The European real estate market in 2015 looks exciting. The economic recovery is picking up, total returns have been very strong over the previous two years and a growing number of markets are reaching record-low yields. Is this going to lead to a price stabilisation, a correction, a slump or maybe a crash? While no-one has a crystal ball, we will argue that we doubt there will be any crash. While we accept that some markets may have got ahead of themselves, no bubble situation exists at present, unlike in previous periods. In any case, we believe that plenty of investment opportunities remain, given that fundamentals are more robust than during previous boom periods.
The current environment
Investors remain overwhelmingly positive toward European real estate. Annual investment volumes in 2015 are likely to exceed the 2007 peak; prime office yields have continued to compress aggressively across the board; and capital values are, in places, more than 20 percent above their pre-crisis peak. Investors have also returned to peripheral markets, driving strong yield compression in the likes of Lisbon and Madrid (office yields have compressed by around 200 basis points since 2013, see “Prime office yields for selected European cities” chart).
Part of this rise can be explained by the rise of global capital. Indeed, global capital now accounts for some 30 percent of total European investment compared to some 20 percent in 2007. This includes both US opportunistic investors and emerging market capital, a lot of which has been concentrated in gateway cities (see “Emerging market investment” chart).
Yet let us not get bogged down by the headlines. Despite the low level of yields, the risk premium over long-term government bonds stands at 270 basis points (the average of the main office market in each of the five main EU countries). In 2007, the premium was just 10 basis points! The likelihood of this gap decreasing due to an interest rate hike by the European Central Bank is remote, at least for the time being, with inflation close to 0 percent. The outlook is, therefore, “lower for longer”, particularly in the euro zone.
Capital value growth across the board
Strong investor demand and rising prices have not been restricted to real estate. All asset classes have repriced as a result of the current environment of low inflation, low interest rates and less uncertainty regarding the economy. Indeed, one of the main implications of the ECB’s quantitative easing programme has been to boost asset prices.
Long-term government bonds currently stand below 1 percent per year for core euro zone countries and a BBB corporate bond yield offers a yield of just 1.6 percent. The commencement of QE led to soaring European equity indices during the first quarter of 2015. Despite the August 2015 equity price correction induced by the uncertainty about China and emerging markets, equity prices have subsequently recovered.
Is it different this time?
The key question that arises from this is the following: is this “irrational exuberance” that will inevitably end in tears? Or is this just a somewhat long recovery process in which some markets have gone ahead of themselves and are thus likely to correct? We believe that it is the latter.
Why is this time different? First, this time we have not seen the same exuberant profit growth expectations that fuelled the dot-com bubble. During 1997–2000, tech stocks experienced levels of price growth not reflected in any other sector of the economy. Shiller’s CAPE ratio (cyclically-adjusted price-to-earnings), a valuation method applied to the S&P 500 Index, climbed to record levels (see “S&P 500, Shiller p/e ratio” chart), significantly above the spike before the 1929 crash. Yet the stock market collapsed when it became clear that most of these newly-listed start-ups could not sustain themselves as profitable companies.
And secondly, nor can we observe asset price bubbles and debt build-up of the scale seen in the years preceding the great financial crisis of 2007. This time is (so far) different. The household sector has been deleveraging in Europe and corporate debt accumulation has been far tamer, with debt levels actually decreasing between 2007 and 2014 in the United Kingdom, Germany and Spain. The banking sector has been deleveraging, too, with euro zone bank assets currently 12 percent below their peak. Contrast this with the massive build-up in asset base before 2008.
Real estate fundamentals are sound
In the absence of bubbly behaviour elsewhere in the economy, commercial real estate pricing (or development activity) has not drifted, in our opinion, into irrational territory. On the contrary, compared to previous booms, property market fundamentals are structurally sound and investors are taking considerably less risk.
In contrast to 2005–2007, leverage has been much lower (in loan-to-value terms) and the yield gap between prime and secondary real estate is much wider. In fact, investors have steered well clear of poor-quality real estate. Even in the United Kingdom, which is leading the cycle, the gap between high-yielding and low-yielding assets remains very high. Unlike 2007, investors have also taken less country risk, limiting their exposure to markets such as Portugal and Eastern Europe.
Furthermore, the European economic recovery seems to be gathering momentum, supported by low energy prices, ECB monetary stimulus and economic reforms. Moreover, development (at the European level) is still modest, while nominal rental levels are generally lower than in 2007 and vastly more affordable in real terms. Therefore, we believe that there is scope for rental growth across all sectors.
The downside of emerging markets
Despite the above, it is fair to ask whether some markets have indeed gone a bit ahead of themselves? Could a correction, therefore, occur?
One potential source is the slowdown in China and commodity-exporting emerging markets. With lower revenues and less capital to spend, this could lead to less overseas investment across all asset classes, real estate included.
But we don’t have a crystal ball. A pricing correction, if it happens at all, could equally come from a slowdown in investor demand, the United Kingdom’s Brexit referendum, a breakdown in European politics, etc. However, it is important to understand what we mean by a “correction”. Not all corrections are the same.
To illustrate this point, let us look at the key price corrections that have taken place in the European real estate market since 1991:
• In 1995, the United Kingdom was emerging from a severe real estate crisis, triggered by overbuilding and a nasty recession. The sector began to emerge (in capital market terms) in 1994–1995 in the expectation that fundamentals would improve. But they did not, at least not immediately. Pricing had in the meantime somewhat heated. The result was a mild price correction — the IPD All Property capital value fell by 4.2 percent in 1996 (see “UK capital growth” chart). All sectors were equally affected.
• In 2001, the dot-com crash was in full swing. Furthermore, strong levels of oversupply in several key office markets in Europe were apparent. Central London offices were, therefore, affected, with capital values dropping by 24 percent from their peak in 2000. Several markets on the continent were strongly affected, too. Capital values declined significantly in the major German cities, Madrid and Stockholm.
• Before the “whatever it takes” shift in ECB policy in 2012, concerns regarding the sustainability of the euro caused investors to “fly to safety”. Prime office yields in Madrid and Lisbon jumped by 70 basis points and investors also sold bad-quality real estate elsewhere. The UK average yield for secondary real estate increased by some 180 basis points in 2012. However, prime London (or Paris, or the German cities) did not suffer any correction whatsoever. This was a secondary real estate correction.
The situation today is (again) different, as described above. Investment is strong but fundamentals are also sound. We do not know what will happen exactly but we would urge the reader to think that 2012-like corrections are not necessarily the norm. They could unfold in totally different ways.
We should also remind ourselves that many opportunities remain in European real estate. But, this time, performance has to come from fundamentals.
As we said in our previous article in this publication (“Keep close: are we at the start of an asset management cycle?” in the September 2015 issue), investors have to get their hands dirty to generate return. Occupier demand is stronger, development has remained under control and there is a shortage of good-quality real estate. In a cycle like this, the key differentiators will be stockpicking, local knowledge, relationships with tenants and hands-on experience.
Fear of the unknown
When yields reach record-low levels, it is natural to fear an impending correction. We believe that, if there is a correction, then it is likely to be mild and short-lived. The financial and real estate fundamentals support today’s yields. The likely cause of a correction is a hiatus in investor demand. But all corrections are different and the type of assets that were hit by previous corrections may actually do pretty well in the near future.