Aviva Investors is forecasting that the European ex-UK real estate market could return up to 8.2% a year over the 2014-2016 period and 7% per annum over the longer term between 2014 and 2019. According to Andrew Hook, manager of the Aviva Investors European Property Fund, investors will best served by strategies that focus on prime property for the next year alongside tactical opportunities in Italy and Spain, as well as senior real estate lending. Andrew sets out his forecasts and rationale below.
Aviva Investors’ expects that European real estate will return 8.2% per annum over the next two and a half years. This follows a strong start to 2014, and despite the slowdown in economic recovery, the European commercial real estate investment market continues to look robust. In the second quarter of 2014, investment activity in Europe (excluding the UK) totaled approximately €30.7bn, up 38% from the same period a year earlier. The greatest year-on-year growth in Q1 2014 was seen in Austria, Portugal and Spain. The strong investment volumes across Europe are predominantly focused on the office sector, which accounted for around 40% of all transactions in Europe (excluding the UK), in the second quarter.
The strength of competition for prime assets in London, Paris and the top-tier German cities is pushing increased volumes of capital towards smaller and higher-yielding markets including the Benelux countries and a recovering Southern Europe. The pricing of prime European real estate continues to be favourable compared with the declines in sovereign bond yields across Europe. Prime real estate remains highly valued for its perceived defensive qualities, and Aviva Investors believes the asset class will continue to attract increased capital from investors seeking diversification and higher yields. It forecasts this particular segment of the market to grow at 7.0% per year between now and 2019, and for the downward pressure on yields in core markets to continue.
- Prime Irish real estate has experienced a more sudden cyclical recovery than many had expected. However pricing is turning quickly. The Dublin office rental market grew by 13% in Q2, during a period when the majority of markets saw no rental growth whatsoever. Dublin was also one of the few markets to see notable rental increases in the industrial sector.
- Spanish real estate has also had a strong turnaround so far this year, and we believe this market along with Ireland will deliver the strongest rental growth over the next five years. Spain’s long term structural issues must still be addressed however, including the extremely high unemployment level and the indebtedness of the public and private sector. With a large number of opportunistic investors active for the last 12 to 18 months, competition and pricing has become very aggressive.
- By market sector, Finnish offices, and Irish and Spanish industrial markets are relatively underpriced and are the most appealing European sectors on a risk-adjusted basis.
Deflation continues to be the main threat to the European outlook
The euro zone recovery so far has been weak and heavily dependent on a major export-led expansion in Germany. The first quarter of 2014 saw GDP in the region increase by just 0.2% year-on-year, however if Germany were excluded then GDP would have actually contracted. We are now forecasting GDP growth of 0.7% this year, and a minor pick up in 2015 to 0.9%.
In addition to its growth concerns, the region is at increasing risk of slipping into a Japan-style deflation trap. The Consumer Price Index (CPI) inflation remains stubbornly low, at just 0.5% year-on-year in June and while the European Central Bank (ECB) continues to insist that there is no deflation risk, we are less sanguine.
The ECB did of course introduce some further policy easing at its June meeting, including becoming the first major central bank to take rates into negative territory by dropping its deposit rate to -0.1%. However, our view remains that the measures to date are insufficient given the degree of damage to the banking transmission mechanism for monetary policy. We believe more needs to be done and expect the ECB will eventually be obliged to undertake outright quantitative easing (QE).
Prime assets retain appeal in an uncertain economic environment
With the balance of risks now weighed to the downside given the threat of deflation and stagnation within the Euro zone, we suggest investors should still be focusing on prime assets. Stronger returns are expected in the near term as a result of robust investor demand for prime real estate exposure. Today’s pricing may be expensive by historical standards but can be tolerated if interest rates are likely to remain lower for a very long time.
A diverse real estate allocation that can capture upside risks is necessary, so we also recommend good quality secondary assets in core (more liquid) markets. If the economic recovery was to gain momentum then we would suggest a focus on value-add and opportunistic strategies throughout the Euro zone where fundamentals are compelling, including selective investments in Spain and Italy.
Generally, senior real estate lending continues to be an attractive strategy. Banks are likely to remain reluctant to increase their exposure to real estate leaving a debt funding gap and creating opportunities, such as development finance, in selective core markets.