Economy

As the number of new coronavirus cases continues to fall on a weekly basis across Europe, new signs of a return to business and consumer activity are beginning to shine through in monthly data, as society adjusts to the “new norm”.

Eurozone consumer confidence readings recovered from -22 to -18.8 between April and May, above consensus forecasts which could provide the first sign that the U-shaped recovery will be less damaging than previously feared. However, this remains at the lowest level ever recorded by some distance.

Consumer trends will be reflected in unemployment rate numbers which we only expect to surface later in the year once furlough schemes are lifted. Bloomberg estimates that 40 million workers have been furloughed across Europe’s largest six economies, Germany, UK, France, Italy, Spain and Netherlands, following the outbreak of Covid-19. Temporary job subsidies are unlikely to prevent increases in unemployment rates after Europe’s furlough schemes are wound up towards the end of 2020. Eurozone (EZ) unemployment is expected to peak at around 11–12% by year-end, up from the current level of 7.3 %.

The European Central Bank’s (ECB) main refinancing rate remains at zero, leaving no further room to lower rates, providing investors with cheap debt (although lending to real estate has become more stretched since the outbreak of Covid-19). Southern European economies with higher levels of debt will find servicing existing debt eats into government spending plans unless central aid can be offered.

The ECB must also avoid fears of a deflationary spiral. EZ inflation is expected to have fallen to 0.1% during May 2020, the lowest rate since 2016 due to falling energy demand. The ECB intends to stimulate demand using the Pandemic Emergency Purchase Programme (PEPP), recently increased from €750bn to €1.35tn, to return back to the 2% inflation target, which equity markets welcomed.

Meanwhile, the European Commission’s planned €750bn recovery fund is intended to help some of the worst-hit and heavily indebted European economies bounce back from the imminent economic downturn.

Germany’s temporary VAT cut from 19% to 16% will also help to stimulate consumer demand for the remainder of 2020. The larger European economies will be able to stomach the additional debt burden more easily in the short term. Yet, closer attention will be paid to whether this has a positive impact on the marginal propensity to consume, or will simply increase household savings ratios. When business activity stabilises in the longer term, governments may opt to increase corporate taxes, which could impact multinational occupiers’ decision making.

It is likely that planned infrastructure spending will be put on hold in the short–medium term to service markedly increased debt repayment costs. Countries which have been least affected by Covid-19 will ultimately have more capital to invest in expansionary infrastructure schemes including green energy initiatives and urban cycle routes which have come to the forefront during lockdown periods. However, green policies will remain on the agenda. Germany has announced increased incentives for buying electric vehicles, a welcome boost for the automotive sector which will stabilise logistics demand levels both nationally and throughout neighbouring countries.

Eurozone GDP growth confirmed a 3.8% slump during Q1 2020, and given the depth of decline in the Purchasing Managers Indices (PMIs) during the second quarter, GDP forecasts appear varied. However, the latest Focus Economics consensus forecasts indicate -12% Eurozone GDP growth during Q2, marking -5.9% economic growth for the full year 2020.

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 regear, 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. Our analysis shows the c.9% vacancy rate level is the equilibrium for stable office rents across the core cities.

We feel that the prospect of prime rental declines to the same extent as those witnessed during the GFC is 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 rate stood at 5.2%, consistent with the previous quarter, as Berlin and Paris CBD vacancy rates both remain under 2% (see below). This is significantly below the 7.9% vacancy rate in 2007, with more headroom to withstand increased supply and remain below the 9% vacancy rate equilibrium.

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 22nd 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.

Retail

Supermarket retailers leading the sale and leaseback trend

Last year approximately €2.4bn of retail properties were sold and leased back, accounting for nearly 6% of the overall retail investment volume. This was a record level since 2010, both in terms of volume and share. The activity was mainly driven by supermarket retailers. The fierce battle on food price to maintain market shares against the growing mass market grocery retailers such as Lidl and Aldi (who had been expanding their footprint across Europe), has substantially squeezed profit margins in the sector.

Since the beginning of 2020, the volume of retail sale and leaseback (S&LB) has dropped significantly, so has its share in the overall retail volume. This is unsurprising given the current pandemic context with the overall investment activity slowing down. Still, with respect to the few retail S&LB deals that were signed in Q1, nearly all concerned supermarkets (EDEKA Germany / Family Cash Spain / Coop Sweden / Match France). Yet, we believe these deals were initiated and negotiated last year.

Will retail S&LB deals continue to increase?

On the retailer side, the Covid-19 period may have proved more difficult for retailers that had to pay rent compared to the ones that owned their retail units. Hence, some retailers may prefer to hold on to their properties. Others may see, in the S&LB option, a financial opportunity to take capital out of real estate assets and put it back in the core retail business or invest in improving their omnichannel strategy to surf the e-commerce wave.

From an investor’s perspective, it is an alternative opportunity to source property and to invest large amounts of capital, which in return, can provide long income streams, especially as the lease terms generally agreed are longer than the typical length prevailing in the respective market. However, the retail landscape is currently critical with both the lockdown restrictions and the surging e-commerce adoption hitting hard the industry. Hence, investors will have to target 'Covid-proof' and 'ecommerce-prepared' tenants with strong covenants. Additionally, as rationalisation and consolation of retail units will continue, investors will have to focus on prime assets, dominant in their catchment.

In Q1 2020, the prime retail yield was at 4.53% on average, 3bps above the level recorded a year ago. We anticipate prime retail yields will continue softening in 2020 and beyond. By the end of the year, we expect the prime retail yield to move out by 30–40bps on average across Europe.

Based on the above-mentioned conditions and forecasts, we do not expect retail S&LB to pick up significantly before the second half of 2021 when downward price correction will be sufficient to highlight the retail risk premium over other assets classes and attract opportunistic investors.

Food vs non-food

Over the past two years, retail S&LB activity was mainly driven by supermarket retailers but the pandemic changed the situation.

Food retailers have been relatively spared by the Covid-19 and sometimes even benefited from lockdown measures as restaurants and canteens were all closed with the vast majority of the European population having to eat at home. Strong resilience of the sector may catch investors’ attention. For food retailers, Covid-19 has highlighted the need to develop their omnichannel strategy by offering/expanding delivery and drive-in services, which will require investment. Hence we are likely to see more S&LB from the grocery sector.

We also expect to see more S&LB deals from non-food retailers with strong covenants, including notably DIY, gardening centres and home improvement, which by essence, need both a physical and an online presence.

Finally, we expect to see more retailers seeking to unlock capital from owned headquarters office buildings and more importantly from distribution centre and supply chain properties. This can be illustrated by the case with Next having completed on the sale of its Leicester headquarters (25-year leaseback) in May 2020 and in the process of selling three major warehouses in Doncaster or with Matalan looking to sell its Liverpool HQ.

Where in Europe?

S&LB activity is not following an endless market cycle. It ends when ownership has massively changed hands from retailers to investors. Historical data shows that the previous two waves of retail S&LB deals were predominantly signed in the UK, Spain and to a less extent, in France. However, we believe there is still some scope for more S&LB in these three countries.

As the next stream will be mainly driven by distressed sales, we anticipate S&LB deals will concentrate in countries most impacted by the Covid-19. The direct impact will be squeezed retailers’ revenues due to a sharp drop in domestic demand expected notably in the UK, Spain and Italy, according to Capital Economics. The ripple effect will be a surge in ecommerce adoption in countries where lockdown measures were strict and ecommerce penetration was low (Italy, Spain, Greece).

Logistics

Early evidence of improving sentiment during lockdown has been recorded in the European manufacturing sector, with May’s latest data indicating an increase from 33.4 to 39.4, although still well below the 50 mark signalling slowing declines in the sector.

Weekly online retail sales have doubled against the previous year in some instances across Europe, according to data from CC Insight, although as shops begin to reopen throughout June, we are seeing signs of this growth normalising. Online retail sales accounted for 31% of the UK’s total retail sales in April, however, we expect more attention to be paid to the impact on total retail sales over the course of the year. Likewise, we are yet to see the extent to which the potential fall in logistics demand from the manufacturing sector will be cancelled out by the increased demand from ecommerce operators.

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 will be delayed into 2021.

Multifamily

Multifamily investment activity in the first quarter of 2020 was close to €11.5bn for the 12 markets that we monitor, already 27% of last year’s total, which was the second strongest year on record, at €43.2bn. Multifamily investment accounted for 23% of total activity. In Germany, it was the largest sector, 1.1 times above offices. Germany was once again the largest market, capturing 71% of the total with over €8.2bn of transactions, followed by the UK (€947m) and Sweden (€699m).

Despite the slowdown of investment activity during the second quarter, resulting from strict lockdown measures across Europe that aimed to control the spread of Covid-19, we anticipate at least another €10.3bn to have been deployed in the multifamily sector by the end of June, with half of the countries expected to achieve significantly higher volumes compared to the previous quarter.

The average prime net yield has remained stable on a quarterly basis at 3.35% and 50bps below the prime office yield. Yields are stabilising in most markets, after a significant inward yield shift trend over the past five years. In Q1 2020, prime yields moved in only in Dublin from 3.75% to 3.6%. Prime achievable yields for newly built income-producing assets are the highest in Stockholm (4.0%) and London (3.8%). Prime net yields in Amsterdam have moved slightly out to 3.1% (10bps).

Impact on pricing has been minimal but rental growth expectations have to be postponed

The minimal impact of the health crisis on investor appetite for multifamily is supported by the strong fundamentals of the sector: rising urbanisation, smaller households, unaffordable house prices and rising occupier demand for flexibility and services. Additionally, housing is a basic need and therefore demand for rental remains stable or even rises in periods of economic uncertainty. Supply of this type of product is low in most markets, and construction activity is restricted by high land values and construction costs, as well as limited labour availability.

The main considerations for multifamily investors following the health crisis are expected to be around affordability and real rental growth prospects. The ability of low-income households to meet their rental obligations will be tested over the next few months as government support measures start phasing out. This will eliminate positive rental growth expectations for this year and next, while some moderate downward rent adjustments may also occur.

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 and is most acute in the UK market.

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. Markets including Germany, Denmark and Poland remain popular with investors.

Investment Markets

Investment transactions

RCA’s latest data indicates that EMEA investment transactions to 10th June 2020 fell 6% compared to the same stage last year, reaching a total of €100bn, although this is below the 18% fall in the Americas and 45% fall in Asia-Pacific. What’s more, much of this volume was boosted by larger transactions and portfolios. On a deal count basis, investment transactions have fallen by 41% on the same stage last year.

Investment activity for March to May shows Germany and UK investment transaction volumes have held fairly firm so far this year, representing a shift to core markets, however, nearly all markets recorded between 30% to 50% falls in the number of transactions changing hands during this period.

By sector, offices accounted for the largest share of transactions during March-May period, however marking large falls on last year. Apartment transactions actually represented a small increase on the previous year as investors show evidence of a shift to core markets, with a number of large portfolios changing hands.

Grocery anchored retail continues to remain on investors’ wish lists, with over 120 monthly transactions over €5m during the months of February and March, more than any other sector and we expect grocery-anchored retail to continue to pique investor interest throughout the year.

A number of the largest completed deals for week commencing 8th June indicate a shift to residential and alternative portfolios according to Property EU data from across the core European markets, including Patrizia’s forward purchase of a care home portfolio, and L&G’s acquisition of 213 residential units in Wembley Park.

Our indication for European investment transactions for the full year 2020 is a fall of between 34% and 52% on the level recorded in 2019 to between €125bn and €170bn. This marks a smaller reduction from the 54% investment transactions decline during the GFC.

Yields

Average prime industrial yields remained unchanged during Q1 2020 and 22bps 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 during the first quarter and by 39bps compared to last year to 5.1% and are now higher than prime logistics for the first time. The most significant yield softening in one quarter was noted in the Czech Republic (75bps to 5.75%), Netherlands (50bps to 5.5%), Ireland and Norway (50bps to 5.0%) and Sweden (50bps to 4.75%).

Given that lockdown only started towards the end of Q2, we expect any price movement to become evident in the second quarter’s figures.

Outlook

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 becomes less competitive than in 2019. Bans on travel and self-isolation guidance have made inspecting assets and conducting technical due diligence more difficult in the short term, although some country borders are slowly being reopened. Domestic investors are clearly at an advantage here. Ultimately, we would expect European institutions to be more active in the second half of the year.

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 transactions – and a shortage of investment transactions is making repricing difficult.

The majority of the debt market remains in pause mode. Clearing banks in the UK are focused heavily on managing their existing granular loan books. The most active parts of the lending market across Europe are the German banks as well as Insurance companies, with this debt being secured against core product. LTVs have reduced from 60-plus % to 55%.

Nevertheless, there remains a weight of money available as debt (particularly as many multi-strategy investors see this as a way to diversify their exposure) and, once appetite and pricing becomes clearer in the coming months, we anticipate the return of investment banks, debt funds and private equity to the market.

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.