In a period of low interest rates for European investors, commercial property offers relatively high yields, defensive attributes and security of income, with retail in particular looking bullish for the future
Over the past few years, a low inflation, and low interest rate environment has caused investors to engage in a frantic quest for yield. This has had an impact across the asset spectrum - not least in the UK and European commercial property markets.
Investors are buying vast amounts of property assets because they offer relatively high yields. Considering that the current dividend yields on the FTSE All-Share and FTSE Europe are approximately 3% and 2.5% respectively, the rationale underpinning this trend seems reasonable.
So what are the implications on the outlook for UK and European commercial property? To determine this, it is worth looking at the recent developments that have shaped these markets.
property builds in 2005
After a couple of years in the shadows, 2005 was the year in which equity markets recaptured the limelight from commercial property as an asset class. Increased merger and acquisition (M&A) activity, and robust corporate profits on the back of strengthening global economic growth, boosted share prices across the globe.
Nonetheless, 2005 was yet another successful year for property. In the UK, for example, deals were up by some 20% in comparison to 2004 and total returns of 19.1% confounded expectations for the third consecutive year.
Returns so far this year have been equally strong. For the first quarter, UK commercial property produced a total return of 4.5%, outstripping the 2.7% return recorded in the same period last year. In truth, last year's slower start was primarily due to the abolition of stamp duty exemption in disadvantaged areas. However, momentum from last year's exceptionally strong final quarter has certainly carried into 2006. That said, it is worth sounding a note of caution. Both the number and value of property deals so far this year have fallen well short of last year's record levels.
The supply pipeline of new office space remains limited. This should support rents and the office sector now seems poised to deliver meaningful rental growth over the next two to three years. Meanwhile, the retail sector has continued to benefit from a continued strong showing in the out-of-town retail warehouse segment. The industrial sector was the weakest in 2005 and the outlook for the sector - dependent as much on retail distribution as on traditional manufacturing - remains uninspiring.
Turning to the broader European market, cross-border flows have been the predominant theme. In particular, a mix of strong returns, greater transparency and the harmonisation of reporting regimes ensured total transaction volumes of direct European commercial real estate hit a record 156.3bn (£99.2m) in 2005.
Transaction volumes rose over 60% in Sweden and 22% in Germany, of which cross-border flows accounted for the lion's share. Cross-border flows made up 59% of the total European investments in 2005 and 27% were funded by investors outside of Europe.
In the office sector, occupier demand has been strong - particularly in Paris, Prague, Dublin and, to a certain extent, Luxembourg. In the retail sector, strong demand for prime locations - Paris, Madrid and Barcelona among others - continues to drive low vacancy rates. High levels of M&A activity are benefiting the industrial sector, which has also led to demand for warehousing units, and bespoke facilities.
Looking ahead, the overall picture is one of continued growth both in the UK and in Europe, although not at the rapid levels of recent years. In the UK, total returns are expected to be around 14% in 2006. After strong performance in each of the last three years, the retail sector is now poised to deliver more muted levels of growth over the medium term. This is due not only to the well-known slowdown in consumer spending but also to the fact that total employment and household disposable incomes are set to slow as increasing taxes and a slowing economy take effect. In turn this will have an effect on void rates, which are already at historically high levels as demand from retailers for retail space continues to slow.
Investors should be bullish over the prospects for the office sector, much of which is influenced by the fortunes of the stock market. Accordingly, the sector has experienced a resurgence - particularly financial and business services - in tandem with the UK equity market recovery. Rental growth should be the most pronounced in the central London office market over a five-year time horizon, with mid-town (the area between the City and the West End) the strongest over the near term. Meanwhile, it is likely rental growth outside London will be more modest.
The outlook for the industrial sector is rather dull, with the manufacturing economy - one of the key drivers of the sector - continuing to be caught in the cross-fire between intense global competition and high input costs. As a result, industrial market rents are likely to lag in comparison to the wider UK commercial property market.
Overall, investors should look for the improving fortunes of the office sector to offset a gradual decline in the retail and industrial names. However, it is worth noting that continued high returns in the UK over the short term are unsustainable and in the long term it would be preferable the UK market corrects itself or at least moves back to its traditional place between equities and bonds. If there is no evidence of this, there would be concern that the property market would be out of line with long-term trends, increasing the likelihood of a more extreme correction in the future.
However, although it is expected parts of the European real estate market will slow along with the UK market, certain areas may continue to grow rapidly. Of particular interest is Germany, where the market is characterised by investor interest from the US, Middle East, and Australia. Underscoring this interest is the anticipation that the European powerhouse is on a path back to normality following years of economic stagnation. Also, as German corporate sentiment improves, investors may have a particular bias towards the office sector in certain areas.
In truth, however, market conditions not just in Germany but across Europe continue to lay a strong foundation for strong office performance in the coming years. In addition, along with the economic recovery in Europe in the short to medium term, net demand for office space is expected to rise slightly.
The strongest levels of demand are forecast in Moscow, Paris, Brussels, Munich and Hamburg and a positive impact will be shown on vacancy rates in all the German cities. However, the growing number of developers adding new buildings to the market in central and eastern Europe, may push up vacancy rates in Warsaw and Moscow.
Other investment opportunities include the Nordic region. Capitalising on the emerging relationship between Russia and the former Soviet Union countries, the region is rapidly growing as an important logistics hub and in turn should benefit the industrial sector significantly. In terms of industrial rental growth, the fastest in central Europe, Spain, the Nordic markets and France, where rate growth has been seen, occupier demand rose strongly at the end of 2005. However, it is unlikely there will be any meaningful rental growth in Germany, Ireland, Netherlands, Italy and Belgium.
Turning to the retail sector, investor demand remains very strong for all formats of European retail real estate, and significant inward yield shift over the past year continues to drive capital value growth. However, it is likely prime rental growth for both unit shops and shopping centres will continue to outstrip the rate of inflation.
The central European shopping centre market will continue to see the lowest performance, as new supply dampens rental growth over the medium term. The best rental growth is forecast in Dublin, Scandinavia (Sweden, Denmark and Finland) and southern Europe (Greece, Portugal, Spain and France) where consumer growth forecasts are most buoyant.
Piecing everything together, a backdrop of continued investor interest and around trend levels of economic growth should support both UK and European property markets during the coming years. In the UK, a gentle slowdown is widely anticipated and is much needed. But regardless of location, property's defensive attributes, relatively high yield and security of income are, and will continue to be, prized by investors.
Bullish on European office sector
Bearish on European industrials
European growth not as strong as previous years
Paul Bruns and Elaine Parkes
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