Economy

As health professionals point to falling coronavirus cases across much of Europe, questions are mounting as to the speed of return to normal working practices and the impact on the economy.

Government stimulus packages are keeping Europe’s economy on life support, with public debt levels forecast to rise by an average of c.20% in the Eurozone (EZ) area, in order to maintain employment levels through furlough schemes. The optimism for a V-shaped recession with a strong bounceback is waning, with the EZ unemployment rate forecast to rise from 7.4% at end 2019 to over 10% by the end of 2020. Early evidence is present with Germany’s unemployment rate rising from 5.0% to 5.8% during April alone. Longer-term repercussions of the increased government debt burdens across Europe could likely point to higher corporate taxes/ introduction of a solidarity tax once the pandemic has passed in order to service debt levels and avoid sovereign default.

GDP growth figures during the first quarter of the year showed -5.8% for France, -5.2% for Spain, whilst Germany is expected to be the least affected major European economy. However, we expect the true depth of the negative spike to be revealed in the Q2 2020 figures as the full weight of the lockdown only came into play during the second half of March. Although we are still at relatively early stages of predicting the full extent of the downturn, April’s Eurozone Services Purchasing Managers Index (PMI) reading of 11.7 marks the lowest level on record (a reading of 50 separates expansion from contraction in the services sector), which was largely dragged down by the hospitality, restaurant and travel subsectors. However, due to the depth of this decline, previous relationships between PMI readings and GDP growth levels are unlikely to hold. Capital Economics May 2020 forecasts indicate GDP growth of -12% for the Eurozone (EZ) during 2020, with a bounceback of 10% in 2021.

On a brighter note, a number of European economies are beginning to lift some lockdown restrictions as office workers gradually return to the workplace. Office landlords will be gratified by the fact that c.80% of office rent was collected during the April period, marking the most resilient of the commercial property sectors. More evidence will be visible in May’s rent collection stats.

Offices

Going into 2020, European average office vacancy rates stood at 5.4%, the lowest rate on record, with core markets including Paris and Berlin hovering just above 1%. We initially factored in more development commitments for the year, and tenants forced to sign for lease extensions given a shortage of alternatives.

Following the Covid-19 outbreak, development activity will be much more restrained due to a contraction of lending to new schemes. Tenants in conventional office leases are likely to re-gear, given few city centre alternatives with record low vacancy rates and delays to delivery of new space. Thus, we expect the rental growth story is likely to be delayed by 6–12 months. Early data for Germany shows a 25% fall in leasing activity during Q1 2020 YoY, although the vacancy rate has remained stable at 3.1% on average over the quarter.

Although each economic downturn is usually different in nature, we can draw on evidence from the Global Financial Crisis (GFC), to analyse the resilience of Europe’s office market. During the GFC, the Euro Area unemployment rate rose from 7.5% to 12% between 2007 and 2013, according to data from Oxford Economics. Analysis of the core European office markets during the GFC indicates that vacancy rates rose from 7.9% to 9.6% which subsequently reduced prime rents by an average of 18% from the 2007 peak to the 2009 trough (see below). This analysis shows the c.9% vacancy rate level is the bellwether for stable office rents across the core cities.

We feel the prospect of prime rental declines to the same extent as those witnessed during the GFC are unlikely, for a number of reasons. Firstly, supply/demand fundamentals present a more landlord-friendly market. At the beginning of the pandemic in Q1 2020, the average European office vacancy rates stood at 5.2%, consistent with the previous quarter, as Berlin and Paris CBD both remain under 2% vacancy (see below). This is significantly below the 7.9% vacancy rate in 2007, with more capacity to withstand the 9% vacancy rate threshold.

Secondly, the government 'bazookas' introduced to provide business aid in response to lockdowns have been faster and firmer than during the GFC. This will limit the number of jobs lost in the short term, assuming a second wave of infections does not materialise. This will also depend on the length of time each government will be able to sustain furlough payments. However, once this aid is wound back, we expect some small and medium-sized businesses to observe some job losses.

What’s more, 2020/21 office development pipelines are significantly lower than the level of new space set for completion during 2008/09. With new office deliveries likely to delayed by 9-12 months, prime rent levels are expected to hold relatively firm and tenant incentives to increase, impacting net effective rents for prime stock. For example, Savills latest Global Sentiment Survey from 15th April outlines how concessions/ terms for occupiers have changed within the office sector. Results of the survey show that 10 out of 16 European office markets are observing a change in payment structure, with three markets observing deferred service charges as landlords and tenants show more signs of working together to find short term solutions alongside government intervention.

This being said, landlords will be paying particular attention to tenant covenant strengths of existing occupied space to avoid high levels of second hand space being released back to the market in the wake of business casualties. Although unemployment will rise, Oxford Economics forecast the overall number of Eurozone office-based workers to increase by 1.3 million by 2024, marking a 3.1% increase. Luxembourg, (+12.2%), Stockholm (+10.4%) and Oslo (+8.0%) top the most resilient cities for office-based employment.

Capital Economics forecast average European city office rental growth to fall by 0.6% across the major European markets during 2020, against the previous set of forecasts released during Q4 2019 indicating 3.8% growth. However, based on a five-year forecast, European office rental forecasts appear relatively unmoved, falling by -0.1% pa on the previous quarter to 1.8% pa by 2024. This is largely indicated by a bounceback in office rents during 2021 as businesses resume occupational activity.

Omnichannel Retail

Retail

The lockdown has had a dramatic effect on the retail and leisure industry, with only 'essential retailers' allowed to stay open, including supermarkets, pharmacies, food stores, petrol stations and others depending on the country. Even after reopening, social distancing measures will restrict significantly the typical flow of consumer trade. In the meantime, confined consumers have shifted towards e-commerce, forcing many retailers to upgrade their omnichannel strategies. The health crisis has accelerated the structural changes that were already underway and we expect further retail store rationalisation and downward pressure on rents. Convenience retailing has proven to be the most resilient during this crisis and out-of-town retail has the potential to recover sooner, as it can more easily meet the requirements for social distancing. In 73% of markets, retail capital values have shown further signs of softening in April, which can lead to value-add opportunities in the coming months.

There are a number of common themes across occupiers in terms of how they are looking to reduce costs such as reducing capital expenditure through supply chains and store refurbs, amongst others. It is likely that some retailers will fall into insolvency, with some tenants asking for rent holidays/ deferments for three months typically. In terms of service charge, retailers are typically asking landlords for this to be kept to a minimum and paid on a monthly basis. For deals that are yet to complete, occupiers are seeking longer rent-free periods.

For the week ending 9 May, Springboard reported that the uplift in weekly UK footfall was the third increase in the last six weeks. Total footfall was up 11.7% week on week (WoW) with high streets reporting the largest weekly uplift at 15.9% followed by retail parks at +10.0%. Shopping centre footfall was up 4.5% WoW. Springboard note that whilst footfall has been swinging from decline to increase over each two week period, the magnitude of the increases have been outweighing the declines, with an average weekly change over the past six weeks of +5.5%.

We expect further retail store rationalisation and investment across omnichannel strategies as retailer margins are squeezed and the share of online retail rises. This will apply downward pressure on rents and intensify the need for alternative rental models, involving more lease flexibility and turnover based rents. Some retail owner-occupiers have opted to sell and lease-back premises in the wake of the coronavirus in order to improve short term cash flow, although more attention is being paid to covenants strength for these transactions.

Close collaboration between landlords and tenants around regears will become more important in shopping centres in order to survive short term negative implications and until social distancing measures are removed. Some incentives may be required to attract customers back including further discounting. Facilities managers will also need to improve hygiene protocols that may require better ventilation, cleaning routines and contactless fixtures.

Logistics

2019’s US/China trade wars, Brexit negotiations and lower EU28 domestic growth marked a weaker year for the Eurozone manufacturing sector. Euro-area manufacturing PMIs (Purchasing Managers Indices) delivered readings well below the 50 mark (separating expansion from contraction) throughout the year, although this has since recovered towards the start of 2020. German automotive production contracted and countries in the associated supply chain observed the knock-on effects. Despite this, the second highest ever level of logistics take-up was recorded in Poland last year, whilst the Czech Republic marked a 9% increase YoY as production facilities accounted for 43% of total space. Prime logistics rents grew by an average of 6% across the European markets, with Lisbon, Warsaw Suburbs and Stockholm all observing double-digit growth last year and this sentiment has been carried into early 2020.

2019 marked an 8% fall in total European leasing activity on the previous year, as a result of the shortage of supply. Average vacancy rates remain low across European markets, including the Netherlands (6.5%), Spain (5.8%), Poland, (7.1%), Czech Republic (3.7%), Romania (5.0%) and the UK (6.7%).

Following the Covid-19 outbreak, a number of European countries have temporarily shut their borders and instructed workers to stay at home in order to contain the virus, which has created warehouse labour shortages. Likewise, the contraction in China’s manufacturing output and the shortages of workers offloading shipping containers at port terminals is creating global supply constraints.

We have observed some logistics operators increasing stockpiling activity given the increased online retail spend by consumers and to shelter themselves from any disruption to the upstream supply chain. Amazon, for example, reported that off the back of “a significant increase” in online retail sales, they are creating 100,000 full and part-time jobs in the US. Lower levels of consumer confidence has led consumers to stockpile necessity goods, whilst delaying luxury purchases. As a result, more luxury goods are being stored in warehouses for longer periods, adding further pressure on supply.

Online retail sales growth continues to exceed analysts’ expectations and given the Covid-19 outbreak has increased consumer dependence on e-commerce, it is likely that this shift will accelerate faster, particularly for countries with lower penetration rates. Online retail sales accounted for an estimated 11.8% of Western Europe’s total retail sales during 2019, above the 10.7% tipping point where demand for logistics space increased significantly in the UK. Forrester’s latest forecasts indicate that online retail will account for 17.8% of Western Europe’s total retail sales by 2024. Assuming industry standards of 75,000 sq m space for every €1bn spent online, this indicates a need for an additional 16.7 sq m of logistics facilities in Western Europe to cater for the growth on online retail over the next five years. Although Forrester’s data indicates that online spend only accounts for 3% of the total food and drink sales in Europe, Covid-19 could be a catalyst to ignite the online sales growth in this sector.

The speed of getting materials to construction sites is being delayed due to labour and mobility issues and it is likely that some of the development forecast for completion in the second half of 2020 will be delivered into early 2021. Likewise, some developers are likely to take stock of the current situation before committing to new schemes, which will add further pressure onto Europe’s already undersupplied warehouse markets.

We generally expect logistics leasing demand to remain resilient during 2020, with online retailers and 3PLs competing for remaining logistics facilities in response to consumer trends. Lease negotiation periods are likely to extend and in this respect, it is possible that the rental growth anticipated for 2020 rental growth will be delayed until 2021.

Hotels

Hotel transaction volumes in Europe totalled an estimated €4.71bn in Q1 – down 1.3% on the same quarter in 2019. Considering that many European countries began entering lockdown from mid-March, this relatively small decline highlights the strength of investor appetite in the early part of 2020.

Confidence in the longer-term fundamentals of the hotel sector remains; interest for development sites in core destination markets continue with a number of investors seeing the current situation as an opportunistic play. Despite this, we will see a significant decline in transaction volumes over the course of the year. This was already apparent in monthly transactions with European March volumes down 77% on the three-year average for March, with April volumes down 63%. This suggests year-end transaction volumes could be at or below GFC levels with an improvement in volumes forecast for 2021.

While recent activity has declined significantly, we have seen some acquisitions complete within the last two months. Dalata Hotels agreed on the sale and leaseback of its Clayton Hotel Charlemont in Dublin, Ireland, to Deka Immobilien for €65 million (Savills advised Deka on the transaction). In addition the Porto Carras Grand Resort in Halkidiki, Greece was acquired by a Russian HNWI for a reported €205m and is reported to be the largest hotel deal to take place during the lockdown in southern Europe.

Residential

Multifamily

Multifamily is perceived as a defensive sector, with demand for housing driven by non-cyclical factors. Urbanisation, shrinking households and rising house prices have been driving demand for rental and the trend may intensify further during a period of uncertainty. In 57% of our markets, we have observed in April that investment activity in residential has remained stable. Rental growth is expected to freeze in the medium-term, however, the demand and supply imbalance for rental stock that is observed in many European cities (such as Amsterdam, Copenhagen and Frankfurt) will persist as construction activity slows down, maintaining the long term fundamentals strength of the sector.

Student housing

The reliance of Purpose Built Student Accommodation (PBSA) on foreign students and especially Chinese will be the biggest risk for the sector. The Covid-19 outbreak has forced international students to return home and the ones that have stayed are asking for PBSA providers to waive rents. Indeed the majority have cancelled contracts of students returning home or provided rent-free periods and discounts for next year’s contracts. The negative impact on PBSA rental income is estimated to last between a semester and a full academic year.

What will happen beyond this time frame will depend on student mobility trends going forward. Past experience shows that education comes out stronger in periods of uncertainty e.g. post-GFC when many people who lost their jobs returned to universities. However, the current situation is likely to prompt more students to study closer to home and live with their parents. Also, long-distance learning may become a safer and cheaper option for extended learning, until the employment market picks up. Government aid to students will also be of critical importance for their university choices. Chinese students may choose to study in Asian universities and we could see more European universities opening branches in Asia.

We believe that the most resilient markets for student housing now will be the ones with demand and supply imbalances for mainstream student accommodation which targets mainly the local student populations and where the student housing product has less dependency on international students.

Investment Markets

We expect investment transaction volumes to recede over the course of the year, particularly as there remains a shortage of openly marketed stock and the bidding process is less competitive than previously.

PropertyEU reported that a number of European retail parks and shopping mall sales have been withdrawn or postponed, although office and logistics transactions continue to change hands. Aperion acquired the Maple portfolio across Germany, whilst 10 Fenchurch Street, London was acquired by a private Hong Kong family office. Bans on travel and self-isolation guidance have made inspecting assets and conducting technical due diligence more difficult in the short term, with virtual tours becoming increasingly important.

With equity still committed and ready to invest across Europe, there appears to be a mismatch in pricing expectations for core product. Vendors have no immediate need to sell and redeploy capital, whilst buyers are seeking 5–10% 'Covid chips' on price - a shortage of investment transactions is making repricing difficult.

Much of this stems from lenders’ initially pausing and showing caution on debt pricing for prime assets, with lending rates moving out as much as double for some core German offices, and doubts rising over the speed of return to pre-Covid levels. Likewise, loan-to-value ratios (LTV) on offer for core deals are reducing from c.65% to what could tend to a new-normal of c.55%, limiting debt-backed buyers’ purchasing power. More focus is being applied to existing tenant covenant strengths and security of income streams.

While some investors are pushing ahead with transactions with the intention to refinance debt once lender caution abates, we believe that the current environment is leading to more core buying opportunities for cash-rich institutions who had previously not been able to compete with leveraged buyers. Nevertheless, as lockdowns begin to ease, property inspections take place and the industry begins to ‘return to the office’, we expect to see lending activity gradually return and being led by Insurance companies and the German banks.

As part of a shift to core, we expect the proportion of cross border activity to decline compared to previous years, particularly from Asia-Pacific capital where we have observed unprecedented levels of investment in recent years. We anticipate that this will affect the Southern European and Central and Eastern European (CEE) markets which are more heavily dependent on cross border capital, relatively more than those in Western Europe.

Core-plus and value-add investors are viewing the pandemic as a chance to count stock on their existing office portfolios. Part of this stems from the fact that pricing in these risk profiles is usually more heavily influenced by strong macro fundamentals. At the other end of the scale, we can expect to see US private equity investors seeking distressed Southern European opportunities offering price chips of 50bps or more.

Average prime industrial yields remained unchanged on a quarterly basis and 22 bps below last year’s levels at 4.93%. Rotterdam (4.25%), Oslo (4.55%) and Dublin (4.75%) experienced a 25bps inward yield shift compared to the previous quarter, while prime yields moved out by 25bps in Amsterdam (4.5%) and Prague (4.5%).

Prime shopping centre yields have moved out by 28bps on average across Europe compared to the previous quarter and by 39bps compared to last year to 5.1% and are now for the first time higher than prime logistics. The most significant yield softening in one quarter were noted in Czech Republic (75bps to 5.75%), Netherlands (50bps to 5.5%), Ireland and Norway (50bps to 5.0%) and Sweden (50bps to 4.75%).

By the end of the year we will know more about the virus, the effectiveness of the measures and the implications on the economy. We will be used to a 'new normality', which we may need to adopt for a longer period and which will change the way we live, work and play. The role of technology and the internet of things will be elevated in our lives, but without totally replacing the physical experience. Consumers will go to work, will go out and shop, will book holidays, buy or rent homes and study abroad again, but the requirements and rules may change for users and providers of space alike. Demand and supply will rebalance and the strength of location and market fundamentals will determine the investment hotspots once again.

Naturally investors will be more cautious about the retail and hospitality sectors, which have been disrupted the most by the lockdown, as well as sectors which rely on short/flexible lease models, such as flexible offices and student housing. There is more confidence in logistics, as well as in multifamily, with several transactions in progress even during the lockdown. Prime offices are also considered quite resilient, although the success of the teleworking experiment may have significant implications on companies’ property strategies in the future. Besides, the impact of the economic slowdown on occupier demand and rents will be more evident later in the year and in 2021.