan, Rome and Paris. Figure 4: Global tourism flows into Europe by origin International Arrival Projection (millions) 800 700 600 500 400 300 200 100 0 1980 1990 1995 2000 2005 2010 2020 2025 2030 Europe Asia and the Pacific Americas Africa Middle East 2 Source: JLL Q2 2018. 3 Source: PMA, Spring 2018. 4 Source: Savills, June 2018, PMA Spring 2018. 5 Source: PMA Spring 2018. 6 Source: Immostat, Q2 2018. Source: UNWTO, World Bank, 2017. 7 Source: JLL Q2 2018.
This catchment is expected to grow further, as international flows are supported by a record influx of tourists from Asian markets, especially China, and simplified visa requirements across the Schengen area. An estimated six million Chinese citizens visited Europe in 2017, up 26% on 2016. This makes Europe the second most popular destination for Chinese outbound tourists, behind Asia itself. In terms of expenditure, Chinese tourists overseas spent some 228 billion in 2017, double that of North American tourists and a 5% rise on the year before. 8 The 2018 EU-China Tourism Year initiative, aimed at improving connectivity through increased direct flights between the regions, should boost arrival numbers further. The World Tourism Organization (UNWTO) expects that by 2020, a quarter of all tourists visiting Europe from Asia will come from China. Strong tourism characteristics have driven retailers towards space expansion in Europe s major cities. These markets typically have amongst the largest percentage of international retailers as a result and are attracting new market entrants from this group. Spanish and Nordic logistics expected to lead the sector The prospects for the European logistics sector continue to look bright, despite concerns over global trade and the threat of increased protectionism. Confidence in the manufacturing sector is running well above long-term trends, with the outlook for export growth still positive. Demand for logistics space grew nearly 15% y-o-y in 2017 and is expected to continue rising throughout 2018. 9 The need to service accelerating online consumption has led to a structural, rather than cyclical, shift in the market. With vacancy rates across Europe falling to less than 5% in Q2 2018, 10 occupiers are increasingly left with limited options for new space. A lack of good quality supply and tightening rental incentives (typically three to six months rent-free on 5-year lease terms), should apply additional pressure to headline rents. Madrid (5%) and Copenhagen (4.3%) 11 have seen some of the highest levels of growth to date this year. With logistics in Spain and the Nordics typically higher yielding than the core European markets, they offer the greatest potential for short-term yield compression and we believe are well-positioned to deliver above-average property returns over the next two years. Structural drivers including 700 billion of transport infrastructure improvements under the TEN-T programme and the restructuring of online cross-border trade under the Digital Single Market initiative should boost the sector even further. Markets which are strategically located along key network corridors or close to growing and affluent populations are expected to benefit most from these developments. 8 Source: UNWTO, 2018. 9 Source: JLL, European Industrial & Logistics, Q4 2017. 10 Source: JLL, European Industrial & Logistics, Q2 2018. 11 Source: JLL, Q2 2018. Pockets of value can be found in second-tier cities Capital raising across the continent and globally remains at record levels, with Europe still the top target for investors for the third year running according to INREV. Given the healthy state of the occupier markets, it has been no surprise that European investment volumes have maintained their upward momentum, rising 9% y-o-y. While the strength of investment activity has continued to add weight to prime property yields, only a handful of markets are still experiencing significant yield compression. Figure 5: Yield spread between prime CBD markets and second-tier cities Prime Office Yield (%) 7 6 5 4 3 2 1 0 +130bps +250bps Paris: CBD Lyon Lille Marseille +50bps +140bps Berlin CBD Stuttgart Cologne Hannover Stockholm CBD Gothenburg Stockholm Edge Malmo Source: JLL, PMA, Cushman & Wakefield, Q4 2017. Milan CBD Rome Milan Semi Centre Bologna Amsterdam CBD Utrecht Rotterdam The Hague In the office sector, there is also now a growing disparity between prime yields in the CBDs of capital cities and those of second-tier markets. As finding value becomes more challenging, investors are turning to adjacent submarkets or good quality second-tier cities where pockets of value can be uncovered. These markets typically offer a discount ranging from 50bps up to 250bps over prime CBD yields. Careful consideration of additional risk is clearly important when looking outside of core submarkets, but fundamentals in many of these locations are improving. While cities such as Utrecht and Gothenburg are smaller than the country s respective capitals, they feature growing connectivity infrastructures, boast innovative and skilled labour forces and benefit from strengthening occupier dynamics. We believe investors targeting real estate in these strengthening second-tier cities are expected to generate higher, more sustainable risk-adjusted returns. In summary, while global trade concerns continue to impact our short-term views, momentum in the Eurozone economy is expected to remain highly accretive to future property performance. With most major cities in expansion mode and improvements in occupier fundamentals extending beyond the key capital cities, the European recovery cycle is now much more widely spread across the continent. As yield compression in core cities begins to slow, rental growth and income will continue to drive healthy returns in the medium term. +70bps +110bps +50bps +250bps +120bps +170bps
Strategic themes and long-term recommendations Offices Look beyond gateway cities and CBD markets for better value Target quality assets in supply-constrained submarkets to capture strongest potential for rental growth Focus on cities with improving connectivity and highly innovative work forces Retail Target dominant, tourist-driven high street retail locations Actively asset manage schemes to enhance potential real estate performance Seek out food-anchored and destination-led retail with diverse leisure offering to capture footfall 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
Contact Alex Lund Senior Associate: Property Research +44 (0)20 7548 6555 alex.lund@mandg.com Vanessa Muscarà Associate Director +44 (0)20 7548 6714 vanessa.muscara@mandg.com Richard Gwilliam Head of Property Research +44 (0)20 7548 6863 richard.gwilliam@mandg.com Lucy Williams Director, Institutional Business UK and Europe, Real Estate +44 (0)20 7548 6585 lucy.williams@mandg.com Stefan Cornelissen Director of Institutional Business Benelux, Nordics and Switzerland +31 (0)20 799 7680 stefan.cornelissen@mandg.co.uk Costanza Morea Italy +39 3440 408 396 costanza.morea@mandg.com Florent Delorme France +33 (0)1 71 703088 florent.delorme@mandg.fr Alicia Garcia Spain +34 915 615 257 alicia.garcia@mandg.com Manuele De Gennaro Switzerland +41 (0)43 443 8206 manuele.degennaro@mandg.co.uk www.mandgrealestate.com 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. 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. Notice to recipients 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. Notice to recipients in Hong Kong: The contents of this document have not been reviewed by any regulatory authority in Hong Kong. If you are in any doubt about any of the contents of this document, you should obtain independent professional advice. Notice to recipients 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 304 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 0HH. 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 3852763 with its registered office at Laurence Pountney Hill, London EC4R 0HH. 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 18 / W311107