ANALYSIS: Outlook weakens against shifting macro backdrop

Europe’s property market is entering uncharted territory amid an environment of rising interest rates and slower GDP growth, writes Tom Leahy, head of EMEA real estate research at MSCI.

After a record 2021, the outlook for Europe’s property investment market has changed considerably through the first five months of 2022. High inflation, rising interest rates, falling consumer confidence, concerns over economic growth and the first major land war to break out within Europe’s borders since 1939 all point to a more febrile environment for investors to navigate.

The current property boom was driven by the post-Global Financial Crisis low-rate environment and a reallocation of capital from other asset classes. Indeed, most players in the property industry have spent their careers in a world of falling rates. Even though on a historical basis interest rates are still low, this current period marks a shift, as Europe’s property market enters relatively uncharted waters.  

Direct real estate is, however, a slow-moving, illiquid asset class. The dealmaking process takes months to complete and recent history – notably the onset of the pandemic -- shows it can also take months for events happening in the wider world to feed through into the market statistics. The latest transaction data show that €106 bn was spent on European property through to the end of May, which is broadly in line with the current five-year average of €108 bn and ranks as the fifth best start to a year since 2007.

But at this stage in the cycle average property prices are well ahead of where they were five years ago and the deal volume numbers may mask some weaknesses at a more granular level. For example, the number of properties to have changed hands through the first five months of the year is down 25% in comparison with 2021 and down 16% on the five-year average.

The difference between the more positive picture suggested by the transaction volumes and the more subdued one presented by the count of traded properties tells us something about how the market is evolving is response to a changing world. The perception that the risks are oriented to the downside means buyers are likely to adopt a cautious approach throughout the dealmaking process, and higher debt costs mean greater emphasis on income streams and a thorough examination of rental growth assumptions. But, as yet, the appetite to acquire and hold portfolios of commercial property has not been significantly diminished.  

Evolution of the office market
The post-pandemic office market is in a state of flux. The belief that hybrid working will persist in some form has led to the reasonable assumption that demand from tenants will focus on the better-quality assets that are well located and present an attractive environment for workers. This is reflected both in the lot sizes and the pricing data, which show prices for Western Europe CBD office buildings less than 10 years old at the point of sale significantly outperformed those older buildings through the pandemic period.

The top buyer of European office property in 2022 so far is Alphabet (fka Google), which has spent €1.46 bn on two buildings in which they occupy space, one in Warsaw and the other in Central London. Similarly, second place on the list is South Korea’s NPS, which bought the UBS office in the City of London for €1.45 bn. Indeed, the average lot size for the top 10 office buyers this year is €695 mln; the same statistic for one year ago stood at €414 mln.

It is clear sustainability legislation and corporate ESG policies are also driving this bifurcation in the market. Buildings that sit below the required emissions ratings are at risk of becoming obsolete – being unlettable in their existing form and requiring a significant injection of capital to bring up to market standard. The data show a significant proportion of CBD office buildings – c.69% in the last 12 months - are sold without an environmental rating from the likes of BREEAM, LEED or HQE, which suggests there remains a huge volume of property in investor portfolios that will require significant capex to bring these buildings up to market standards as they evolve towards carbon neutrality.

Retail resurgence
The secondary retail market exemplifies how these forces of obsolescence have already caused a major loss of value for asset owners left holding the parcel when the music stopped. Indeed, the negativity towards retail in general has been the pervasive narrative since deal volumes last peaked in 2017. At this point, the sector accounted for more than 25% of the total transaction market; by 2021 retail’s share had fallen to just 10%.

However, the latest data show something of a recovery in the transaction market. European retail investment was up 40% in Q1 2022 versus Q1 2021 and the sector has accounted for a slightly larger piece of the investment landscape so far in 2022.

In the UK, there has been a notable resurgence in some segments of the market, particularly retail warehouse, where transaction volumes have accelerated through the last 12 months. Investor demand is reflected in the very strong total returns reported in MSCI’s UK Quarterly Property Index: UK retail warehouses returned 8.6% through Q1 2022, up from 7.9% at Q4 2021. This makes it the second-best quarter on record, behind the 15.2% returned in the three months to December 2009, during the initial recovery phase from the Global Financial Crisis.

Some of the opening-up in the transaction market has come as owners have been willing to take a loss on an asset in order to reposition portfolios. For example, Henderson Park bought the Silverburn Centre in Glasgow in May 2022 for £140 mln, less than half the amount Hammerson and CPPIB paid for it through a distressed purchase back in 2009.

Industrial and apartment still in demand
If investor demand for office and retail property is polarising in response to changes in the occupier market, apartment and industrial property remains sought after. Transactions in both sectors through the first five months of the year are above their five-year average; however, the number of traded properties is down year-over-year, which is indicative of the increased caution with which investors are operating.

Weight of capital has pushed down average transaction yields for prime logistics to be on par or below those for CBD offices, which represents a substantial shift in just the last three to four years. However, the scale of yield compression is giving some investors pause for thought because of the shifts in the macro environment. The performance of some listed owners of industrial assets like Segro, which has seen its share price fall c. 23% YTD (vs. +2.7% for FTSE 100), suggests a more muted outlook for the sector. However, the occupier market remains incredibly tight and rents are growing across most European logistics markets, which is a strong positive signal for most players in the market.

Russia and Ukraine
The unrelentingly grim news emerging daily from Ukraine is a sombre backdrop as many of us go about our daily business relatively unaffected by this European war.

Western-backed sanctions on Russia have reached unprecedented levels, but for global real estate, the direct impact from these measures has been negligible. Russian capital has very little presence in global commercial property markets: outbound flows have averaged just $330 mln per year in the last five years and known Russian ownership of commercial assets in the world’s largest property markets is sparse. Additionally, Ukraine’s institutional property market is small and domestic, therefore, international exposure is minimal.

Moreover, it appears that the markets in countries bordering onto Ukraine are functioning in a relatively normal fashion, at least in terms of capital flows. Central and Eastern Europe (CEE) accounted for 5% of all European acquisitions by volume in Q1 2022, which is just below the five-year average, but does not represent a substantive slowdown. Moreover, some marquee deals have signed, the largest of which was Alphabet’s purchase of its Warsaw office for €583 mln.

Therefore, the impact on commercial real estate is indirect. Since the conflict broke out, Oxford Economics has downgraded its GDP growth expectations for Europe’s economies, as higher commodity prices, disruption to supply chains and falls in business and consumer confidence feed through into an environment where supply chain pressures have combined with pent-up demand from the pandemic to push inflation to multi-decade highs.

In response, central banks have shifted in a tightening phase. Rising rates mean higher cost of debt, which at a certain level will start to put upwards pressure on transaction yields. The relationship between the two is not linear and margins can be squeezed before the effect feeds through, but it is a clear risk in the current environment. NOI growth can offset this effect, especially in sectors where rents are index-linked, but given the deteriorating macro environment, it is not a given.

Over the long term, property returns correlate far more closely with GDP than they do with inflation. This combination of slower growth impacting the occupier market and higher rates putting upwards pressure on yields suggest a weaker outlook for property in the shorter term than was envisaged at the start of the year.

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