A new report* by Savills Investment Management (Savills IM) shows that average prime yields in European real estate are set to move lower during the year, driven by intense competition for limited supply in core markets.
The Savills IM team covers nearly 104 real estate markets across Europe. By analysing prime rents and prime yields the team is able to compare the figures to historical data going back to 1990 to determine what the momentum in the real estate cycle is. Real estate markets have a very distinct, wave pattern momentum that go through different cycles over time.
“Overall, what we see is that there are still a number of European markets continuing to experience yield compression,” says Irfan Younus (pictured), Head of Research, Europe, Savills IM. “Urban logistics have experienced 25 basis points in yield compression whereas prime CBD offices in cities like Berlin and Frankfurt have compressed by 10 to 15 basis points, on a relative basis.”
Younus says that Europe is now entering Phase 4 of the property cycle.
In Phase 1 of the property cycle, yields move out as rents decline; in Phase 2, yields stabilise as rents continue falling; in Phase 3, which some refer to as the ‘Goldilocks Period’, yields compress at the same time as rents start to rise (this is the best time for investment returns). Finally, Phase 4 is where yields stabilise and rents continue to rise because there is enough economic momentum in the market.
“Early cycle cities like Munich, Stockholm and Paris yields have already stabilised,” explains Younus. “The only thing you will continue to see is rising rental growth. Having said that, there are laggards. The likes of Brussels and Tier 2 cities such as Malmo, Luxembourg and Lisbon and Tier 3 cities such as Antwerp, which didn’t take part in the recovery following the ’08 global financial crash or the Eurozone crisis, are benefiting now from a late cycle recovery. As such, they will likely see more yield compression this year.”
Looking more broadly at Europe, continued investor demand for prime real assets in core markets will drive down average prime yields as investors seek out returns in a continuing low rate environment.
Occupier demand drivers in the market are looking strong for the next year, helped by continued modest recovery in economic growth, European Central Bank Asset purchases and strengthening labour markets, according to the Savills IM report. This is supporting take-up activity in the offices sector and is boosting retail sales, while occupier demand for logistics space is expected to remain healthy, thanks to growing e-commerce.
“A number of core European property markets are yielding 3.5 to 4.5 per cent and look more attractive than corporate bond markets, which might only offer yields of 1.5 per cent or less. So investors are looking at the relative pricing of core real estate compared to bonds and are buying it for income reasons.
“we are also seeing flows from multi-asset investors who are are worried about the US fixed income markets and have fears that the same could happen here in Europe and lead to capital losses. There is also a good economic recovery underway. Europe struggled after the financial crisis and only the strongest economies performed, including after the Eurozone crisis. Now, growth is much more broad-based across all 28 EU member countries.
“That is driving demand for real estate space and pushing up rental growth and creating momentum, which one often associates with a real estate cycle,” explains Younus.
Factor in as well the heightened volatility in global equity markets in early February, and there is little surprise investors are favouring real estate assets.
Intense competition for limited property supply in core markets continues to exert downward pressure on yields. This is why prime yields declined in a number of markets towards the end of 2017.
Urban logistics is one area, in particular, that investors might want to consider. Although speculative completions have increased, there is a shortage of vacant, prime and modern space in Europe’s core logistics hubs. In its report, Savills IM says that urban logistics is set to be one of the most significant growth markets over the next few years as e-commerce continues to grow across Europe.
Younus says that Savills IM’s research team has observed that whenever a retail market sees online sales crosses 6 to 8 per cent of total retail sales, traditional retailers start to struggle and kick starts significant demand for logistics space.
New retailers are now offering a combination of online platforms as well as physical stores.
In terms of trends, the percentage of online sales in the UK retail market is approximately 18 per cent, in Germany it is 14 to 15 per cent, while in Sweden it is around 12 per cent, both France and the Netherlands are around 8 per cent but as Younus states, for the rest of Europe “it has yet to exceed that 6 to 8 per cent threshold”.
“When that happens, we will see more demand in Europe for urban logistics space. The traditional logistics transport corridor arches from London to Amsterdam all the way down to Milan. What we have seen recently, with transport networks improving in Eastern Europe, is the emergence of a new corridor. Places like Poland have much lower labour costs, cheaper land, more relaxed labour laws and so on.
“The dynamics of urban logistics are changing. If you are in one of these dynamic cities (i.e. London) where the population is growing there is not much space in the CBD to build new logistics units. Investors realise there is a scarcity and are buying up these logistics units, which is pushing up prices,” states Younus.
Although this has led to yield compression, logistics units are still yielding around 5 per cent compared to retail assets yielding 2.5 per cent and prime offices yielding 3 per cent in core European markets.
Capital being deployed into the real estate space has driven yields to record lows and this is unlikely to change in 2018. Younus confirms that nearly 75 to 80 per cent of the markets the Savills IM team follows are below where yields were in 2007.
“The key message for 2018, in my opinion, is that gone are the days where you could buy and sit on a real estate asset and benefit from yield compression and rental growth; in other words, benefit from the ‘Goldilocks Period’.
“For investors, stock selection is key; what tenants are you buying? Is it a single or multi-let unit? What sort of rents can you expect?
“One has to try and identify risk factors: what am I underwriting for exit yields? How can I capture rental growth? How constraint is the supply pipeline? This is to insure that they have accounted for the risk factors to protect their investment returns,” concludes Younus.
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