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The macroeconomic environment
The macroeconomic environment is improving in the eurozone under the influence of a weakened currency, falling energy costs and partially completed
At the same time, unemployment continues the decline begun in 2013, falling to 10.3%, or one point less than a year ago: the eurozone created nearly two million jobs in 2016.
High levels of consumer confidence, which are back up to the highs seen in 2008, are increasing household consumption. This has grown 1.7% over the
Such dangerously low inflation and the slow-moving economic recovery have prompted the European Central Bank to continue its quantitative easing policy. The latest measures taken by Mario Draghi have led to a further reduction in bond yields, which (for example) dropped to 0.50% for 10-year French government bonds on 1 March. This is 0.63 points less than six months ago. As for 5-year rates, they are now negative in several countries and may remain very low for several weeks.
The office rental market
Against this backdrop of modest growth and recovery in the labour market, office space markets will perform better overall, even though not all of them
In the core countries of northern Europe1 in the eurozone, average employment growth was slightly below 1% in 2015. At the same time, existing office space supply continues to be restricted (8% in the Paris region, 10% in Frankfurt, etc.) while the volume of real estate in construction is greater than 3% of existing inventory in only two cities (Berlin and Brussels). Other cities post construction below 2% of existing stock, a very low rate which raises some questions over rental market liquidity if the labour market recovery gets stronger. The first signs of this imbalance were revealed in Germany: since 2013, rent increases have outpaced employment growth in Munich at around 3%. The situation is similar in Berlin and Hamburg. Obviously, the vacancy rate has dropped in nearly all German cities.
In the Paris region, after three weak quarters in 2015, a substantial amount of space was leased in the fourth quarter, resulting in the year ending with 7% growth compared to the previous year, and activity levels near the average for the decade. However, these conditions have not triggered a recovery in rents, which were nearly flat in central Paris for 2015. Average rents in the Paris region are still below their 2007 high, particularly if we include incentives granted to tenants.
In the Netherlands, after a crisis linked to an oversupply, followed by the post-2008 economic slump, rents are now rising once again. Even though this growth remains modest (for example, +1.5% for Rotterdam in 2015), employment is expected to increase by more than 1% in the coming years (source: Capital Economics) due to an office space pipeline that is finally under control. This means rents will most likely continue to increase. The story is the same in Belgium and Austria: employment growth was close to 1% year-on-year at end-2015, and available space is relatively restricted. This will help rents return to growth after three lost years.
In Scandinavia (excluding Finland) employment is generally on an upward trend: nearly +2% in 2015 for Sweden, and +0.4% for Norway. Things look good for the entire region in 2016, while vacancies remain limited: approximately 9% vacancy in the major cities, sometimes below 4% in central districts, while the pipeline for new buildings is reasonable at between 1% and 3% of existing inventory. This has led to rents going up for the most part (+13% in Stockholm, +2% in Copenhagen in 2015), even though the Norwegian office space market is beginning to post rent declines (-1.5% in 2015) due to a drop in demand caused by the reduction in oil prices.
The United Kingdom has had three very good years in terms of rents, thanks to a booming labour market. However, it seems that the market has peaked, with employment prospects dimming somewhat (with only a +0.4% increase expected in 2017, according to Capital Economics). However, the vacancy rate in London is exceptionally tight (4%), but the volume of construction to be completed by the end of 2017 raises the issue: the equivalent of 7% of existing inventory is currently under construction in the City, which suggests rents will begin correcting in 2018. Meanwhile, rents should rise still higher in 2016, after several years of increasing by more than 5%.
In other western European countries2, the situation varies from country to country. For some peripheral countries (Ireland, Spain), employment is growing rapidly (from 2.2% to 2.7% in 2015) and should continue to do so in 2016. For Portugal and Italy, the situation is less promising, with employment growth at just 1% while unemployment remains high. Office space available remains higher than 12% in major cities, except for Ireland where vacancies are slightly higher than 8%. This vacancy rate is offset by an exceptional amount of new construction planned by 2017, which may unbalance a rental market that has barely recovered from a string of bad years. In other cities, new office space remains limited at around 2% (source: various brokers). The countries worth watching in 2016 are Ireland and Spain, two countries undergoing recoveries. Office space markets in both countries had been hit particularly hard (with rents down by 50% at the worst moment of the cycle). For Ireland, the recovery is mostly complete, with rents returning to 2007 levels, while a number of upcoming building completions threaten to throw this tiny market off balance once again. In Madrid at end-2015, rents were still 30% lower than in 2007. But they have since risen and, given expected employment growth, are likely to continue their gradual climb.
In Central Europe3, the recovery in employment is off to a slow start (approximately +0.7%), but is not expected to take off in 2016. Available office space is historically more than 10% of existing stock in major cities (14% in Prague, 12% in Budapest, etc.), but what’s surprising here is that the percentage of new buildings to be completed by 2017 could represent as much as 17% of existing inventory in Warsaw and 30% in Bucharest. In 2015, this oversupply negatively impacted Polish rents (down 3% to 4%), while rents in the Romanian capital, which remained stable in 2015 at 20% below their 2008 value, are not expected to increase. However, Prague and Budapest are taking a smarter approach, with construction representing 3% of existing space currently underway. This should help bring down the vacancy rate and contribute to the growth, albeit modest, of rents after two flat years.
The investment market
Investment volumes in corporate real estate (including office space for the most part, but also retail, logistics and accommodations) were up to €270bn in 2015, up by 23% (source: RCA, January 2016). The United Kingdom, Germany and France represent 80% of the total, with all European countries posting strong growth (see illustration, Germany) except for Spain (+5%), France (+15%) or Poland (stable). The situation in France is explained by a lack of supply rather It should be noted that very large transactions, in the form of portfolios, have come back to the scene after practically disappearing between 2008 and 2013.
The reasons for this influx of cash can be found in current monetary policy. The environment of extremely low interest rates allows competitive financing (even though the loan-to-value ratios are significantly lower than in 2007) and encourages beneficiaries to increase their real estate investment to capture current returns that are much higher than bond yields. As an example, Prequin calculates that European real estate funds raised capital of €60bn in 2015, twice as much as in 2012.
These conditions are clearly impacting real estate yields, which have been on a decidedly downward trend for many years, but which, obviously, are following the trend for long-term bond yields. As a result, returns on prime4 buildings in core markets are 4% at end-2015 (versus 5% in 2010), while for peripheral countries they are 4.9% (versus 6.25% in 2010). They have fallen by 40 bp in one year, representing a price increase of nearly 10%, all other things being equal.
It is not certain that price increases will have stopped in 2015, in fact, quite the opposite. The risk premium is approximately 300 bp in favour of real estate. Such a level has never been seen before, suggesting that there is still some room for returns to drop in 2016, possibly even below 3% for office space in Paris (3.25% at end-2015). Furthermore, in countries undergoing recoveries (Spain, Italy, the Netherlands, etc.), the reduction in returns could be even more substantial if they return to the mean.
In contrast, after 2016, nothing is certain. This is really the trap to be avoided in such a situation: if long-term interest rates rise due to renewed economic growth, the negative impact to real estate values may be significant, especially if there are no robust increases in rent to offset the decline in value with an increase in revenue. It is more important than ever not to base real estate strategies entirely on price increases, but to ensure that properties have the capacity to generate lasting or increasing revenue. This principle is worth repeating, as well as the IPD/MSI assessment in 2004-2014: more than three quarters of real estate performance in France comes from rental income, with the rest being return on capital.
1 France, Germany, the Netherlands, Austria and Belgium
2 Portugal, Italy, Spain, Greece, Finland, Ireland
Residential real estate has played a fundamental role in the recent crises in several eurozone countries, first by fuelling unsustainable economic growth and then by triggering or exacerbating he recessions that followed. However, the importance of the role it played and its contagion channels to the rest of the economy varied significantly from one Member State to the next.
Global Views Analyst
Strategy and Economic Research Department at Amundi Japan