Spotlight: The impact of a low rate environment

A sustained low interest rate environment: the impact on European real estate

What's happened?

The European Central Bank (ECB) has cut the deposit rate by 10 basis points to -0.5% in its September meeting. The ECB subsequently announced that in order to stimulate growth in the Eurozone area, it would acquire €20bn per month of government bond purchases for “as long as necessary” to accommodate the impact of the policy rates so that the inflation outlook increases to close to 2% pa.

Euro Area GDP growth is forecast to slow sharply this year to 1.1% due to lingering weakness in the manufacturing sector, a less favourable global backdrop and geopolitical concerns hampering investment and exports. Risks to the outlook remain elevated and include rising global protectionism, slower-than-expected growth in China, a no-deal Brexit and sluggish domestic growth.

What does this mean for real estate investment?

Lower risk-free rates have been the influential driver of office yield compression across Europe’s markets, which has had a huge impact on the lending community across Europe. Lending rates to CBD offices have dipped below 1.5% per annum on most of Europe’s core cities, with c. 60% loan-to-value (LTV) ratios on offer for investors.

As a result, €69bn of global equity was raised in 2018 for non-listed European real estate (see Chart 1), according to INREV. Rather than institutions continuing to pay to deposit funds in Europe’s banks, lenders are increasingly looking to deploy their capital into income-producing opportunities across Europe.

Likewise, global real estate investors are aware of the relatively attractive income on offer in Europe compared to domestic markets. As capital controls loosen in Asia, funds are more willing to increase exposure across Europe in multi-country funds.

Back in 2013, 10-year German bonds were yielding 1.6% and we have since witnessed a steady decline in bond yields to 0.4% at end 2018 which are lodged into negative territory in H2 2019. During this time, annual European real estate investment rose from €173bn to €297bn (see Chart 2), as multi-asset class investors shift their focus from fixed income to real estate. Prime European office yields have compressed 12bps YoY to a record low of 3.7% during Q2 2019, and as investors increasingly scrutinise the fundamentals backing each investment opportunity, we expect end year investment volumes to reach €241bn, 18% below the level in 2018.

So which sectors have benefitted most from the fall in bond yields?

Chart 3 shows the investment volume increase for the last five years (2014–18) versus the previous five years (2009–13) across each sector. The sectors which have seen the strongest increase in investment on the previous five years are those where long-term ‘bond-type’ income is generally more common, including within the hotel sector (+132% on previous five years), the industrial sector (+142%) and the alternative sector (+143%). For example, sale and leaseback agreements in the hypermarket sector and transactions involving long-term leases to hotel operators have been more sought after, as investors are becoming more sector agnostic. Investors have also tapped into the demographic changes, with ageing populations bringing more income opportunities including care homes, senior living and multifamily. However, we should also be aware of some of the more cyclical investment factors, including a shift to alternatives late in the cycle.

Given modest economic growth prospects, investor interest has grown for long income funds across Europe with 20 years+ unexpired income. After all, the round trip costs associated with acquiring real estate has encouraged investors to take a longer-term view, as this could equate to over two years’ worth of income from CBD offices at current price levels.

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