16 Jul 2018
The European economy is approaching a turning point. On June 14, the European Central Bank (ECB) announced it would wind up its quantitative easing programme in December 2018, marking the end of a three-year period in which the bank unleashed massive monetary stimulus to spur growth across the continent.
The ECB’s decision reflects economic improvements across the euro zone. While growth fell to 0.4 per cent in the first quarter – a slowdown analysts attributed to a combination of extreme winter weather and strikes in France and Germany – all leading indicators point to continuing expansion over the remainder of the year. As of March 2018, the euro zone unemployment rate stood at 8.5 per cent, its lowest level since December 2008.
Despite a strengthening labour market, inflation remains sluggish. Headline inflation slowed to 1.2 per cent in April, lagging the ECB’s target of two per cent, while core inflation stood at 0.7 per cent. With Europe’s economic recovery still fragile, the bank has given very clear guidance on its policy intentions, signalling it will maintain interest rates at record lows into next year, despite the withdrawal of QE.
Strong occupier demand, coupled with limited development, is spurring an acceleration of rental growth across prime office property. Vacancy rates on prime offices in the EU-15 countries (excluding the UK) fell to pre-crisis lows over the first three months of 2018 (see figure 1), while year-on-year rental growth stood at 5.4 per cent. Investor demand remains strong, driven by favourable relative pricing and improving fundamentals.
Figure 1. Falling vacancy rates in European offices
European retail markets have been buoyed by robust consumer spending. However, annual rental growth rates have begun to slow and year-on-year transaction volumes decreased by nine per cent in the first quarter. The prime retail yield now stands at a record low of 3.3 per cent.
Demand for industrial space continues, as the wide yield spread to retail property and offices attracts yield-hungry investors to the sector. Over the first quarter, investment volumes were up by 28 per cent compared with 2017, while prime industrial rental growth in the EU-15 rose by two per cent year-on-year.
However, a decline in the IHS Markit euro zone Purchasing Managers Index – which fell to a 13-month low in April – may indicate a slowdown in exports that could impact the industrial sector over the coming months. IHS Markit cited the impact of strikes and adverse weather at the beginning of the year but also pointed to the uncertainties surrounding Brexit and threat of a global trade war, which could weigh on exports over the longer term.1
The ECB’s withdrawal from bond markets could lead to a rise in yields, eroding the relative attractiveness of real estate, although this is not our core scenario. With the ECB prepared to keep interest rates low – the bank says a rate hike is unlikely until after the summer of 2019 – any rise in yields will be gradual. We expect real estate to reprice in 2018 and 2019 in line with bonds, with a moderate decompression of about five basis points expected across most markets.
A greater hazard is the development pipeline, which has become a concern in some central European markets. After a prolonged lull following the financial crisis, development is increasing rapidly in some central European cities such as Budapest, Prague and Warsaw (see figure 2), which may struggle to absorb the extra capacity. Budapest has 500,000 square metres of office space under construction, a significant increase on its current stock of 3.4 million square metres.
Figure 2. Rising supply in central Europe and Dublin
Investors should adopt an income-oriented approach to mitigate risks as the end of the cycle approaches. We recommend focusing on improving or creating income growth by seeking opportunities to actively manage, reposition and develop assets in strong locations. We expect offices in central Paris, high-street retail assets in Dublin and industrial property in Antwerp to be among the top performers by sector over the next five years.
Debt is likely to offer better risk-adjusted returns than equity as it will shield investors from the impact of expected capital declines. It should be stressed that while few markets now offer good value on a risk-adjusted basis, the relative pricing of real estate remains attractive in a historic context, with the risk premium still relatively high.
For longer-term investors, we recommend looking at thematic strategies that play against the current cycle. Focusing on structural drivers of demand, such as the continued growth of e-commerce (which will favour centrally-located logistics hubs) and ageing demographics (which will boost demand for retirement villages), should provide opportunities for patient investors over the coming years.
1 ‘Eurozone manufacturing gauge drops to 13-month low,’ Financial Times, May 2018
Vivienne Bolla is Analyst, Real Estate Investment Strategy and Research at Aviva Investors.
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RA18/0683/31102018