NOI growth to drive total returns in Europe

Net operating income is becoming the key to driving total returns against a backdrop of tight yields, according to Invesco’s Real Estate House View: European summary 1H 2018.

As a result, it will become increasingly important to consider lease structures and opportunities to deliver market-level rental growth at an asset level and to look for sub-market and asset opportunities that can outperform the general market via active asset management, according to the report.

‘Manage to core’ is the new mantra

Unsurprisingly, value-add assets are becoming increasingly popular, particularly ‘manage to core’ to create core assets in strong locations, according to Christian Eder, director of European Real Estate at Inveso Real Estate: ‘These assets deliver better returns in the office sector and Germany’s office market doesn’t see much speculative development. Also, submarkets in city centre locations have very low vacancy rates, which means there’s a good chance of being able to let properties there.’

Invesco describes the ‘manage to core’ strategy as ‘taking some development risk but competition for suitable assets is likely to result in aggressive pricing, so risks should be carefully assessed’. Ultimately, successful investors will require a good understanding of key asset characteristics and greater granularity in understanding sub-market characteristics.

Office-based employment growth to slow

The office market in Europe faces headwinds as Europe’s working age population starts to decline, coupled with disruption in the service sector due to automation. Also, office employment growth, which has been a key driver of demand in previous cyclical upswings, will be more modest in this cycle, according to the report.

In particular, cities such as Frankfurt, Berlin, Madrid and Helsinki are expected to deliver strong three-year office rental growth from 2018 to 2020, according to Invesco.

Co-working has become increasingly prevalent, particularly in the tech sector which, in turn, is having an impact on European office markets. While many investors still have to be convinced as to why they should jump aboard the co-working train, the occupier market is signaling that the growing start-up segment of the economy is being joined by more established occupiers who are attracted to the increased employee satisfaction and flexibility. This suggests that office spaces need to be flexible enough to offer occupiers a broad range of working configurations for their staff as well as attractive amenities.

That’s not to say that all investors are jumping on the co-working bandwagon. Eder, for his part, remains cautious: ‘We wouldn’t look for a single tenant in a co-working building but we do see the value of holding some co-working space. However, it’s hard to know how it will perform during a downturn. In Germany’s ‘Top 7’ last year, 5.5% of overall take-up was co-working space, which is pretty incredible. That said, co-working is like a gym – with end users on short contracts.’

Hotel market delivers a stellar performance

European hotels continue to hog the top spot, according to Invesco, with average occupancy rates up 61.8% as of February this year and daily rates averaging €98.90, equating to a 5.1% jump in the revenue per available room. Invesco favours ‘seven-day trading markets’ where supply is constrained, unless there is the option of benefiting from exceptional lease terms, market mispricing or infrastructure developments. Markets like Munich hit the right note, due to its stability, as do Edinburgh and Paris, according to the report.

Resi market benefits from strong demand

Quality supply remains tight in most European cities and Germany is no exception. ‘The scarcity of modern residential product is astounding,’ said Eder. ‘Around 284,000 apartments were completed in Germany last year but it’s still not enough.’ The German government's Federal Office for Building and Regional Planning (BBR) has said that Germany actually needs an average of 350,000 new homes a year over the next three years to cover demand.

Invesco favours mass market residential assets in sustainable locations, particularly strong ‘live-work-play’ environments, such as London. Frankfurt has also seen strong growth in recent months.

Retail lags behind

The retail sector, predictably, is lagging, as high streets and shopping centres alike struggle to reposition themselves to complete with online shopping. Smaller, mass-market retail segments are especially vulnerable to store closures as retailers rationalize their portfolios, according to Invesco. Fashion retailers are also struggling to make their mark. Today, they account for just 26% of take-up, compared to 40% in 2012, according to Eder. ‘Strong, dominant pitches will do well. However, fashion stores in the city centres are shrinking and will need to be replaced with something else.’ (ssk)