AEW, the global real estate investment manager, released its mid-year European outlook with updated forecasts following the outbreak of the Ukraine conflict. AEW explores how European markets can best deal with the double trouble of lower GDP growth and higher inflation, adopting stagflation as its new base economic scenario.
Key findings of the report include:
- As the above-target inflation endures, Eurozone bond investors have now priced in some rate hikes for 2023 and tapering of quantitative easing for late 2022. AEW’s base case assumes only limited and modest rate rises – given hikes are ineffective against imported commodities and energy inflation – and that government bond yields will remain lower for longer. The upside and downside scenarios assume more proactive central bank tightening and bond yield normalisation.
- Prime rental growth across all sectors came down by half from 1.8% pa to 1.2% pa for the 2022-26 period. Prime rental growth across residential and logistics markets – sectors less sensitive to GDP growth – shows continued strong momentum at just above and below 2.5% for the next five years. On the other hand, prime office rental growth halved from just over 2% pa to 1% pa and forecasts for prime shopping centres also reduced significantly.
- AEW projects that property yield widening will be modest over the next five years, with yields across most property sectors forecast to be stable. This is based on AEW’s base case, which forecasts limited bond yield widening, and the historically low sensitivity of European property yields to changes in bond yields.
- AEW’s current base case total returns come in at just below 5% pa across all sectors for the next five years, mostly based on lower GDP and rental growth projections. Our latest projected return is 120 bps lower compared to our previous September 2021 base case.
- Prime logistics is projected to have the highest average return (just above 6% pa) of any sector in the next five years, due to the sector’s strong rental growth.
- Prime shopping centres are the second-ranked sector with a forecasted total return of just under 6% pa over the next five years due to the high current income return. The significant re-pricing in retail recorded over the last 3-4 years did not take into account the difference in quality between prime and secondary assets.
- In a cross-country comparison, the UK comes out on top showing consistently higher income and total returns, as yields did not tighten in as much in the UK compared to most Continental European markets post-Brexit. Germany shows significant capital growth despite lower income returns compared to other countries.
- Focus shifts to income with no capital growth increase expected in France, Spain and Italy for the next five years and negative capital growth in CEE markets.
- AEW’s updated risk-adjusted return approach shows an average positive excess spread of the expected rate of return (ERR) over the required rate of return (RRR) of 25 bps for the 168 European markets covered. This represents a significant decline of 165 bps in the excess spread versus the previous September 2021 base case.
- This reversal in an excess spread is mostly due to a decline in expected returns resulting from lower capital growth projections. This in turn is triggered by lower market rental growth expectations as yields are stable. As part of the double trouble impact, AEW’s required returns also increased, mostly as a result of recent government bond yield widening.
- By comparing the ERR with the RRR, AEW classifies markets as attractive (ERR > RRR), neutral or less attractive. Overall, out of the 168 European markets covered 65 are classified as attractive, 65 as neutral and 38 as less attractive.
- AEW’s updated mid-year 2022 outlook shows fewer attractive markets down from 70% in September 2021 to 40%, with neutral markets increasing from 26% to 40% and less attractive markets increasing from 5% to 20% of covered markets.
Hans Vrensen, Managing Director, Head of Research & Strategy at AEW, added: “The world is in a very different place to when we published our previous outlook in November last year. The Ukraine conflict and supply chain disruption caused by both the sanctions against Russia and the continued Covid-19 lockdowns in China are both slowing the post-Covid global GDP growth recovery and leading to higher levels of inflation. As a result, our economic base case assumes a period of stagflation with lower for longer bond yields.”
“With slower GDP growth expected to reduce future rental growth, our analysis forecasts that prime property yields will remain broadly flat over the next five years. Importantly, the European real estate market remains robust with low vacancy rates and limited risk for an oversupply of space or excess financial leverage. Recent capital raising data confirms that the stability of real estate income remains in place and still appeals to many investors. However, in this period of stagflation, a selective and disciplined approach to investment will be crucial. Our projections show that capital growth will temper, especially in the markets of CEE, Italy and France. As a result, we expect to see a shift of focus to income returns. The UK looks particularly attractive on both a capital growth and income return basis given yields have not tightened as much in the UK as in Continental European markets post-Brexit. Additionally, we remain positive on European prime logistics and shopping centres, with the former expected to deliver the highest returns over the next five years.”
“Since we classify 130 out of the 168 covered markets in our relative value assessment as either attractive or neutral, there is plenty to choose from in European real estate investment markets as they remain in a solid position to deal with the current double trouble.”