Over the past couple of years, European real estate returns have been largely driven by investment in distressed opportunities. Value investments were plentiful, both in the core and core-plus styles. Yet, with a more competitive market, such opportunities are now increasingly scarce. Indeed, the next investment cycle is likely to be characterised by lower nominal returns unless investors are willing to “get their hands dirty”. We believe that we are at the start of an asset management–led investment cycle. The kind of expertise required for this type of cycle differs from previous ones. This is a cycle where local knowledge, acquaintance of local occupiers and local business practices and preferences is key.
Conditions for an asset management cycle
“Asset management” includes filling up vacancy, re-gearing leases, improving the tenant mix, taking on short leases, refurbishing assets and outright property development. The idea is take an asset with a quirk, but in a fundamentally good location, and deliver a quasi-core asset at the end of the investment period. Successful asset management requires local knowledge and expertise, strong relationships with existing and prospective tenants, and an understanding of their requirements.
Asset management tends to pay off when either of the following conditions are present:
• Businesses are confident, expanding and willing to commit to location decisions, ie. moving to a new office, expansion within their existing building, consolidation of their operations in a single location, extension of their current lease, etc.
• There is a shortage of good-quality supply due to limited development or low capital expenditure in existing assets; occupiers have a limited choice of relevant options.
In other words, asset management tends to pay off either when demand is buoyant or when supply is scarce or both. Emerging rental growth for good-quality space is a signal that one or both conditions is present.
Are businesses confident?
While conditions are improving, European GDP growth rates remain mild. However, forward-looking indicators suggest that growth is set to pick up in 2015. The sharp fall in the oil price has helped, boosting household disposable incomes and business margins. Monetary policy remains loose, a weaker euro should drive export growth and Europe’s banking system received a cleaner bill of health than expected from the ECB’s asset quality review.
Improving macro conditions have been reflected in occupational markets across Europe. In 2014, office take-up was at its highest level since 2008, retail sales growth returned to pre-crisis levels, and logistics demand almost matched the record high set in 2011.
Conditions have also improved in peripheral Europe. During 2014, office take-up rose by 76 percent in Lisbon, 48 percent in Barcelona, 32 percent in Dublin, 24 percent in Amsterdam (while not in peripheral Europe, this market has suffered in recent years) and 16 percent in Milan. The same is true in the retail market, with annual retail sales growth hitting 5.0 percent in the United Kingdom, 4.1 percent in Spain and 4.6 percent in Germany, against the euro zone average of 2.6 percent.
Business surveys point to rising confidence. The composite euro zone PMI currently stands at a four-year high (54.0) and indicates further expansion of economic activity, particularly in the services sector. Euro zone employment is also rising once again following four years of contraction post-2008.
Is there a shortage of good-quality space?
Over the past three years, we have witnessed the lowest level of new supply across Europe’s largest office markets for more than 30 years. Net additions have been approximately 0.5 percent of stock per year, well below the long-term average of 1.7 percent of stock. The same is true in both the retail and logistics markets. Furthermore, there has been very little capital invested into real estate during the crisis; ageing and obsolescence have become rampant.
The lack of new supply has led to a severe shortage of good-quality availability. Despite this, overall vacancy remains high. For example, in the office sector, available office space is either poor-quality, located out-of-town or deemed unlettable (or only lettable in strong growth conditions).
Good-quality real estate remains scarce across all sectors:
• CBD office vacancy rates in central London and the main German office markets are at their lowest levels since 2001. In Amsterdam, vacancy in the South Axis (the CBD) is below 7 percent, while the wider market has a vacancy rate of more than 17 percent.
• In the UK retail sector, prime central London High Streets and super-regional shopping centres are virtually fully let, while some medium-sized, fashion-led shopping centres in secondary towns are suffering vacancy rates of more than 20 percent.
• Design-and-build has been the main driver of logistics demand over the past couple of years as occupiers struggle to find suitable available space. In 2014, build-to-suit and newly-built schemes for owner occupation accounted for 40 percent of French and 59 percent of German logistics take-up.
Development has started to pick up in places but remains well below pre-crisis levels and is largely pre-let; speculative development is rare. PMA forecasts that office net additions to stock across Europe are unlikely to surpass 1.2 percent per year over the next five years, well below the long-term average. There will be pockets of higher development, such as in the City of London (even if the pipeline for 2015 and 2016 is low) and Warsaw, but these remain the exception. The lack of good-quality space is likely to persist.
Emerging rental growth
Rental growth remains patchy and polarised across Europe. However, some of the northern European office rental markets turned the corner in 2011, such as London and the major German and Nordic cities. Even in peripheral Europe, rents are now picking up. In Q4 2014, Madrid and Amsterdam prime office rents rose for the first time since 2008 and 2011, respectively. Prime rents have also stopped declining in Lisbon, Barcelona and Milan following years of decline.
However, only the best-quality offices in each market are enjoying rental growth. For example, in Madrid, although prime rents rose by 2.2 percent at the end of 2014, average rents are still in decline. For UK regional offices, prime rents have risen by 4.1 percent over the past two years in contrast to a decline of 0.8 percent for average-quality space, according to IPD.
In the retail sector, rental growth is equally polarised. The most dominant retail schemes, where retailer demand is at its highest, have enjoyed strong rental growth. Prime High Street rents in London have risen by 48 percent over the past five years, followed by 35 percent in Berlin, 37 percent in Vienna and 23 percent in Paris. Over the same time period, regional UK High Street rents have declined by 14 percent. In the Netherlands, city centre retail rents have risen by 4.4 percent since 2009, however, suburban shopping centre rents have declined by 3.2 percent.
An example: German retail warehouses
German out-of-town retail is one of the key examples where asset management gains are possible in the current cycle. Both demand and supply conditions, as well as some structural changes, are shaping this opportunity.
After two decades of consumer activity post re-unification, German consumer fundamentals are now strengthening (record low unemployment, strong earnings growth, rising house prices and low household debt) and retail sales are rising at their fastest rate for more than 25 years. Germany, once again, is the top location for planned international retailer expansion, according to CBRE.
The composition of existing retail stock in Germany is unusual by European standards, as most retailing takes place in retail warehouse parks and little in shopping centres. The majority of these parks are old and dated due to a lack of investment during the 2000s, when the German economy struggled and the German consumer was largely viewed as a “value shopper” who enjoyed shopping in “functional” stores.
As a consequence, German retail warehouse rents are among the lowest in northern Europe. There are also structural reasons for low rents, as German retail tenants tend to enjoy renewal options (not at market rent, but with a continuation of the lease signed), and indexation is not full and is only captured after cumulative inflation has hit a certain percentage (usually 10 percent).
Implementing asset management strategies often takes longer than expected in Germany. Planning is restrictive, change of use is hard to obtain and the process is long and cumbersome. However, on the upside, retail parks are protected from new competition.
However, there is potential for strong asset management gains over the next decade. Firstly, the German consumer appears to be changing; increasingly demanding a retail “experience”. For example, Real, the largest German hypermarket operator, recently embarked on a refurbishment programme (remodelling stores, offering higher-quality produce and introducing new lines) of 50 selected stores, in which retail sales climbed by more than 15 percent and the number of customers rose by 25 percent. Retailers may be more willing to pay higher rents if retail sales are rising on the back of investment in their stores.
Secondly, we believe that eager, new retail entrants are increasingly likely to accept leases without renewal options and higher indexation in order to gain exposure to the strong German consumer.
There would appear to be multiple asset management opportunities in the German retail warehouse sector. However, in order to be successful, local knowledge is essential. Being acquainted with the planning process and knowing the typical retail park tenants (retailers such as Obi, Metro Group, Edeka, etc) is highly advantageous. If an investor wants to attract a major retailer into a refurbished scheme or to a retail park with just one year remaining on the lease, local knowledge is what truly makes the difference.
Outperformance driver is in place
Current market conditions are conducive to asset management–led investment strategies. Businesses are increasingly confident on the back of an improving economic backdrop. New supply has been low for more than five years, creating a quality vacuum. Both strong demand and a lack of relevant supply has driven rental growth for the best-quality assets in both core and now peripheral European markets.
There are fewer compelling value investments available across Europe. Asset management is likely to be the key driver of outperformance over the next investment cycle. However, in an asset management–led investment cycle, stockpicking, local knowledge, relationships with tenants and hands-on experience will be key in achieving higher returns.