Despite the abundance of capital targeting real estate, first-quarter activity was restricted by the ongoing Covid-19 measures
Occupier demand drives sector allocations
Offices remain the largest sector in terms of investment turnover, but it has lost part of its share to logistics and living sectors, which currently benefit from demographic and technological changes caused or accelerated by the pandemic. Office investments are expected to reach about €60bn in Q1–Q3 this year (based on Q3 closed and pending deals according to RCA data), accounting for 32% of transactions, below the long-term average of 35%.
Living and Care sectors are likely to capture 29% of the activity by the end of Q3 and logistics 20% of the total, continuing a busy start to the year, boosted by a number of large portfolio deals. Both living sectors and logistics markets accounted for a significantly higher proportion of total investment than their historical averages.
Retailers and logistics operators have been driving occupier demand for warehousing space, and the shortage of buildable land has been driving vacancy rates down and rents up. Overall, European logistics vacancy rates have fallen by an average of 80 bps YoY to 4.6% (Q2 2021). As a result, prime rents have risen by an average of 3.2% YoY.
The residential sectors in major urban centres are characterised by structural undersupply of housing, which has led rental growth over the past few years. The average multifamily rent is 26% higher compared to five years ago (on average) across the cities we monitor. Currently, affordability has become a critical issue in many markets, and rent controls are tightening. Nevertheless, the stable, indexed-linked income streams that the sector offers remain the key point of attraction.
We believe that the widening gap between rental and capital value growth is driven by the weight of capital targeting the limited product available that meets investor criteriaEri Mitsostergiou, Director, European Research
Although retail is the sector that investors are mostly avoiding, due to changing consumer habits and risks around occupier covenant strength, there is a sub-segment that shines: food-anchored assets/supermarkets and strong performing retail parks/warehouses are in high demand. Competition has pushed prices at historic low levels and they are converging with shopping centres, which are experiencing corrections across markets. With the average prime European retail warehousing yield at 5.41%, the yield gap with shopping centres is at 10 bps in Q3 2021 versus a five-year average of 75 bps. European average prime supermarket yields are at 5.38% and edging downwards.
Capital values are growing faster than rental values
While the share of office investment has dropped, pricing of core office product remains keen. Prime CBD office capital values continue to rise faster than their respective rental values in most capital cities. In Q3 2021, the average rent index (2001=100, eight cities) is at 114 points, while the average capital value index has increased to 208 points, reflecting investor competition for prime assets in core markets. A similar discrepancy between the two cycles had also been observed during the previous peak of the market. In Q3 2007, the rental index was at 100 points and the capital value index at 121 points, showing that during the current market cycle, capital value growth has reached new record high levels. From the eight cities we analysed (London, Paris, Berlin, Munich, Madrid, Amsterdam, Warsaw and Stockholm), the capital value index is still lower than the past peak in London (-2%) and Warsaw (-26%). In the remaining cities, the widest gap between capital values in the current and the previous market peaks are observed in the German cities (Berlin capital values are 225% higher in Q3 2021 compared to Q3 2007).
Wall of capital is driving yield compression
We believe that the widening gap between rental and capital value growth is driven by the weight of capital targeting the limited product available that meets investor criteria; buildings with the best specifications and highest ESG credentials in core European markets. A symptom of this competitive environment is the convergence of prime yields in CBD and non-CBD locations. For the eight cities analysed above, the gap between prime CBD and prime non-CBD office yields is at 81 bps in Q3 2021, up from 61 bps in Q2, but still lower than the long-term average (10 years) of 120 bps. The previous low was noted in Q3 2008 at 79 bps.
On the other hand, we observe that investors continue to avoid secondary offices, which either require significant refurbishment or they may need to be repurposed. The uncertainty around the impact of hybrid working patterns on office demand is an additional caution factor. This probably explains why the yield gap between prime and secondary offices is widening. In Q3 2021, it was at 139 bps (on average in the eight CBD locations), vs a 10-year average of 114 bps.
No major rent corrections so far in this cycle
During periods of economic slowdown, property rents are expected to drop, as weaker demand for commercial space leads to higher voids. During this unique downturn, despite the fact that take-up dropped by 24% over the five-year average (H1 2021), prime CBD rents did not experience a significant fall so far as, in several markets, the supply of prime space is still tight. In H1 2021, headline rents were on average just 1% YoY lower, while incentives had increased. Overall, office vacancy rates continue to creep upwards, rising by an average of 150 bps to 7.2% over the past 12 months (Q2). In some cases, the amount of grey space has also increased. Among the fastest risers in terms of space availability were La Défense, Warsaw and London City. Markets with a higher exposure to financial services were already observing a tapering of demand prior to the pandemic.
Although we expect by the end of the year prime CBD rents to remain stable in the majority of markets, Q3 evidence indicates that we will witness modest prime rent corrections (-1% up to -5%) in some cities, compared to last year (Berlin, Munich, Madrid, Barcelona, Dublin, Warsaw, Prague).
How is rising inflation going to impact the real estate investment market?
Rising inflation is a threat to muted rental growth
According to Capital Economics forecasts, the average European All property rents are projected to grow by 1.2% pa by 2025. These rental growth expectations imply that property rents will be vulnerable to higher inflationary pressures. Although most lease structures in Europe provide for index-linked rents, which offer a hedge against inflation, the question remains if, by the end of the lease, market rents will have adjusted in real terms. Economists reassure us that inflationary pressures are a short-term symptom of supply-side shortages, and they do not expect this trend to last.
According to Capital Economics, the effects of reopening and supply problems could intensify in the next few months. After rising to a near 10-year high of 3.0% in August, they expect that eurozone inflation will rise even further in the short term, a result of the increase in gas prices. But this is due to temporary forces that should fade next year, as global consumption and trade patterns return to something like their pre-pandemic norms, and producers are able to increase their output. They project that the headline rate will average 2% in 2022.
Is there a risk from rising bond yields?
Prime real estate yields have reached unprecedented low levels during this market cycle. However, real estate still appears good value compared to other asset classes, driving strategic allocations in the sector, which exacerbates competition. Ultra-low risk-free rates across the European economies have also dragged property yields to ultra-low levels. These levels have become more acceptable by investors in recent years, as higher market liquidity and positive market fundamentals have supported investor confidence in property.
Rising inflation puts increasing pressure on the European Central Bank (ECB) to abandon its expansionary monetary policy. In the financial markets, this potential shift can lead to higher bond yields. This would have a negative impact on the real estate markets as it would lead to higher financing costs. It would also reduce the property risk premium, which currently sits comfortably at 348 bps (Q2 2021), and potentially shift investor interest in other asset classes.
During 2021, European bond yields rose slightly in anticipation of a potential policy shift from the ECB. In September, the Bank confirmed that it will reduce the pace of its asset purchases slightly, but this is a long way from being a 'full taper'. According to Capital Economics, what does seem likely for the coming months is that the Bank will maintain its focus on 'favourable financing conditions', allowing bond yields to rise only very gradually as the economy recovers. According to their forecasts, the ECB is likely to leave its deposit rate unchanged until beyond 2025.
Since the majority of eurozone government bonds are still showing negative or around zero yields, more capital is likely to flow into the real estate markets. Additionally, property still offers a good hedge against inflation. This could mean further yield compression in the core property segment.
Investor interest in real estate will remain strong
We believe that investor interest in real estate will remain solid in 2021 and 2022. As governments gradually lift Covid-19-related restrictions and cross-border mobility improves across the globe, we expect pent-up cross-border investor demand for European property to translate into transaction activity and boost investment volumes. This year we expect the total to be close to €270bn, at least 15% above last year‘s levels. This will be driven by dynamic activity in the Nordics and expectations for higher turnover levels in most other markets.
We expect pricing for core to remain keen. Capital values may rise further for the best-in-class assets in key markets. This will be supported by economic recovery and improvement of fundamentals. As investors realise that the prospects of higher returns in the prime market segments become more and more limited, interest in tactical allocations into the value-add segment will rise. This is a trend that we already observe through investor requirements, but has not materialised yet due to the pricing gap in buyer and seller expectations. However, the liquidity gap between prime and secondary assets is pointing to potential price effects in the short term for this market segment. This may unlock opportunities for redevelopment, refurbishment and repurposing of assets, which need to be upgraded in order to meet occupier and investor criteria.
Early signs from the office leasing markets are indicating that activity is picking up. There are more enquiries for space, and the size of the requirements is also larger. Companies see their employees gradually returning to the office, and based on a new hybrid working model, they reassess their property requirements. This is expected, on the one hand, to intensify demand for the best-in-class office space in good locations, and on the other hand, to put more pressure on secondary stock for upgrading. We expect prime CBD rents to remain quite stable over the coming quarters. In the medium to long term, we believe that the increased CapEx required to upgrade prime office space to meet environmental criteria will begin to push up asking rents.
In the logistics sector, we anticipate rental growth to accelerate over the next 12–18 months, particularly in core markets, driven by undersupply of existing and future stock. Retail rents, on the other hand, will continue to experience downward pressure, with the exception of locations with high footfall, which are likely to show more resilience as mobility and tourist flows recover.
Investment into income-producing living sectors will remain high, supported by rising demand for rental across all demographic groups. Demand exceeds supply of operational assets, therefore, we expect to see more investments into development projects.
Positive rental growth prospects
One of the key considerations for investor sector and geographical allocations is rental growth and its future outlook. This has become even more important in an environment of rising inflation.
The sector that is expected to demonstrate an above-inflation rental growth trend (>3% YoY) in 2021 and 2022 is logistics. We believe that we are going to witness this in markets where the e-commerce penetration rate has exceeded the inflection point of 10.7%, where we observe rapid occupier demand for logistics space. These markets include the Nordics, Netherlands and France. Shortage of development land will contribute to this trend through rising land values.
Despite the drop in office take-up (-24% vs 5ya in H121), we believe that prime CBD rents in markets with tight demand and supply conditions could also experience positive rental growth again in the medium term. Higher asking rents may also be linked to a premium for best-in-class buildings, that meet the required ESG credentials. In most European cities, office vacancy rates remain below 9%, which is the level that triggers rental falls historically. In a number of cities it is still below 5%, including Berlin (2.3%), Cologne (2.9%), Paris CBD (4.4%), Hamburg (4.0%), Munich (4.0%) and Stockholm CBD (5.0%).
Stable income streams and capital preservation
Capital preservation and stable, long-term income streams also fit some investment strategies. In a low yield, low rental growth environment, this option may become unavoidable. The sectors that offer this type of return are multifamily, senior housing and care homes. Already they are expected to capture 29% of the activity by the end of Q3 (according to RCA data). Structural undersupply of housing in major European capitals and ageing population provide the strong fundamentals behind these market segments. Regarding the growth of elderly populations, cities where increases above 20% are forecast between 2020 and 2025 are Amsterdam, Madrid, London, The Hague and Utrecht.
In terms of overall household creation growth over the same period, the cities that are expected to experience strong increases by 2025 include German, French, Dutch and Nordic cities.
Value-add opportunities and yield compression prospects
In this competitive investment environment, several investors are looking for value-add opportunities that can offer higher returns through cyclical plays or active asset management.
One of the sectors that offers yield compression prospects is the Food sector. Supermarkets and discounters show rising liquidity and yields are moving in (the European average is at 5.4% vs 5.7% two years ago). Although in some markets they are already at sub 5% levels (France, Spain, UK, Germany), higher-yielding opportunities may be found in Southern and Eastern Europe (e.g. Poland 7%, Greece 7%, Italy 5.75%, Czechia 6.15%, Portugal 5.5%).
Conversely, other retail formats are experiencing significant yield corrections. The average prime shopping centre (SC) yield in Europe stands at 5.31% (Q3 2021), the highest it has been since 2014. The UK, Germany, France, Spain and Ireland have experienced the strongest price corrections (prime SC yield has moved out by 25% or more compared to its last peak). Certain retail assets in these markets can attract opportunistic interest, especially as economic activity bounces back. Given the market context, understanding and selecting the ‘right’ retail stock is fundamental. While some assets may lose their lettability for retail uses indefinitely, others can benefit from the recovery of consumer spending and changing shopping patterns. For example, the convenience sector and retail parks, in particular, have proven resilient against a backdrop of subdued footfall for retail as a whole, compared to pre-Covid-19 levels.
In terms of active asset management opportunities, these could include: repurposing of repriced retail assets on the back of improving consumer spending, conversion of retail to high turnover storage to support the growth of e-commerce, conversion of secondary offices to residential, refurbishment of obsolete offices to high standard space with strong ESG credentials.