Europe’s recovery means income growth, not prices, is likely to drive property performance in the next few years – which means attention to fundamentals is important, says Matt Hall of Invesco Real Estate.
A synchronised global upswing in economic growth is providing further momentum for the European recovery. Gross domestic product forecasts continue to be revised upwards and unemployment is falling, which generates positive sentiment for businesses and consumers and points to increased spending.
This, in turn, should boost occupier demand for real estate across most sectors. Furthermore, with signs that inflation is picking up, this will provide a boost to the income earned from real estate through indexation of leases.
Better economic conditions also point to the start of a slow normalisation of interest rates. We believe that 2017 will prove to have been a turning point with, for example, the US Federal Reserve raising rates twice last year, and the European Central Bank signalling a reduction in bond purchases.
Although we do not see this as creating a challenge for the pricing of European real estate in the short term, given the competitive pricing of core assets, there is a need to ensure asset-level fundamentals are able to deliver income growth over the hold period.
Overall, we expect prime yields to be broadly stable over the next three years. Demand for European real estate remains robust, with total investment volumes in 2017 estimated to be up 13% on 2016 levels. Sources of capital remain diverse, with about 30% of investment from non-European sources, in particular US, China and Hong Kong. Domestic institutions were slightly less active, but remained net purchasers in 2017.
We expect the diversity of capital sources to remain a feature of the European real estate market in 2018. According to Preqin, unlisted vehicles raised slightly less capital in 2017 than they did in 2016, but the slowdown was modest, suggesting that unlisted funds will continue to be active in 2018.
Furthermore, the latest investor intentions survey from trade body Inrev indicated that institutions are intending to allocate more capital to real estate in the current year. The latest capital-raising survey demonstrated an increase of circa 25% raised for non-listed real estate globally. Europe remained the top target for capital during 2017 with €67.2 billion or 44% of the total, a growth of about 19% on the previous year.
If, over the next few years, we believe real estate performance is likely to be driven by the ability to achieve income growth, it is important to consider lease structures and opportunities to deliver market-led rental growth at an asset level, and also to seek sub-market and asset opportunities that should outperform the general market through active asset management.
The combination of an expected cycle duration of at least three years and the low yields investors now have to pay to acquire prime assets is leading investors to favour value-add strategies, with a particular focus on ‘manage to core’. Creating core assets in good locations should, in our view, deliver attractive returns and provide much-needed quality stock given the modest levels of development in many markets.
In general, we favour this type of strategy, and taking some development risk, but competition for suitable assets is likely to result in aggressive pricing, so risks should be carefully assessed.
Identifying the best opportunities will require a good understanding of key asset characteristics and greater granularity in understanding sub-market characteristics.
Logistics overtakes retail
We believe that structural changes in retailing and a general evolution of supply chains will favour rental growth in the logistics sector. This is a significant change to outcomes in previous cycles where retail was a key beneficiary of rising consumer incomes. There are a number of factors driving outlook for logistics rents:
• Ongoing strong demand from retailers from both the pure online sector and traditional bricks-and-mortar retailers who are investing heavily in their online capabilities;
• Retailers are willing to sign longer leases - often in excess of ten years - than third-party logistics operators, and are therefore focused on acquiring locations of long-term strategic importance to their business; and
• Demand from retailers is focused on ‘irreplaceable’ locations around major urban areas and on key transport nodes. Rental growth is expected to be strongest in these locations.
Due to the rise of e-commerce, physical retail real estate is likely to lag during this cycle, especially in smaller, mass-market retail segments vulnerable to store closures as retailers continue to rationalise their store portfolios.
As retailers adapt to the new business environment, they have become increasingly cautious about expanding their store networks. Many are closing or disposing of their non-performing stores, while also optimising the productivity of existing outlets. Some retailers are looking to transfer some risk to landlords – for example, with shorter lease terms or turnover rents. These are global trends that are resulting in increasing polarisation in the retail sector.
Offices: Is co-working working?
In the office sector, the positive economic environment should support steady rental growth in the near term. However, the sector faces headwinds as Europe’s working-age population starts to decline and the service sector faces disruption from increased automation. Therefore, office-based employment growth, which has been a key driver of demand in previous cyclical upswings, is forecast to be more modest in this cycle.
We are also seeing changes in the way people and companies work together. The co-working phenomenon has spread from freelancers, contractors and entrepreneurs, particularly in the tech sector, to the mainstream, with corporate occupiers either taking advantage of co-working facilities for their staff, or even looking to introduce working environments in their own offices that create synergies and build communities. While investors are not yet fully convinced of the long-term viability of the co-working model, the occupier market is signalling that the growing start-up segment of the economy is being joined by more established occupiers who are attracted by improved employee satisfaction and flexibility.
For real estate owners, this suggests that office assets should be flexible enough to provide occupiers with a wider range of working environments and amenities for their staff to ensure that they can recruit and retain the best talent.
Increasingly, property managers may find themselves moving to a more operational model of building leasing and management.
Current asset pricing is at historic highs across Europe, and are expected to remain that way for the foreseeable future. Investors seeking performance from the real estate sector will have to drive income growth to deliver excess performance throughout the current cycle. Fortunately, economic growth is becoming more firmly entrenched throughout Europe, providing targeted opportunities for NOI growth. Furthermore, we are entering a period of secular change in terms of long term drivers of our economies. Demographic shifts, consumer preferences and business strategies are all expected to undergo significant change in the coming years, maintaining a finger on the pulse of these changes remains essential for driving long-term real estate performance.
Matt Hall is a director of European research at Invesco Real Estate
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