Demand for European commercial real estate is underpinned by an increase in technology and professional service jobs, according to Duncan Owen, Global Head of Real Estate at Schroders.
European commercial real estate markets have performed strongly. Prices in Europe’s major cities have risen on average by 40-50% since 2013 (source RCA) and except in southern Europe, they are now 10-20% above their previous peak before the global financial crisis (GFC).
In his outlook for 2019 he said: “Is now time to go back into the retail sector given that the transition to omni-channel retailing still has a long way to go? Projections suggest that the internet’s share of UK retail sales, for example, will almost double from 17% to 30% over the next 10 years. Unfortunately, that suggests that the recent wave of retailer failures and store closures in northern Europe will continue and that there will be a sustained fall in rents. At present, that reality is not reflected in current valuations and retail yields.
“However, looking forward, if most investors shun the sector and yields jump over the next 12 months, then there could be some interesting opportunities to buy defensive retail assets (for example, dominant shopping centres, convenience stores). There may also be opportunities in town centre buildings which can be re-modelled into mixed-use schemes incorporating apartments, offices, medical clinics, places of worship.
“We continue to see value in parts of the European commercial real estate market. The upswing in office and industrial rents has further to go in most winning cities and some segments such as hotels where management agreements are attractive. The big concern is the current economic and market cycle. Whilst we may not be at the peak of market pricing, no one would be surprised in a year’s time if we discovered we are in reality there now. Therefore, 2019 could be a year of price corrections which may offer some good opportunity for investors who are well capitalised. There is more than one real estate cycle in Europe.”
RPA Perspective Intuition suggests that markets are due a correction, but it would be wrong to assume that real estate cycles are fixed like the tides, said Owen.
He added: “History shows that the length and strength of upswings has varied enormously across different cities and sectors over the last 50 years. For example, e-commerce is currently driving a wedge between the retail and industrial sectors and whereas industrial capital values in the UK rose by 10% over the first 10 months of 2018, shopping centre values fell by 7%.”
He believes that European commercial real estate faces two main risks. Firstly, the growth of populist parties across Europe has increased the chance of radical shifts in economic policy. The obvious example is Brexit, which poses a threat to financial services and office rents in the City of London and the Docklands. Conversely, this has given a modest occupational boost to office demand in Frankfurt and Paris. In addition, Catalonia’s declaration of independence has raised a question mark over assets in Barcelona, while the Italian government’s budget dispute with the EU has hit foreign investor interest in Milan and Rome.
The second clear risk is higher interest rates. Schroders expects the Bank of England and the European Central Bank to raise base rates and the refinancing rate to 1.75% and 1% respectively by the end of 2020. Yet, despite textbook theory that real estate yields should move in parallel with government bond yields, we think that the increase in office and logistics yields over the next 2-3 years will be limited to 0.25-0.4%. Retail could be the one sector where yields rise and capital values fall more sharply.
