In just a year, a continent once racked by uncertainty is riding high on a wave of confidence. Businesses are hiring, consumers are spending, exports are rising, and even governments are starting to loosen their purse strings. The immediate outlook for the economy is much improved, but we must be careful about giving too much weight to the short term. For many, it is the outlook for the next five to ten years that matters most. In time growth is set to moderate, while global monetary policy is already starting to tighten.
Confidence among both businesses and consumers has put the wind in the sails of real estate occupiers. Aggregate European office take-up grew by 8% in 2017, surpassing the 13 million square metre mark and eclipsing the record total from 2007.2 Our forecasts for office rent growth have been revised upwards. With the French economy beginning to fire on all cylinders, we expect to see higher rental growth in Paris in the coming years. However, it is the German cities, driven largely by Berlin and Frankfurt, where we foresee the most impressive rental growth figures in Core Europe. Central London may likely see further rental decline, although under our base case Brexit scenario, rents should then pick up in the early part of the next decade.
We have downgraded our near-term outlook for shopping centres significantly, with Continental Europe’s two largest markets both experiencing downward pressure on rents, particularly so in Germany. We expect core Europe and the United Kingdom to remain weak over the next five years, but Southern Europe and the CEE region should be stronger performers.
In contrast, structural changes should drive broad rental outperformance in logistics. Paris is expected to be among the best-performing markets, although Germany, where prime rents held up well following the financial crisis, looks likely to see below-average rent growth. In London, although uncertainty surrounding the Brexit negotiations is having an effect on office rents, we expect the logistics sector to be better insulated.
European real estate pricing has tightened further in the past six months. However, real estate remains attractive in a multi-asset context thanks to strengthening income growth and a still-significant yield spread over other fixed income products. According to a recent survey, two thirds of investors also plan to increase their European real estate allocations during the next two years, a greater number than a year ago.
We expect that prime yields could reach a floor in 2018, but there may be differences between sectors and markets. Logistics has been closing the pricing gap to offices and retail over the past five years, and we expect this trend to continue looking ahead. Whereas on average, office yields were around 190 basis points higher than logistics in 2012, we are forecasting the gap to be approaching 100 basis points by 2022.3
There is still momentum in the European market. Nevertheless, returns are almost certain to moderate during the next five years as yield compression comes to an end and changes in capital value become more reliant on rental growth. Prime all property total returns have averaged close to 13% per year over the last five years, but we are forecasting a return of just over 8% in 2018 and an average of 5.2% per annum until 2022.4
The highest absolute returns are still expected in the CEE region, although on a risk-adjusted basis the Benelux countries and Finland are set to be the strongest performers across most sectors over five years, with the U.K. market also expected to outperform towards the end of the forecast period. At a sector level, logistics should be a relative outperformer, while exposure to other long-term growth sectors such as European residential and hotels could also help to improve portfolio returns.
Market and sector selection may continue to have a strong bearing on relative performance. However, even in the better-performing markets, projected returns may not be sufficient to meet some investor requirements. In this case, we believe investors have three main options: 1) lower target returns 2) take calculated risks at the expense of more volatile returns or 3) focus on non-cyclical growth segments.
All three strategies have their merits. However, on balance, we feel the third strategy is most attractive. While this is a temporary move up the risk curve, by overweighting locations and segments positioned to benefit from long term demand drivers, we expect to see higher risk-adjusted return over a sustained period of time.
Source : Deutsche Asset Management