Does European property still offer attractive returns? - Capital Economics
European Commercial Property

Does European property still offer attractive returns?

European Commercial Property Focus
Written by Kiran Raichura
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Set against other asset classes, European commercial property looks fairly valued. Our returns forecasts for 2020-23 of around 5% p.a. on an MSCI all-property basis will look relatively attractive in a multi-asset context. However, comparative total returns in the US are set to reach around 6-6.5% p.a., making this potentially a more attractive market for investors on an absolute basis.

  • Set against other asset classes, European commercial property looks fairly valued. Our returns forecasts for 2020-23 of around 5% p.a. on an MSCI all-property basis will look relatively attractive in a multi-asset context. However, comparative total returns in the US are set to reach around 6-6.5% p.a., making this potentially a more attractive market for investors on an absolute basis.
  • Yield falls were the initial driver of capital growth in the early years of the cycle, but since 2015 office rents have grown by around 5% p.a., boosting capital values. But yield falls have slowed in the last year or two, so does this mean that the cycle is nearing an end?
  • This cycle has been characterised by regular downward revisions to yield forecasts and, even though we have tended to be more bullish, we have also fallen into this trap. However, the renewed “lower for longer” environment for bond yields has prompted a major revision to our yield forecasts, leading us to expect euro-zone office yields to fall by another 25 bps in the next three years.
  • There are four key reasons for this. First, on a relative valuation basis, property looks well-placed against a basket of alternative asset classes. Second, there remains a vast quantity of equity capital seeking to invest in European commercial property. Third, there is both good availability and a low cost of debt available for commercial property investment. Finally, office rental growth prospects still look decent, despite the slowdown in euro-zone economic and employment growth in the short-term.
  • What’s more, our proprietary measure of valuations and our in-house model, both point to further falls in office yields, reinforcing our confidence in our view that they will fall over the next couple of years, before stabilising in 2022.
  • Along with our rental growth forecasts, this means that we expect euro-zone offices to produce total returns of around 7% p.a. in the 2020-23 period. Second-tier cities such as Lisbon and Rotterdam are set to be amongst the best performers, whereas the German cities are set to record some of the lowest total returns in the next four years.
  • Elsewhere, we expect further weakness in retail rents in the next couple of years. And, with investors growing concerned about future cashflows from these assets, we expect retail yields to tick slightly higher in the next year or so. On the other hand, we expect a continuation of solid occupier demand growth for logistics assets and are forecasting that the sector will see the largest yield falls in the next few years. As a result, the sector will outperform office and retail.
  • Those total returns forecasts for prime assets translate to around a 5% p.a. all-property total return on an MSCI basis over the next four years. In a low-yield, low growth environment, these figures will stack up well against other asset classes. However, we do think they will be bettered by US commercial property and, although short-term prospects for UK commercial property are fairly weak, we expect returns there to outperform those in the euro-zone later in the forecast period.

Does European property still offer attractive returns?

This Focus is an adapted version of a presentation given at the Capital Economics Property Forecast Forum held in London on 20th November 2019.

Given the weak outlook elsewhere, this Focus will consider whether European property still offers attractive returns.

We will first detail the outlook for euro-zone office yields, outlining why they can continue to fall and how far they could go. Then give our expectations for the best and worst performing office markets. And will finish by highlighting our key views on the retail and industrial sectors.

Property yields still have further to fall

European commercial property has seen a similar yield-driven cycle to the UK and US. If we break euro-zone office capital growth into its components – yield impact and the impact of rental growth – you can see that while yield falls have been the major driver, rental growth also picked up from 2015. (See Chart 1.)

Chart 1: Euro-zone Office Capital Value (% pts y/y)

Source: Capital Economics

Since then, while rents have grown solidly at around 5% per year, yield falls have slowed, declining by just a few basis points each quarter for the last two years. (See Chart 2.) So, are these yield falls nearing their end?

Chart 2: Euro-zone Prime Office Yield Shift (bps, q/q)

Source: Capital Economics

We believe that yields will fall further. In the last few years we’ve been consistently bullish on the prospects for European property, often calling for lower yields. But, Chart 3 shows that even our forecasts for office yield falls have generally not been substantial enough.

Chart 3: Euro-zone Prime Office Yields (%)

Sources: Capital Economics, Various Agents

Three years ago, we said that office yields would fall by 40bps in 2017-18. While there aren’t consensus forecasts for European property yields, the view of many that we spoke to at the time was that yields were pretty much as low as they could go. As it turned out, even that prediction wasn’t bold enough!

Chart 4 show the same chart, but now with our current forecasts added to it. Our prediction for yield falls of 25bps in the next three years is again likely to look quite punchy to some. Of course, the mood in the market has again moved towards expecting some further yield falls, but we’re not sure that they’re as pronounced, or as prolonged, as what we’re now forecasting.

Chart 4: Euro-zone Prime Office Yield Forecasts (%)

Sources: Capital Economics, Various Agents

Why will office yields fall?

We see four key reasons as to why yields can fall as far as we’re expecting:

  1. First, property looks fairly valued when compared against alternative assets (bonds and equities).
  2. Second, and, partly as a result of number 1, there’s still a huge volume of capital trying to invest in European property.
  3. Third, the debt market is supportive of further investment.
  4. Finally, office occupier markets look well-placed. That means decent prospects for rental values, which will give encouragement to potential investors.

Chart 5 shows our valuation scores for euro-zone offices over time.

Chart 5: Euro-zone Prime Office Valuation Scores

Source: Capital Economics

You can see that office valuations went from undervalued in 2016, to overvalued in 2018, but have since returned to fair value.

This suggests current property valuations look reasonable relative to other assets, providing other asset prices don’t substantially change!Our second factor was the huge amount of capital targeting European real estate. Data from Preqin show that since the start of this year, 45% of private real estate funds that have closed have exceeded their target fund-raising amounts. (See Chart 6.) This is the highest proportion on record.

Chart 6: Proportion of Target Size Achieved by Private Real Estate Funds (%)

Source: Preqin Pro

What’s more, there’s been a big increase in demand for funds targeting core assets over the last year, which will support further demand for prime assets.

Our third factor was the debt market. While a debt market on steroids was one of the major causes of the size of the last downturn, investment flows this cycle have been far less reliant on debt. LTV ratios and the cost of debt are far lower today than in the last cycle

Chart 7 shows the total cost of borrowing in Spain and Germany. It shows that, while the all-in cost of debt for core asset purchases in the early years of the decade was between 4% and 6%, that’s now fallen to more like 1% to 1.5%. This is noteworthy because the current rate is below property yields, meaning that any addition of debt will be immediately accretive to returns. This makes property look more attractive than it might otherwise.

Our final factor was the decent outlook for rental values. Of course, the picture for euro-zone GDP and employment growth is pretty poor. But we think that the outlook for office rents is stronger than the economic drivers alone might imply.

Chart 7: Total Cost of Debt on Core Office Investments (%)

Sources: CBRE, Refinitiv, Capital Economics

With the supply response relatively muted this time around, vacancy has fallen to all-time lows. And, we expect it to trend a little lower in the next couple of years as speculative development stays fairly muted. As a result, we expect rental growth to stay solid at around 2-3% p.a. (See Chart 8.)

Chart 8: Euro-zone Office Vacancy (% Year-End)

Sources: CBRE, Cushman & Wakefield, Capital Economics

How far can property yields fall and how long for?

Chart 9 shows how our valuation scores can be used to predict future yield movement. A higher valuation score implies a bigger yield fall. The Q3 2019 valuation score suggests that property yields could fall by around 20bps in the next 12 months. (See Chart 9.)

Chart 9: Euro-zone Office Valuations and Yield Shift

Source: Capital Economics

Moreover, our simple model of office yields links their prospects to those of German Bunds, as a risk-free rate, and to euro-zone unemployment, which best represents the outlook for demand.

Our model results are shown alongside actual euro-zone office yields and our forecasts in Chart 10. Given that we expect Bunds to stay close to current levels in the next few years and that euro-zone unemployment is set to edge lower, it’s no surprise to see both the modelled output and our actual forecasts point to additional yield falls.

Chart 10: Prime Euro-zone Office Yields (%)

Source: Capital Economics

The result of our expectations for rents and yields is that capital growth will still be strong in 2020 and will stay positive throughout the next four years, driven by a relatively even combination of rental growth and yield shift overall. (See Chart 11.)

Chart 11: Euro-zone Prime Office Capital Values (% y/y)

Source: Capital Economics

What does this mean for total returns?

Lower initial yields mean that income returns will be lower than at any time on record. (See Chart 12.) However, our capital value forecasts will support a decent level of total returns in the next few years, although by the end of our forecast horizon, total returns will be reliant on the income portion and will reach only 3-4% p.a.

Chart 12: Euro-zone Prime Office Total Returns
(% y/y)

Source: Capital Economics

As a result, our average annual return for euro-zone offices is around 7% in the 2020-23 period. With investors reducing their return requirements to reflect the lower interest rate environment though, we think that these returns still look attractive in a multi-asset context.

But, within Europe, market selection could make a notable difference to returns. Chart 13 shows our forecasts for annual average office total returns for the next four years in Western Europe. We expect some of the strongest performance in the region’s smaller cities, shown in grey, such as Lisbon, Rotterdam and Antwerp, buoyed by their higher income yields. But markets that were late to recover, such as Madrid, Barcelona, Brussels and Amsterdam, are also set to perform well. (See Chart 13.)

Chart 13: Prime Office Total Returns
(% p.a., 2020-23)

Source: Capital Economics

At the bottom end, our forecasts for weak German growth and the already-low income yields on offer there and in Switzerland, will ensure that Zurich, Geneva and Munich see sub 5% p.a. total returns. Scandinavian cities are set to underperform due to expectations of rising interest rates later in the forecast horizon.

How do the other sectors’ prospects compare?

Chart 14 shows the price indices for European retail REITs and European office and industrial REITS.

Chart 14: European REIT Prices
(Index, Jan 2010=100)

Sources: Refinitiv, Capital Economics

It shows that, while the two indices tracked each other closely in the first half of the decade, they’ve diverged since early 2017. Since then, the retail index has fallen by 45%, whereas office and industrial has risen by more than 30%.

Chart 15: Prime Shopping Centre Yields in Selected Cities (%)

Sources: CBRE, Cushman & Wakefield, Capital Economics

This divergence comes as little surprise – after all, the difficulties in the retail sector are well-documented. And investor concerns about the sustainability of retail property cashflows have already led to a re-pricing of shopping centres. (See Chart 15.)

Our retail forecasts are for prime high streets and, until recently, these locations had been resilient. However, in the last year or so, we’ve witnessed a reversal in the balance of supply and demand in the occupier market. In general, there is reduced appetite from retailers for these prime pitches at their current rental levels, while new developments and refurbished units in central areas have added to supply.

Chart 16 shows the rising percentage of our Western European markets seeing year-on-year falls in rents. With rents falling in one third of markets over the last 12 months, the retail sector looks as weak as it has done since the middle of 2010.

Chart 16: Annual Change in Western Europe Prime Retail Rents (% of Mkts)

Source: Capital Economics

There is both good and bad news for the retail sector. The bad news is the weakness is spreading, with double the number of markets to see rent falls next year. We also expect a similar number of markets to experience yield rises next year. The result is that returns on retail assets will be the weakest of the three sectors.

The good news is, rents won’t fall in all cities – Paris will be a key pocket of resilience. We also think the low interest rate environment will keep the correction in yields relatively small, as the risk premium has already expanded mechanically as bond yields have fallen. Therefore, prime total returns will stay positive in the next few years.

For average and secondary assets of course, the picture is far bleaker.

Aside from Amazon, Netflix and owners of trampoline parks, one of the big winners of the structural changes in the retail sector has been industrial property. Those structural changes are likely to mean that industrial take-up stays strong, despite slower economic growth.

This will keep vacancy low but won’t necessarily translate into the rates of rental growth seen in the UK. High capital values mean that developers can already profitably build new units in most markets without requiring higher rents. The strongest rental growth will be in markets that are most land-constrained and where there are already signs of land prices rising, for example, Paris, Dublin, Madrid and Barcelona.

The bigger picture is that we expect the sector to see the largest yield falls in the next few years and to benefit from its relatively high income yield. This will see industrial outperform office and retail.

Conclusions

Slow but steady economic growth will support European commercial property rents as new supply will be constrained. Although capital values are at all-time highs, prime property looks fairly valued, meaning that the prolonged period of loose monetary policy that we expect, will provide impetus for yields to fall further and stay low.

Markets that allow only a limited supply response will outperform, with Paris, Madrid and Rotterdam as major examples.

Overall, with expected returns of around 5% p.a. on an MSCI all-property basis over the next four years, European property looks fairly attractive in both a multi-asset context and against UK commercial property, but is likely to underperform the US, where returns will be closer to 6% or 6.5% p.a.


Kiran Raichura, Senior Property Economist, +44 20 7811 3917, kiran.raichura@capitaleconomics.com