Hermes Real Estate’s Roberts: State of commercial property in Europe
Divisions over what Europe means to its people were highlighted by the results of the Europe-wide elections in May. What does Europe now mean to real estate investors? Nigel Roberts, head of strategy at Hermes Real Estate, comments.
The signing of the Maastricht Treaty in 1992 established the foundations of the European Union, leading to the creation of the euro. At the time, real estate investors began to consider the potential implications for real estate of the single market.
Would market practices and investment performance converge? Would cities assume greater economic importance as national boundaries became less significant in determining economic growth? Crucially, would a single market create new investment opportunities? These questions did not anticipate a major financial crash – such as the crisis of 2007-08 and its aftermath.
However as Europe has struggled to recover with GDP over the past five years averaging -0.25% pa, Europe’s real estate investors have been rewarded with total returns from commercial real estate, measured by IPD, of 5.8% pa. This was ahead of bonds at 4.4% pa and below 13.2% pa from equities. In 2013 real estate returns were 5.9% (4.0% in the Eurozone) and again between bonds (2.2%) and equities (22.3%).
Whilst each country reported positive nominal real estate returns in 2013, performance varied widely across markets: Spain delivered a total return of 0.3%, Germany 5.2%, the UK 10.7% and Ireland leading with 12.7%. The UK delivered the strongest returns over the past five years with an average of 8.0% pa, strongly influenced by London and the strength of investor demand, particularly from international investors driving down yield for core real estate.
These performance data illustrate the still divergent characteristics facing real estate investors in Europe. Operating conditions in Europe’s domestic real estate markets have shown no discernable convergence, with market transparency, tax leakage, valuation practices and leasing conditions still varying widely.
Each market and sector needs to be judged on its merits. International investors may make strategic allocations to Europe, but in practice market risk, pricing, and prospects as ever reflect the inherently local market conditions within which the real estate asset class performs. Table 1 highlights the variety in market conditions in some of Europe’s main markets.
Table 1. The variety of market conditions in Europe’s major real estate markets.
|Office Prime Rent Levels €/M2/pa||Office Prime Rent %pa||Office Prime Yield %||Total Transaction Volumes €bn||Total Returns All Property %pa|
|Q4 2013||2009-13||Q4 2013||2013||2013|
Source; JLL, IPD
These complexities however have not stopped Europe’s investment market from more than doubling in size to $2.5 trillion since 2001. Much of this growth occurred prior to the global financial crisis. Today it accounts for over 40% of the global market according to IPD. The UK, at over $595bn, along with Germany and France, are the largest markets in Europe and together make up 55% of the European total.
Investor demand for European real estate has also recovered rapidly since 2008, despite the region’s weak economy. Investors have been attracted by the income yield on offer and the positive yield spread over government bonds. Improved lending conditions and expectations of rising rents as the economy recovers have also fuelled investor sentiment. In 2013, transaction volumes at $220bn were 37% up on 2012 and the first quarter of 2014 continued this trend, with transactions totalling $43bn; 3 times the volume in Q1 2009.
Prime real estate in Europe’s largest and most liquid markets – London and Paris – has attracted the most cross-border capital. Yields in London’s West End are approaching levels achieved at the peak of the market in 2007, but downward yield pressure driven by the weight of money affects most markets in Europe. Office yields in core markets in Germany, Sweden and Brussels are also approaching levels of the previous peak. Further anticipated yield compression is driving investors towards recovering markets such as Madrid, Barcelona and Dublin, as well as more mature markets such as Paris. In some cases the inexorable search for yield has potential to inflate values out of proportion to the occupier demand fundamentals.
To date there has been a strong disconnect between Europe’s weak occupier markets and its strong investment performance. Occupational demand has been muted, expansionary demand has yet to materialise and corporate consolidations and portfolio improvements dominate activity. Office rental values show no material increase since 2011 and at Q1 2014 year on year growth was only 0.9% according to JLL’s office rental index.
Investors are clearly moving up the risk curve to smaller markets, recovery plays and more secondary market opportunities, seeking value in an asset class supported by an unusually low interest rate environment. Whilst capital values remain below peak levels in all but a few markets, investors will inevitably be looking for the intended benefits of the “European project” to reassert themselves with a return to widespread economic growth and prosperity coupled with a strong single currency to reinforce their investment decisions.