Around €55 billion was invested in commercial property across European real estate markets in the third quarter of 2015, according to Savills, taking the total turnover since the start of last year to €157.5 billion and representing a 20 percent increase on the same point in 2014.
But while, in the main, investors continue to favour core markets within the United Kingdom, Germany and France, which still account for 67.8 percent of total volume, the share of peripheral markets is rising.
In addition to lower levels of competition for assets, regional cities offer diversification that complements top-tier European cities, delivering more stable performance through the cycles with less volatility in rents. Furthermore, the ability of a portfolio to absorb market shock is increased when an allocation is directed at regional cities.
The average prime CBD office yield across Europe dropped to 4.6 percent in Q2 2015, below the previous 10-year low of 4.7 percent in Q3 2007, meaning that investors seeking value are increasingly looking to regional markets to satisfy their return criteria, with a particular focus on prime assets in secondary markets as a means of securing future yield compression. Although yields are sharp in regional markets, there is nevertheless a discount to core markets such as London, Paris and the German top seven cities, says Andy Schofield, director of research at TH Real Estate.
“Investors who have a specific distribution yield currently struggle to meet their requirement in core Tier 1 cities,” Schofield says. “Regional markets often do better late cycle, when their rental growth picks up pace in line with consolidating economic growth. Core Tier 1 markets, such as central London and Munich, are currently experiencing strong rental growth and this will continue over the short term.
“However, there is a risk that rising development and occupier affordability issues will choke off growth over the medium term at a time when regional markets are still posting modest growth.”
Casting the net wider
On the other hand, however, it has never been more difficult for investors to eke out value, whichever market they choose to invest in. Since Q2 2012, the yield gap between the core markets and the peripheral markets of Europe has been closing, reflecting improving investor confidence in the markets of Ireland, Spain, Italy and, more recently, Portugal, which have gone through the toughest periods of austerity and reforms and which have shown signs of improving economic performance (recent general election results in Portugal and Spain notwithstanding—Ed.).
Growth in the euro zone economy remains firm and continues to benefit from healthy domestic demand, particularly private consumption and strong exports. GDP is forecast to grow in nearly all European countries, and Oxford Economics expects the European Union to have expanded by 1.6 percent in 2015 and to see further growth of 1.9 percent in 2016.
Europa Capital is one investor with an eye on regional markets, while maintaining a focus on core cities. Its pan-European funds have historically been focused on the core markets of the United Kingdom, France and Germany, where they invest 60–70 percent of their capital owing to better liquidity in these markets, regardless of the cycle, and where lenders will generally support value-add strategies in those territories. But, says Nic Fox, head of Middle Europe at Europa Capital, part of the opportunity that accompanies investing in a pan-European programme is that the many markets that make up the map are not synchronised.
“Despite efforts to homogenise Europe, the European Union alone offers 28 markets of varying scale, demographics and climate, founded on diverse legal and tax systems, political influences and property market dynamics,” says Fox. “Little wonder, then, that some markets outperform others.
“Beyond Europa Capital’s broad geographical portfolio approach, therefore, we seek to identify ‘winning cities’ that display economic and property market dynamics that we consider make them undervalued. In turn, we adopt an asset-specific strategy to exploit that opportunity to extract premium returns.
“Examples of cities that we favour currently are Berlin, where prime office rents are roughly half those of Frankfurt, where the population is growing and where new tech industries are attracted through an abundance of young, intelligent university leavers. We also favour Barcelona, arguably Europe’s most alluring city, but where a shortage of quality housing in the city is beginning to force apartment prices significantly ahead of inflation.”
Other investors, such as Germany’s TLG Immobilien AG, are no stranger to secondary cities, having been active in the regions of Germany in and around Dresden, Leipzig and Rostock for around 25 years, but is now seeing its competition increasing among other institutional investors who are showing more interest in these regional hubs.
“Regional commercial real estate markets tend to be less volatile than the various A-markets for office space, like in Frankfurt, for instance,” says Niclas Karoff, member of the management board of TLG Immobilien. “These regions offer a relatively broad field of investment opportunities if you have detailed knowledge of and access to the market thanks to a longstanding regional presence. These locations have a solid, dynamic economic foundation that broadcasts its own appeal beyond the individual regions and leads to population growth.”
The fundamentals remain the same
M&G Real Estate, on the other hand, is active in both Europe’s capital cities and regional markets, having recently acquired offices in Madrid, High Street retail in both Milan and Copenhagen, a retail park in Dreieich, Germany, and a logistics facility in Troyes, France, as long, it says, as the fundamentals are in place for long-term income growth.
“Our hit list comprises cities and regional markets with tight development pipelines, with low supply and increasing occupier demand, and the opportunity to invest in multiple established submarkets,” says David Jackson, director: fund management at M&G Real Estate. “These would include Cologne, Stuttgart, Lyon and Cannes. For regional markets in particular, opportunities for us are likely to be found in both prime opportunities in secondary cities in core markets or in defensive opportunities in peripheral markets.
“The key for us,” says Jackson, “is to identify affluent locations that are undergoing significant urbanisation and have strong demographics. This produces fundamentals that are more likely to be resilient in economic downturns, providing longer-term income opportunities.”
Good things lead to better things
For Prelios Real Estate Advisory, meanwhile, Poland’s regional markets are becoming more and more attractive to its investors as a result of the growing paucity of good investment opportunities in Warsaw. Kraków, Wrocław and Tricity (Gdan´sk-Gdynia-Sopot) are increasingly popular among the BPO/SSC sectors as a result of lower costs, but also due to local demographics. Dynamic, young and well-educated people are easily absorbed by new businesses, and this trend supports further development of the office sector as the vacancies are quickly absorbed by new tenants.
“In Gdan´sk, for example, Intel has decided to locate its business and employ 2,000 people. A further 6,000 people provide services to this company,” says Maja Biesiekierska, head of advisory and asset management for Prelios Real Estate Advisory. “All together, they occupy some 100,000 square metres of office space, which represents 20 percent of the modern office stock there. With every new business in town the tenant market will grow and will trigger new development projects.”
Teasing out the opportunities
More than half (€28 billion) of European investment in Q3 2015 originated from overseas, with the majority (59 percent) directed into just two markets; the United Kingdom and Germany, according to Savills.
In the United Kingdom, Bristol retail tops Cushman & Wakefield’s UK Fair Value Index as the most underpriced market, with robust retailer and consumer demand boosting rental growth above the national average (a projected 1.5 percent per year over the next five years). Industrial markets in Newcastle and Glasgow and retail markets in Manchester also feature in the top four.
“The first choice after London is always Manchester,” says Mark Rawstron, senior director of Bilfinger GVA’s Manchester office, “as this has a really strong international brand. This is followed by Birmingham and then the next-tier cities — Leeds, Bristol, etc.”
UK investment volumes increased by 73 percent during Q3 2015, reaching £1.05 billion (€1.41 billion) at quarter-end, according to Knight Frank.
Birmingham and Manchester accounted for 49 percent of total UK turnover in Q3 2015, with significant transactions completing in both cities during the quarter. In Birmingham, the largest deal was the purchase of Colmore Plaza by Ashby Capital for £140 million (€187 million), reflecting a net initial yield of 6 percent. Significantly, the deal marked the first acquisition for Ashby Capital outside of London.
In Manchester, the largest transaction was Deutsche Asset & Wealth Management’s acquisition of 2 St Peter’s Square, from Mosley Street Ventures, for £100 million (€134 million). The building is due for completion in 2016, with EY already secured as a future tenant.
With investor appetite increasing for regional opportunities, prime yields hardened in both Bristol and Sheffield during Q3 2015. In Sheffield, prime yields moved in by 25 basis points to 6.50 percent.
In Bristol, meanwhile, prime yields moved to the lowest level since 2007, following a 25-basis-point decrease to 5.00 percent. Prime yields held firm in the United Kingdom’s remaining regional cities in Q3 2015.
Investors alert to rational additions
In Germany, Q3 2015 transaction volumes outperformed Q3 2014 by 46 percent as interest from foreign buyers soared. The German commercial investment market saw €37.9 billion invested throughout the first nine months of the year and, with much of the stock of large-volume core assets sold out, investors have been encouraged to divert their capital into proven secondary locations or to assets with shorter lease terms.
“In Germany, we like Stuttgart,” says Stefan Wundrak, head of European research for TH Real Estate. “The city is land constrained and therefore offers stable rental values and growth opportunities. The region’s economy is focused on high technology manufacturing, with companies such as Porsche, Mercedes and Bosch, offering excellent diversification benefits for investors in first-tier markets, which are usually relying on business services.
“For similar reasons, we would consider the manufacturing cities of Bilbao in Spain and Toulouse in France. Strong universities are often key to second-tier cities’ success and Toulouse strongly benefits from its university. The university cluster effects are among the reasons why we have taken Leeds, in the United Kingdom, and Bologna, in Italy, into our investment universe,” Wundrak comments.
In the main, the clear attraction for investors of the regions is the relatively lower level of capital competition in these markets. But, says Europa Capital’s Fox, there is no plan to shift focus to the regions in any meaningful way, rather to remain alert to specific opportunities that constitute a rational addition to a pan-European value-add portfolio and that will be accretive to overall returns.
“There is an inherent higher risk in investing in non-core markets (most obviously because of the more limited exit audience), but Europa Capital doesn’t necessarily demand a premium for that risk, unless the overall risk exposure demands it,” says Fox.
“In mainland Europe, the markets of Germany, Italy, Poland and Spain in our view differentiate themselves from the rest of the continent in offering multiple cities demonstrating specific economic dynamics, scale and investability not exclusive to the capital. France should, in theory, offer similar potential but 70–80 percent of GDP and property market activity in France is generated in the Île-de-France region (Greater Paris), which is a rational ground for focusing our efforts on the capital.”
M&G’s Jackson points out that core property fundamentals can be found in affluent cities beyond traditional investor safe havens, such as cities in Germany beyond the top seven. But most investors consider entering emerging markets defensively, avoiding locations with oversupply issues and focusing on, for example, unit shops in cities that benefit from international tourism or defensive food stores, dominant in their catchment area, with strong covenants that typically have long leases and so can provide long-term income streams.