Europe remains in the early stages of economic recovery, with the pace of growth continuing to disappoint. Nonetheless, there is an expectation that a stronger recovery will gradually take hold over the coming few years, leading to job growth and higher demand for real estate space.
Deflation remains a major concern but this has also provided central banks with room to loosen monetary policy further. This has led to a considerable reduction in the outlook for euro zone bond yields, which are set to remain extremely low for much of the rest of the decade — and, according to Oxford Economics, boosting the relative attractiveness of real estate.
Having seen a period of relative quiet, politics in 2015 will almost certainly be more disruptive. The evolution of events in areas such as Greece and Ukraine will need to be monitored closely.
Occupier market fundamentals
European occupier market fundamentals have reached a turning point. The patchy economic recovery is still affecting demand for space, but following a strong close to 2014 annual aggregated office take-up across major European cities last year is estimated to have grown by 5 percent to 10 percent.
That said, within the aggregated figures trends varied widely across markets, with southern Europe, London and Paris seeing stronger growth, while demand in the Netherlands and Germany remained relatively flat. This momentum is expected to continue over the coming two years, as the return of employment growth supports office space requirements.
The overall market balance began to improve last year and should continue to do so. Across most markets, even in those locations experiencing rental growth, developers remain cautious. Thereby the gradual recovery in demand should further erode the availability of space.
Average vacancy is set to remain high, but in certain markets there is clear evidence of shortages in the best-quality space. Prime rents across major cities are seeing upward pressure and, by and large, most will see rental growth over the coming two years.
In terms of location, we expect Spain to be a clear outperformer as rents rebound following a period of major adjustment. Other markets set to see stronger than average rental growth include those with more robust economic prospects, such as the Czech Republic, Sweden and the United Kingdom, as well as parts of Paris following recent rental falls.
According to PMA and IPD, last year delivered strong prime real estate returns, on the back of decreasing yields. As yields edge down further and the pace of rental growth picks up, returns across sectors are set to average around 10 percent over the next two years. The recovering southern markets are set to outperform as rents move back into healthy growth, following a long period of adjustment.
Beyond 2016, the positive impact of falling yields in Europe is likely to start to reverse, and the rental cycle should start to cool as the development cycle picks up.
Toward the end of the forecast period, we expect value growth to moderate considerably in the majority of European markets and prime returns to weaken. This is likely to be most evident in the United Kingdom, where expectations of earlier interest rate rises are forecast to result in steeper increases in property yields, pushing the outlook for prime returns close to zero by the end of the decade.
The alternatives and real assets research and strategy team at Deutsche AWM has developed a proprietary statistical model that forms the foundation of our understanding of future real estate market performance and how it reacts to wider economic developments. This quantitative process provides the basis for the relative market views that we consider alongside the views of our experienced teams working on the ground in the countries, including the United Kingdom, Germany, France, Spain, Italy and Poland.
The current outlook for European real estate implies a certain set of strategic opportunities. These are listed in the boxed copy on pages 30 and 31.
Trends in capital flows indicate that global markets will continue to offer a level of diversification and wealth preservation for some long-term investors. Although prime yields have continued to compress across core Europe, given solid occupier fundamentals select investors who are willing to hold assets over the cycle should still find value on major High Streets and in office markets such as central London, Paris and Frankfurt.
Southern European markets are forecast to provide some of the highest returns over the next five years. Investor interest has intensified over the past 18 months, compressing yields and raising returns. Although yield compression is almost complete, returns are set to be driven by a rebound in prime rents.
Supported by e-commerce and the extension of Europe’s manufacturing supply chain, we see a long-term increase in demand for high-specification logistics facilities, located along key transport hubs and close to major population centres. Given a higher income return and expectations of modest rental growth, this sector is set to be one of the best performing over the next five years.
There will remain opportunities in second–tier markets and cities in the United Kingdom and Germany. Given relative pricing compared to London and the Big Six German cities, and the improving occupier market, attractive risk-adjusted returns may be achieved by taking on additional leasing risk. Across both countries, investing in smaller markets will require a higher level of specialist local knowledge.
For those investors willing to take on a greater level of risk, in cities such as Warsaw and Prague long-term economic outperformance and higher yields should more than compensate for expected periods of cyclical volatility.
Finally, given the reduction in new supply that has been delivered over recent years, growing obsolescence and rising demand is resulting in an increased rental premium on newly-built or refurbished space — particularly in constrained city-centre locations.