It has been almost one and a half years since the European economy and capital markets were hit by Covid-19, in an environment marked by waves of the pandemic, uncertainty, and lockdowns. Eurozone GDP dropped by 6.7% in 2020 and the crisis has increased economic fragmentation within the single-currency area: Germany, Austria and the Netherlands have experienced a less severe recession, with GDP dropping 5.1% in Germany compared with 8.0% in France. The huge monetary and fiscal stimulus has mitigated the economic fallout of the pandemic, limiting the rise in unemployment and shaping the economic and financial environment that companies and investors make decisions around. This environment has shaped real estate trends, with capital values holding up relatively well on average. However, discrepancies have emerged across both asset classes and countries, with markets becoming increasingly fragmented, as Covid-19 has hit European commercial real estate markets to a different extent. Hotels and non-food retail assets were most affected, with temporary closures, as well as a significant decline in tourism. On average, European real estate activity dropped in 2020 compared to the previous year and remained subdued in Q1 2021 compared to its ten-year average. Overall, rental values on the retail market were revised down.
Leasing markets: impact on logistics mitigated by booming e-commerce
Leasing activity in logistics markets has been resilient due to the surge of online commerce, which is a driver of leasing demand. Prime headline rents in Europe were roughly stable in 2020, with some scattered increases. Logistics is also partially tied to physical retail, which means the dynamics are uneven.
Leasing activity of office space was down sharply in 2020, by around 40% YoY on average with reference to a sample of 28 European markets. After several years of high take-up, the economic and pandemic reined in leasing activity sharply. First, the lockdowns and travel restrictions limited visits and shifted companies’ attention to maintaining business continuity during the lockdowns. The lack of visibility on health and economic issues made companies less open to making real estate decisions, while issues related to work set-ups increased. As a result, many companies took a ‘wait-and-see’ stance on their real estate decisions. Some of them cancelled or postponed projects and renegotiated or extended their leases.
In Q1 2021 – still impacted by lockdowns in many European countries – the average office take-up decreased in YoY terms with reference to a sample of 28 European markets, but remained stronger than the levels experienced in Q2 and Q3 2020. The vacancy rate – which before the Covid-19 crisis was nearly 100 bp lower than its level prior to the 2008 Great Financial Crisis (GFC) – increased in 2020 in many markets due to the sharp slowdown in leasing activity. This upward move continued in Q1 2021, with the vacancy rate rising to 8.2% in the EU-15 area, as measured by CBRE Research, for an overall rise worth 200 bp in 15 months. It remains below its ten-year high and close to rates observed in early 2017.
Rent dynamics have been significantly affected by Covid-19 and its fallout, playing as a sudden stop in average rental growth. However, no major decrease has been recorded thus far.
The situation varies across markets and submarkets, as the vacancy rate remains relatively low compared to its average in some central business districts (CBD). This can explain the resilience of headline prime rents in 2020 and Q1 2021. Nevertheless, rent dynamics have been affected significantly by Covid-19 and its fallout, playing as a sudden stop in average rental growth. However, no major decrease has been recorded thus far. Covid-19 increased the bargaining power of tenants when negotiating new leases, which is reflected by higher commercial incentives, although with geographical disparities.
Investment markets: growing segmentation requires rigorous analysis
The European commercial real estate investment market has proved to be more resilient than the leasing market, with a decline of around 20% in 2020 compared to 2019. With over €210bn invested in 2020, the real estate investment turnover was close to its ten-year average. This shows that investor demand for commercial real estate has not dried up despite the crisis, unlike during the 2008 GFC. In Q1 2021, investment volumes dropped significantly, but the situation is not as critical as in 2009, as the volumes currently invested in commercial real estate are around three times those invested in Q1 2009. Germany has kept its leading role in the continental European market in terms of investment volumes in commercial real estate, followed by France.
The European commercial real estate investment market has proved to be more resilient than the leasing market.
Although down around 30% YoY, offices remain the leading asset class on the real estate investment market and the deepest one in terms of investment turnover, despite rising investor appetite for residential and logistic assets (demand for logistic assets has been driven by the double-digit growth experienced by e-commerce). Despite the acceleration of remote working, we believe offices will still be needed in a post-Covid-19 world as a collaborative tool and as a mean to attract talent. In the likely new hybrid work model – where in-presence and remote work options coexist – office space should evolve from a place where employees sit at their desk to a space where connecting and sharing ideas is made easier. This evolution should depend on companies and jobs. The current persistence of low prime yields for offices may signal confidence in prime office space by long-term investors.
The current persistence of low prime yields for offices may signal confidence in prime office space by long-term investors.
Hotels were hit strongly. The Covid-19 related travel restrictions have affected hotels primarily in gateway cities and global tourist destinations, which have also faced indirect competition from ‘staycations’, including non-hotel lodging solutions. Despite predictions that travel will not return to its pre-pandemic level until 2023 at the earliest, the hospitality industry could undertake actions to mitigate the impact and emerge stronger. According to the World Economic Forum, hotels may reduce emissions, reinvent the hotel experience around tailor-made services, hybrid work models, health and wellness.
Shopping malls and brick-and-mortar retail have been hit hard by the pandemic and the rise of e-commerce, but trends towards omnichannel shopping could offer some resilience to both sectors. Retailers should manage their store network as a dynamic asset that compounds physical and digital channels to fulfil customer needs by building dynamic store formats that create a fruitful customer experience. Given the multi-store nature of many retail real estate footprints, the adoption of a comprehensive strategy to tackle decarbonisation will be paramount.
Demand for high-quality ESG residential buildings in smart cities remains strong, but supply is still out of balance.
More generally, the greater focus on quality assets – with long lease terms and strong tenants – has helped keep prime yields low, leading to resilient prices. However, assets with vacancies, short-term leases or fragile tenants often saw their yields rise, resulting in decreasing values. Another significant development last year was the rise of risk aversion. An emphasis on the visibility of rental payments favoured rigorous analysis of tenants’ financial strength and some divergence in terms of market yield, both across asset classes and among assets within the same category. To sum up, in 2020 the investment market became segmented after several years of yield convergence.
In 2020 the investment market became segmented after several years of yield convergence.
Divergences in market values
In light of the above developments in both leasing and investment markets, a divergence in values was recorded in 2020 across assets, depending on the asset class and the quality of location. The segmentation by asset class is showcased by discrepancies in capital value growth: the asset classes most impacted were European hotels and retail assets, with drops in capital values worth 6% and more in 2020. At the same time, residential and industrial/logistic assets recorded capital value growth above 3% last year. Such opposing trends highlights different investor behaviour, as well as the different features of leasing markets. In terms of portfolio management, these results highlight:
- the advantage of a diversified portfolio to limit idiosyncratic shocks; and
- the role of income return, which can help limit the adverse impact of capital value drawdowns on the total return performance or enhance the positive impact of positive capital value growth.
Higher fragmentation reflected in greater performance divergences. Highly diversified and income focus portfolios are key.