Still value in European property markets, despite late cycle challenges

Value can still be found in more than half of European real estate markets, despite late cycle challenges, according to AEW Europe’s 2019 European Market Outlook Paper, published this month.

Despite the expectation that bond yield normalization will push out prime property yields in the next five years, 51 of the 90 markets covered are rated attractive, despite the anticipated yield widening. AEW’s risk-adjusted return approach identifies opportunities across 90 European real estate markets by comparing the expected to the required rate of return for each market.

AEW rates markets in three categories: markets where the expected and required rates of return are within a reasonable band of around 20% (neutral); markets where the expected return exceeds the required rate of return (attractive) and markets where the expected return is not sufficient to exceed the required rate of return (less attractive).

Offices are the most attractive European property sector, according to the report, with the expected return in 23 of 37 markets exceeding the required rate of return. Frankfurt and Berlin are considered some of the most attractive office markets, along with those experiencing a delayed recovery, including Glasgow, Madrid and Rotterdam.

‘The required rate of return is quite similar for offices in Frankfurt and Berlin, although Frankfurt is not quite as strong as Berlin,’ Hans Vrensen, head of research & strategy at AEW in Europe, told REFIRE.‘They have the same level of depreciation. Frankfurt is also being driven by expected rental growth due to low vacancy rates. We also expect more supply in Frankfurt as it’s easier to build offices there than in Berlin. We expect a yield widening of 70 bps for European offices over the next five years.’

Of the 20 logistics market studied, just four are deemed attractive. Two of them are in Germany - Berlin and Munich - with Copenhagen and Madrid also making the short list.

‘Munich’s logistics sector is strong, partly on the back of its manufacturing industry. Rental growth could be very strong for Munich,’ Vrensen said. (AEW is forecasting annualized rental growth over a five-year period of 1.8% for logistics in the Munich area, compared to 1.5% in Frankfurt.) ‘The question is what will happen to capital values. Berlin and Hamburg are also strong on the logistics front, partly due to geographical reasons but also because of market timing and the fact that they have a strong development pipeline,’ Vrensen added.

However, in the most challenging sector, retail, Germany fails to make the cut. Of the 33 retail markets studied, the few where the expected rate of return is higher than the required rate include Madrid shopping centres as well as Vienna, Zurich and Dublin high street retail. In total, 17 of the retail markets scored in the unattractive bracket.

‘Most of our clients accept that the European real estate markets are entering into a late cycle stage, after taking advantage of the favourable conditions over the last 5-10 years,’ said Rob Wilkinson, CEO of AEW in Europe. ‘Our outlook provides a realistic and relevant perspective for investors as they set their strategy going forward. With yields moving out, it is clear that more careful stock selection is needed. Combined with an intimate on-the-ground knowledge of specific markets, value can still very much be found.’

Canny investors can still find good investment opportunities, according to Vrensen:‘Here is a positive message for investors dealing with the late cycle, as actual deal data on initial yields over the last 12 months shows a wide range of variation. This confirms that investors can still meet this challenge by disciplined stock selection.’

The global economic recovery is expected to continue despite increasing trade frictions and political complications, albeit at slower rate, according to the report. In the euro zone, a slowdown in GDP growth for the next five years is provided for. The result of this continued macro-economic recovery is that central banks are being pushed to increase base rates and reverse quantitative easing policies. However, the depth of the impact of Brexit on the UK is still uncertain.

‘At a recent talk at the LSE, someone said that a no deal Brexit could cut GDP by 1% to 10% on a cumulative basis,’ Vrensen said. ‘If this happened, all property types could be affected, although logistics could be protected. There would be a reshuffling of the supply chain whereby goods coming into ports in Rotterdam etc. to then be put on trucks to the UK would have to be delivered directly to UK ports to avoid import duty. A hard Brexit would require both more port and logistics space in the UK.’ (ssk)