EUROPE OUTLOOK: Growth eases, but property’s long cycle rolls on

What lies ahead for the European real estate industry in 2020? PropertyEU canvasses the views of a dozen leading players on the themes likely to shape the market.

Ask a dozen leading real estate players what their expectations are for European real estate in 2020 and the consensus view - for the investment environment at least – is that relatively little will change versus last year. Sure, economic growth is seen slowing in most markets across Europe and this may dampen rental increases, but the benign conditions of plentiful capital and low interest rates promise another strong year for the industry. Barring an economic recession – which no one foresees – or a ‘black swan’ event, the base case is for another 12 months of sustained - albeit slower - growth.

‘From a capital markets perspective, access to and availability of debt is likely to remain robust. For 2020, it’s hard to see any material change from a real estate perspective,’ says Indraneel Karlekar, global head of research and strategy at US-based Principal Real Estate Investors, which manages or sub-advises close to $86 bn (€78 bn) of real estate assets globally.

‘Where we might expect to see a little bit of change compared to last year is perhaps more of a push towards fiscal stimulus in some European markets,’ he notes. ‘That might lead later in the year either to expectations of slightly better [economic] growth and/or slightly higher inflation. I would view that as generally quite positive for the broader economy and by translation for real estate via the occupier markets.’ The Netherlands has already announced some fiscal policies. ‘We might expect to see that in Germany and France too later on in the year,’ says Karlekar.

The state of the market in Europe today is one which is ‘reasonably well balanced’ between occupier demand and capital markets, according to Principal. From a global perspective, Europe continues to be a strong destination for real estate investors, with transaction volumes well above the historical average. This continued attractiveness, says Karlekar, is due to the ‘available capital for financing and limited supply of property’.

In its annual strategy outlook for 2020, Principal points out that European investors sold more commercial real estate in the US last year than they bought - the first time in seven years. This, the firm says, is a possible sign that they see better opportunities in their home markets than in key global markets that appear to be fully priced.

U-turn on interest rates
Last year’s abrupt, global reversal in monetary policy wrong-footed many in the financial and real estate markets, who had counted on a gradual tightening of interest rates. But the surprise move by global central banks actually turned out to be good news for property, and is generally viewed as the most significant intervention affecting the industry’s near-term future.

Coupled with the European Central Bank also returning to quantitative easing in November in response to slowing global economic growth, the ‘lower-for-longer’ rates will ensure capital continues to target real estate. The lower bond yields resulting from the rate cuts are expected to keep property yields more stable than previously expected, effectively extending the current cycle, says global investor AEW.

‘After the recent central bank policy reversals, the lower-for-longer scenario has now become our base and, perhaps counter intuitively, this can mean good news for real estate investors. With bond and property yields expected to remain at current levels for some time to come, strong competition for deals will continue,’ says Rob Wilkinson, CEO of AEW in Europe, where the company manages nearly €32.3 bn of real estate assets on behalf of funds and separate accounts.  

In its latest assessment of 100 European markets, AEW identifies 80 as ‘attractive’ or ‘neutral’, based on risk-adjusted returns. ‘The favourable general market outlook is further supported by a low level of the traditional cyclical market risks as both excessive supply of new space and the use of debt remain modest at the moment,’ says Wilkinson.

Real estate allocations
With allocations to real estate remaining high – global fundraising hit a new record of $151 bn (€136 bn) in 2019 while dry powder for private equity real estate amounted to $319 bn (€286 bn), according to Preqin – Europe is expected to take a large slice of the pie in 2020. Insurers, pension funds and sovereign wealth funds will remain key cross-border players as the low interest rate environment drives their search for higher-yielding income-producing investments. This is unchanged from previous years, says Paul Guest, lead real estate strategist at UBS Asset Management, but with a ‘subtle difference’. There is now ‘an ostensible urgency’ among institutional investors to deploy capital into real estate, he notes. Many are lumbered with the fiscal burden of ‘deteriorating demographics’ (such as ageing populations and increased dependency ratios) and real estate fits the bill of providing dependable long-term income to match their liabilities.

Inrev’s annual investor intentions survey reveals institutional investors are set to move up the risk curve in 2020 in their search for alternative ways to deploy capital and drive returns. The survey found that 20% of global investors investing in Europe are opting for ‘opportunity’ as their preferred investment style.  This is up from 9.8% last year and marks the highest percentage since 2009. Of the total of €98.1 bn of new capital expected to be invested in real estate globally in 2020, the lion’s share (61%) will come from investors in Europe, with just under 20% each from investors in North America and Asia Pacific.

Can we expect any new sources of capital entering the fray? If Korean investors made their mark in Europe in 2019, this year the baton is likely to pass to Japanese pension funds, UBS’ Guest predicts. ‘We anticipate that Japanese pension funds will dip their toes deeper into direct real estate in 2020,’ he says. ‘This has been a very gradual process. Anecdotal evidence suggests that Japan’s institutional funds have made substantial allocations and are focused on the mature core markets of the US and Europe.’

ESG issues to the fore, and the year retail makes a (partial) comeback?

PropertyEU has selected its own key themes of 2020, based on company outlook reports and conversations with market players.

 1. Where are we in the cycle?

The European property market cycle has been extended into extra time, thanks to lower-for-longer interest rates and government bond yields, which will keep rental growth in check and prime property yields low for the foreseeable future. As one interviewee in ULI/PwC’s Emerging Trends in Real Estate Europe 2020 report put it: ‘It is hard to express strongly enough what an extraordinary turnaround that has been. The cycle feels like it is going to go longer. Nothing seems to be overheating.’

The office cycle in particular will stretch a little further as its fundamentals hold up through the short term, supported by continued expansion in many metropolitan areas, which has translated into increased office demand, rental growth and declining vacancy. According to CBRE, aggregate take-up for 2019 was down around 1% and a slightly bigger decline of 2.5% is forecast for 2020, reflecting supply shortages in some markets. Prime vacancy rates, which declined across all major office markets in 2019 to end the year at around 6.8% on average, will be flat or slightly higher in 2020. 

Says Mike Bessell, European research strategist at Invesco Real Estate: ‘Clearly we are later in the cycle, simply by virtue of most global real estate markets having seen limited downside corrections since the GFC. However, with the ongoing low interest rate environment globally driving ongoing capital allocations towards yield assets, as well as more conservative lending markets since the GFC, the sector continues to be well supported at current levels, and we therefore continue to believe this current cycle can be sustained for the medium term.’

 2. How low will yields go?

Germany probably wears the crown in Europe in terms of record low office yields, after a clutch of year-end 2019 sales saw prime yields dip below 2.75%. The buyers in the deals in question – in Munich and Dusseldorf - were domestic institutional investors, who, as one agent put it, were seeking to get their hands on ‘the best new buildings in the best locations’.

‘(Most) international investors tend to (only) pay that in their own domestic markets. These investors are using negative interest rates to justify a stronger entry point yield,’ he said.

In the City of London office market, prime yields had hardened to 4% by July, supported by deals such as the sale of 8 Finsbury Circus to Singapore-based Stamford Land for £260 mln. The spread between London and other European cities is expected to widen as long as Brexit uncertainty persists.

In Paris, office yields were around 2.8% by year-end and the club of European cities where they are moving near or below the 3% mark is growing. Prime logistics yields are also continuing to test the floor. In October, a South Korean institutional investor paid €135 mln, equating to a circa 4.25% yield, for a 125,000 m2 logistics warehouse in Prague, setting a new benchmark for the Czech Republic where two to three years ago yields were closer to 5%.

The prevailing industry view is that yields will tighten further in 2020. ‘Ongoing incremental allocations into the sector are going to push yields in certain markets tighter, but we expect these pockets of outperformance to be reasonably selective given current pricing levels,’ says

Invesco’s Bessell. Over the next 12 months, the firm expects to see ‘further tightening in logistics and certain speciality sectors, and there is likely to be some further tightening for trophy assets in key CBD locations. However, there will be some offset from further widening of yields in retail’, says Bessell.

3. Which sector will outperform?

UBS AM’s Paul Guest says his bet for 2020’s outperformer – retail - may seem ‘controversial’ and ‘needs some very heavy caveating’. Any outperformance from retail, he stresses, will be exclusively on an asset-level basis, not a market level. And, he adds, given the stages of retail value decline to date, it is only the US and possibly the UK where values have dropped to a point where opportunistic buys may make sense. ‘We are talking about very selective assets and not the sector as a whole!’ he stresses.

Indraneel Karlekar of Principal Real Estate believes it may be too early for distressed investors to step in. ‘They will be looking at a couple of things: first, are they convinced the shakeout in retail is over? It’s a big open question and I don’t think there are any definitive answers yet. Second: there are not a lot of sellers out there. So there’s a big bid-ask spread at this point. I don’t think we’ve found capitulation yet in the retail market. Until we see that, it’s a little premature at this point to say distressed investors will be making significant inroads. It will happen at some point but I don’t think we’re there yet.’

 UK retail

For its part, AEW says a value-add strategy for UK retail - which took a severe battering in 2019 - should prove attractive. In its 2020 European market outlook, the firm tips prime shopping centre and high street markets as ones that will score well under its risk-adjusted return approach, despite the prevailing negative sentiment. London City and West End continue to rate among the highest ranked office markets, regardless of Brexit uncertainty. Meanwhile, Dublin logistics is identified as an unexpected beneficiary of the UK’s anticipated departure from the EU, as some supply chains re-align directly into the Irish capital rather than via mainland Britain.

According to Aviva Investors, most markets in Europe look attractive on a risk-adjusted basis given the favourable relative pricing implied by low government bond yields. In general, logistics and office markets offer better prospects than the retail sector. ‘Most European logistics markets have been boosted by the transition to e-tailing, but the stand-outs appear to be the Randstad, Paris and Copenhagen,’ say real estate investment strategy and research analysts Vivienne Bolla and Souad Cherfouh.

They further see strong occupier markets driving office performance in Paris, where development constraints suggest scope for sustained rental growth. Prospects in Copenhagen, some German cities, Amsterdam and Lyon also look positive. ‘While there has been less re-pricing of retail assets than in the UK, we expect it to emerge in non-core locations, with investors increasingly favouring strong assets in the best locations.’

What about logistics?

The logistics sector has been the investor darling for the past few years and its shine is not expected to wane, as its main driver – internet retailing - continues to grow across Europe. As levels of e-commerce penetration vary widely across markets,  ‘there are some really interesting opportunities to grow into the demand in some of those markets where penetration levels are still low,’ says Principal’s Karlekar.  ‘Some markets have high levels of ecommerce penetration like UK, Germany and France,. In others it is quite low like Spain, Portugal and Italy.  I think that is where you will see the demand for e-commerce-driven logistics.’

Karlekar does not expect occupier strength to decline significantly over the next 12 months as the economy slows. ‘In some markets where there is oversupply you may see some weakness in rents but not necessarily occupier demand,’ he says.

CBRE expects rental value growth to be highest in supply-constrained locations such as London, Dublin and Barcelona. Growth is expected to moderate in the German and Dutch markets due to lower economic growth expectations and weaker manufacturing output.

Like offices, investment yields have also been hardening for logistics, with gross prime yields in Germany averaging just over 4% in 2019, while in Poland, a recent Amazon warehouse deal set a new record low for that market of 4.25%.

Multifamily and new living formats

Multifamily is tipped by many as a sound strategy, driven by structural demographic changes such as growing urban populations, greying communities and delayed family formation. Over the past decade, multifamily has outperformed the retail and office sectors in a number of European markets including Germany, Norway, Netherlands, Sweden and the UK. In Germany for instance, residential returns have averaged 7.4% per year over the past decade, says CBRE, compared with 5.9% for retail and 3.8% for offices.

Severe shortages of affordable housing to buy across most major cities in Europe are forcing many people to rent, driving investor interest in the PRS market. Total investment rose by over 40% to €56 bn in 2018, according to JLL, and this momentum is seen continuing into 2020 with a considerable weight of capital and many new entrants looking for opportunities to deploy at scale.

But the strategy does not come without risk. Rising rents and the lack of affordable housing are increasingly part of the populist agendas in many countries, exacerbated by slow policy responses on the supply side, says UBS' Guest: 'For the multifamily investor, changing government policy is a key risk since lawmakers have an incentive to tackle this issue; e.g. through the rental caps imposed in Berlin, Dublin, and parts of the US.' 

Invesco Real Estate highlights the increasing investor interest in a variety of less traditional real estate sectors, such as European hotels. ‘We would expect these to be strong performers in 2020,’ says Bessell.

Cushman & Wakefield pinpoints living formats as a sector that will evolve as demand increases for inclusive, curated communities where retirement and starters live side by side.

‘Older generations could profit from new concepts created by and for the younger generation, such as intergenerational living or co-locating,’ says Andrew Phipps, head of EMEA Research & Insight. ‘The sharing economy could evolve into the idea of shared living, bringing heterogenous consumer bases together.’

Another trend gaining ground across western Europe is of companies investing in talent and technology to help differentiate themselves from their competitors. ‘As companies evolve, their real estate requirements must reflect this shift,’ says Arvi Luoma, head of European investments at leaseback specialist WP Carey. ‘That is why we have seen an increasing demand in countries including France and Germany, as well as across Scandinavia, for research and development facilities located in regional academic hubs housing world-class universities.’

4. What’s happened to development?

Despite the economic recovery since the GFC, office development has been fairly modest across Europe, leading to supply shortages in some parts. CBRE expects 2020 to mark a turning point on the supply front, with new completions ‘some way higher than in either of the past two years’ and a similar amount scheduled for 2021.

Higher availability is expected in London, Paris, Dublin and most of CEE, contrasting with a tightening of supply in Spain, Italy and the Netherlands. On balance, the generally widening supply is expected to have a knock-on effect on prime rents across Europe, with growth slowing from around 4% in 2019 to 2% in 2020.

Invesco’s Bessell characterises development in general as ‘an attractive source of incremental returns for those investors who are well enough capitalised to undertake the works’. But, he notes, ‘activity is somewhat limited as lenders generally remain cautious of development risk under the current banking regulations’. Increasing development costs also place a premium on properly securing development contracts, says Bessell, while on-the-ground local expertise is increasingly needed to deliver schemes given planning complexities across key European cities.

Principal says it continues to see interesting opportunities in ‘shovel-ready’ development projects in select markets, particularly in the logistics and warehouse sector. ‘We will continue to remain active in e-commerce-driven warehouse space,’ says Karlekar. ‘The way we are handling the strategy in the UK is either via direct development or rededevelopment, not by buying core industrial assets as we think they are quite expensive.’ He also predicts ‘a slight uptick’ in new development for multifamily properties in some markets where there is strong demand.

5. Which cities to watch in 2020?

According to Aviva Investors, Paris stands out as a magnet for global talent; Stockholm, Berlin, Amsterdam and Copenhagen have world-renowned clusters in digital and biotech fields, while Munich, Frankfurt and Dublin compete globally with vibrant activity in financial, automotive, information and communications technology, media, cultural and creative industries and engineering sectors.

Paris is also the clear favourite in the ULI/PwC Emerging Trends report, thanks not least to the Grand Paris project, a €26 bn infrastructure and urban development project set to transform the city. It is followed in the ranking for best overall real estate prospects by two German cities – Berlin and Frankfurt – with London in third place in spite of Brexit. 'London has staying power. Even if it’s mispriced, London will always be the gateway to Europe,' says a global investment banker polled for the survey.

Rather than taking a city-level approach, Invesco says the focus needs to be more nuanced given the length of the cycle to date. ‘As a firm we are increasingly seeking to identify attractive sub-market characteristics, and therefore see some positive opportunities, as well as areas of risk, in most major cities,’ says Bessell. 

 6. Which (geo)political event is likely to impact real estate most?

CBRE cites an escalation of US-EU trade tensions, with further falls in demand for European exports, as the main risk for Europe. Within the region, many observers agree that the ongoing Brexit process will continue to overshadow the UK market and erode sentiment among international investors.

James Gulliford, Savills joint head of UK investment, comments: ‘Despite the Conservative Government receiving a mandate to deliver Brexit, uncertainty over the UK’s relationship with the EU will not immediately diminish, and property will continue to contend with a wide variety of old and new structural, economic and legislative changes throughout 2020 and beyond.’

‘The path through the Brexit process in 2020 is likely to have a major determining factor on the investment market in London and the UK, and as the UK has historically been the most liquid European real estate market, this is by definition the key focus for the sector,’ says Invesco’s Bessell.

‘I think people are still waiting on the sidelines to see how things play out,’ notes Principal’s Karlekar. ‘I hope there is clarity on how all this ends in the next few months because if there is anything investors don’t like it’s uncertainty. Once there is certainty you will see investors looking to re enter the London market.’

Says WP Carey’s Luoma: ‘In the UK, 2020 could be a somewhat turbulent year, with the issue of Brexit remaining unresolved. Given this looming uncertainty corporate owner-occupiers can mitigate the risk tied to short-term volatility by pursuing a sale-leaseback and opting for long-term leases of between 15 and 25 years.’

Blackstone’s vice-chairman Byron Wien, and Joe Zidle, chief investment strategist in the firm’s Private Wealth Solutions group, also include Brexit in their list of Ten Surprises for 2020. They predict a good outcome for the UK, saying: ‘Having secured a workable Brexit deal, the UK turns out to be the winner in its divorce from the European Union. The equity market rises and the pound rallies. The UK benefits from a long transition period and growth exceeds 2% as foreign direct investment resumes now that the outlook is clarified. The EU economy remains soft, and European markets other than the UK underperform the US and Asia.’

 7. Climate risk/ESG issues rise up the agenda

Climate risk and environmental, social and governance (ESG) issues are climbing up the real estate agenda, driven by a combination of regulatory and public pressure – the latter manifested over  the past year in worldwide climate marches.

‘People are leading the green revolution and “forcing” businesses to make a change,’ says C&W’s Phipps. ‘From a real estate perspective, climate change will affect valuation, leasing and investment markets. An eventual downward repricing of higher-risk assets will be the market’s way of redirecting capital to locations and assets less exposed to climate risk.’

BlackRock, the world’s largest asset manager, kicked off 2020 by saying it would put climate change centre-stage across its $7 trn (€6.3 trn) portfolio. In two letters to company bosses and clients, CEO Larry Fink outlined wide-ranging plans in response to the climate crisis. The move followed a year of mounting criticism of the company’s climate track record that saw Japan’s Government Pension Investment Fund withdraw millions from a BlackRock-run passive mandate.

More and more investors are asking what their real estate allocations can achieve beyond financial returns, say Aviva’s Vivienne Bolla and Souad Cherfouh: ‘Investors are increasingly concerned about the environmental, social and governance (ESG) impact of their investments and searching for opportunities to improve Europe’s infrastructure and deliver a societal benefit.’

Evidence of this is reflected in the statistic that 93% of investors now include ESG criteria in their investment decisions, according to the Global ESG Real Estate Investment Survey published in March 2019. Among occupiers, 72% of occupiers express some degree of preference for WELL-certified buildings, says CBRE.

AEW says GRESB has become mainstream as an ESG real estate fund benchmark, with the number of funds covered increasing from 198 in 2010 to 903 in 2018. Europe is the most represented region with 446 real estate funds, totalling $979 bn of GAV.

Head of research & strategy Vrensen, says now is the time to devote more time to ESG issues. ‘As the European property market cycle is extended, the sector can focus on adopting the latest best practice ESG processes and reporting procedures, especially on the building level. This is consistent with our positive market outlook, as the usual cyclical risks of excessive new supply of space and use of debt are now less of a concern. We could call it the calm before the storm - with no clouds on the horizon yet.’

Climate issues and ESG have become ‘a core conversation across the world’, says Principal’s Karlekar. ‘We have been at the forefront of implementing ESG principles across our portfolio, not just because clients say they want it but also because ESG makes economic sense. It delivers direct benefits to the property, whether that be lower occupancy costs or improved efficiencies. We are constantly looking at ways of improving/enhancing our ESG performance.’

Invesco’s Bessell does not believe the focus on ESG is new: ‘I’m not sure this is a “why now” question. In our experience, the underlying investors in real estate funds have focussed on fund ratings in this area, such as GRESB, for some time now. And many real estate owners and tenants have long looked at the environmental ratings for buildings, such as LEED or BREEAM. As such, what we are now seeing is the wider public focus on this discussion bringing the spotlight onto the work that responsible real estate investors have been doing for some time.’

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