The European economy is enjoying strong growth, but with real estate investment markets advanced in the cycle, value is becoming hard to find. Monika Sujkowska discussed what’s in store for the European real estate market in 2018:
In his annual speech in September, European Commission President Jean-Claude Juncker claimed “the wind is back in Europe’s sails,” and with some justification. Euro-zone GDP expanded by 2.5 percent year-on-year in the third quarter – well above trend – and unemployment fell to 8.9 percent, down from 9.9 percent a year earlier.
Our projections indicate that if the region continues to grow at the current pace, it is likely to reach full economic capacity at the end of 2018. Until then, inflation should remain muted, lagging the two per cent target set by the European Central Bank (ECB). The bank will be able to take its time in normalizing monetary policy, and with monetary conditions remaining loose, real estate will continue to look relatively attractive compared with other asset classes, driving further investment activity. By late 2018 or early 2019, however, the ECB is likely to begin hiking interest rates from their current, unprecedentedly low levels.
Given we are at a late stage in the investment cycle, investors should follow a few rules of thumb: focus on assets in places that are likely to see sustained occupier demand, and avoid properties in structurally-weaker locations, even if they are currently well let. We recommend zeroing in on cities with a diverse local economy, healthy demographics and a high share of knowledge-intensive employment, which should stay relatively resilient amid the rise of automation.
Here are our three predictions for the key trends that will shape European real estate markets next year:
1. Solid rental growth will continue
We expect fundamentals will continue to improve over the next 12 months. Retail sales are strong and industrial production is surging. The Markit Manufacturing Purchasing Managers’ Index (PMI) for the euro zone rose to an impressive 60 in November – the highest level in more than 17 years. These trends are likely to foster rising occupier demand throughout 2018. With a scarcity of supply – the amount of empty space in the office sector has declined to almost pre-crisis levels – rising demand should result in positive rental growth in most markets. Rental growth is expected to soften from 2019 onwards as supply increases.
2. The last year of strong returns
Our five-year outlook suggests 2018 will be the final year in which investors can expect strong returns on European property. We forecast total returns of 6.7 percent across prime European commercial real estate assets next year, but the average annualized return will be much lower between 2018 and 2022, at 2.6 percent. A normalization of yield levels from 2019 is the main reason behind our forecasts for softer returns, with the impact unlikely to be sufficiently offset by rental growth.
It would be prudent for investors to consider selling weaker assets over the next 12 months, especially those located in markets that are likely to under-perform in the next stage of the cycle. Investors should avoid properties exposed to income risk and limit their use of leverage, as declining capital returns and rising borrowing costs will reduce returns on investment over the medium term. Real estate debt is likely to offer better risk-adjusted returns than equity investments, as it will shield investors from the impact of capital declines.
3. Prime retail and industrial sectors will outperform offices
Selected markets will offer value to investors with medium-term investment horizons in 2018. Prime industrial assets in Belgium, France and the Netherlands remain attractive on a risk-adjusted basis over 2018-2022. Improvements in manufacturing output, combined with structural trends such as the growth of e-commerce, have resulted in solid and sustainable occupier demand for good-quality logistics space, and the sector offers relatively high yields. Prime German retail assets should also deliver stable returns, with the sector benefiting from strong consumer spending despite the lingering threat of online disruption.
…and two risks to the outlook
1. A sharper rise in bond yields
Although it is not our base case, there is a risk that the global bond market might begin to price in a more aggressive rate-hiking cycle by the Federal Reserve and other major central banks. A spike in bond yields would erode the relative attractiveness of real estate and lead investors to turn to other asset classes.
2. A rapid expansion in supply
Supply remains modest across most European real estate markets but development has begun to pick up in some cities (see figure 2), with the office supply pipeline for 2018-’22 exceeding the long-term average in Central Paris, Berlin, Stockholm and Stuttgart. With capital values relatively high and the amount of available space falling, the economics of property development look increasingly favorable, and anecdotal evidence suggests banks are now more willing to move up the risk curve to lend to developers. All this considered, it is possible development might expand more quickly than we anticipate, with a negative impact on rental growth. Investors should monitor new building starts across the continent to ensure they are not caught out by a surfeit of new supply.
