Euro crisis evolution and European real estate markets
Ongoing economic stress and divergence in the eurozone have continued to be the key drivers of real estate market trends in Europe in 2012, says Peter Damesick (pictured), EMEA chief economist, CBRE…
The Draghi plan for unlimited purchases of sovereign bonds by the European Central Bank (ECB) of countries facing excessive borrowing costs helped lift sentiment in recent weeks, but concerns over Spain’s need for a bailout and uncertainty over whether European Stability Mechanism (ESM) funds can be used to capitalize banks are currently raising tensions again.
Eurozone leaders still need to develop an effective policy response to head off the risk of a destructive chain reaction of financial stress and capital outflows across the European periphery that could lead to a break-up of the euro.
This document assesses the impact of the euro crisis on commercial real estate investment markets in Europe and assesses the short term outlook. It highlights the relative merits of real estate as an investment asset in the present uncertain and challenging environment.
Polarisation in European Real Estate Markets
The euro crisis has induced greater caution among real estate investors, leading to constrained activity in increasingly polarised markets in Europe with a strong focus on investment in larger, liquid, core markets perceived as ‘safe havens’.
Key market trends in 2012 can be summarised as;
- Occupier demand in many markets has been hit by uncertainty and weakening economies
- Office rents have stalled or are still sliding. In markets such as London and Paris, where rental recovery had begun, momentum has been lost in the past year. In office markets where recovery had not started, such as Madrid, rents remain under downward pressure
- Retailer demand is very concentrated on prime city centre locations and dominant shopping centres
- Development activity is firmly in check in most markets, with little finance available
- Investor activity maintains a strong focus on prime assets in core markets
- Secondary property is suffering – investors are shunning property with less secure income streams and there a dearth of debt finance for investment secondary. The yield gap between prime and secondary has continued to widen
- Investment activity in European markets weakened over H1 2012 with total volumes down by 22% on the previous half-year
- There has been a relative shift in activity towards non-euro markets – this has favoured the United Kingdom and Nordic markets, which are seeing less decline in activity than Europe overall. The Nordic markets increased their share of the European investment market from 14% in 2011 to 18% in H1 2012
- The size and liquidity of the London market continues to exert a strong pull on international investors. London accounted for 20% of European investment transactions in H1 2012 and attracted almost half of the global capital flowing into European markets from outside the region
- Southern European markets are particularly weak – the share of the five euro periphery markets (Spain, Portugal, Italy, Greece and Ireland) in total turnover in H1 2012 fell to 4.9%, compared with 13% in 2008-09
- Investment activity contracted sharply in Central and Eastern European markets in H1 2012, falling by over half compared with previous six months. The focus of investor activity has narrowed to concentrate on Poland and the Czech Republic
- Prime yields in stronger markets remain relatively stable, but weakness has appeared elsewhere, for example in southern Europe, the Netherlands and the UK regions. At a sector level, prime High Street retail shows the most resilient performance, while prime office and industrial capital values have slipped back into negative territory in terms of annual changes at the European level
The outlook for European real estate is clouded by continued uncertainty over how the euro crisis will play out. Currently our main case assumption is the eurozone authorities and national governments will do enough to keep the eurozone intact, but with a weak economic outlook for 2013 and slow recovery to follow. Key short-term implications for European real estate include:
- Weakness in occupational markets and limited, patchy rental growth
- Constrained investment activity, with limited availability of debt
- Continued market polarisation, with further re-pricing outside core markets
- Further gradual unwinding of bank legacy loan portfolios – a steady flow, but not a flood, of secondary asset disposals
- Very subdued development
- Prime space shortages, with vacancy increasingly concentrated in lesser quality stock
While investor sentiment has been influenced by the sovereign credit rating downgrades and the lack of a solution to the eurozone crisis, demand for prime real estate in core locations remains undiminished. Solid fundamentals have driven an increase in the number and diversity of foreign buyers looking to enter the region, which is testament to the enduring attractiveness of key cities such as London and Paris.
European real estate currently displays investors’ preoccupation with a flight to ‘expensive safety’. This seems likely to continue as long as the high level of uncertainty over the economic outlook persists. The positive market reaction recently seen in response to ECB bond-buying proposals shows that establishment of true policy credibility in the eurozone could do wonders for sentiment. A lift in consumer and business confidence would be the key to accelerating the pace of recovery. In turn, this could transform sentiment among real estate investors, inducing greater willingness to take a larger measure of risk in acquisition strategies.
Despite the challenges created by the current environment, good quality real estate still has significant positive attributes to attract capital to Europe markets.
- Prime property investments in Europe provide income yields significantly in excess of those available on AAA-rated government bonds and superior risk-adjusted returns to equities
- Well-let real estate offers a combination of both bond and equity attributes. In the short term, well-let real estate has the certainty of income that investors also get from bonds. In the longer term, there is potential for that income to increase in line with market rents (providing a partial hedge against inflation). In many countries it is also common for the property owner to benefit from annual increases in income in line with inflation or some other price index for the duration of the lease providing an additional short-term inflation hedge
- A further defensive feature of commercial real estate at present is the low level of new supply in most European markets. In Western European cities, the annual level of new office completions is now running at historically low levels. Continued tight constraints on development finance will keep supply in check for an extended period. The low level of new development will be conducive to rental growth when demand eventually recovers
For the present, investors face an environment in which the market is unlikely to deliver performance through positive rent and yield movements. Property can nonetheless still provide advantageous income returns relative to the yields on top-rated government bonds. To get enhanced performance in this context, one of the most fruitful tactics for some investors will be to commit capital to existing property holdings to improve asset quality and the level and security of the income stream.
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