June 2015
For professional investors and advisers only. This document is not suitable for retail clients.
Schroder Real Estate
Investment Management
European Real Estate:
Into the Upturn
Mark Callender,
Head of Real
Estate Research
The eurozone economy has finally turned the corner following a protracted
recession which began with the global financial crisis, but was then exacerbated
by the sovereign debt crisis in southern Europe. Last year saw eurozone GDP
rise by 0.9% and the consensus is that growth will accelerate to 1.5% this year
and 1.8% in 2016. Focusing on the major economies, Germany and Spain are
forecast to lead with growth of 1.75–2.5% per annum, France is expected to
track the eurozone average and Italy is likely to lag behind with growth of 0.9% per annum.
Figure 1: Eurozone bank lending
and economic growth
Figure 2: Forecast economic growth
2014–2019
6
16
Ireland
14
4
12
Germany
10
2
8
6
0
4
-2
0
-4
-4
‘00
‘02
‘04
M1 real terms y/y%
‘06
‘08
‘10
‘12
‘14
-6
‘16
Netherlands
Portugal
Italy
0.0
0.5
1.0
1.5
GDP (%YOY)(EA19)(WDA)(ESA2010):
Euro Zone (RH Scale)
Source: Thomson Datastream, Schroders, February 2015.
Tony Smedley,
Head of Continental
European Investment
for Real Estate
Austria
Finland
-2
-6
‘98
Belgium
France
2
Oliver Kummerfeldt,
European Real
Estate Analyst
Spain
2.0
2.5
3.0
% p.a
Source: Oxford Economics, March 2015.
In the short term, the main driver is expected to be consumer spending, reflecting the
boost to households’ real incomes from the collapse in oil prices and a modest increase in
employment. Consumer confidence in the eurozone has re-bounded to its highest level since
2007 and retail sales grew at an annual rate of 2.3% in the first quarter of 2015. In addition,
the ECB’s decision in January to start a € 1.1 trillion programme of quantitative easing has
prompted a sharp depreciation in the euro against the dollar which has helped export-led
economies such as Germany.
Schroder Real Estate Investment Management European Real Estate: Into the Upturn
2
Of course, the eurozone still faces challenges. Greece could leave the euro in the next
couple of months and any escalation of the conflict in eastern Ukraine is likely to hit business
and consumer confidence. There is also a small possibility that deflation in the eurozone
could become entrenched, if businesses and consumers start to defer purchases in the
belief that future prices will be lower. However, while there are clear downside risks, the
eurozone economy is significantly stronger now than it was 2–3 years ago. The majority of
governments have completed their austerity programmes and the average budget deficit
in the eurozone is forecast to be 2.5% this year, compared with a peak of 6% in 2011
(source HSBC). The ECB has also established the European Stability Mechanism to protect
governments against future liquidity crises in bond markets. Moreover, the major banks
have been re-capitalised and are now starting to lend again, which bodes well for shortterm growth (see Figure 1 above). Finally, Spain and to a lesser extent France and Italy have
enacted a number of supply side reforms which should boost their competitiveness over
the medium-term.
The outlook for the eurozone economy is therefore for steady, if unspectacular growth.
The key question for real estate investors is whether now is a good time to enter the market?
One way of tackling the question is to analyse the historical returns which were achieved
by investors who bought real estate at the start of previous upturns in the economy. The
left hand chart below shows the amount of spare capacity in the eurozone economy, as
measured by the output gap (source OECD). In economic theory, the output gap is the
estimated difference between total demand in the economy (GDP) and its productive
potential, given the size and flexibility of the labour force, the stock of capital equipment
and IT, education, etc. When the eurozone economy is just emerging from recession, as
at present, then the output gap is negative. This reflects the high level of unemployment
in several countries and the fact that many companies are still operating with a significant
amount of spare capacity. By contrast, when the eurozone economy is operating at full
capacity (e.g. the late 1980s, mid-2000s) then the output gap will exceed 2%.
Figure 3: Eurozone output gap
GDP, 1985=100
180
Output gap %
5
170
4
160
3
150
2
140
1
130
0
120
-1
110
-2
100
-3
90
-4
80
'85 '86 '87 '88 '89 '90 '91 '92 '93 '94 '95 '96 '97 '98 '99 '00 '01 '02 '03 '04 '05 '06 '07 '08 '09 '10 '11 '12 '13 '14
Output gap
GDP
Potential GDP
Source: OECD, Schroders, May 2015.
Note. Figures for the eurozone before 1991 are estimates based on France, West Germany, Italy and Spain
-5
Schroder Real Estate Investment Management European Real Estate: Into the Upturn
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Figure 4: Continental European real estate total returns in real terms
and the output gap
'85–'90
'86–'91
'96–'01
'97–'02
'02–'07
'95–'00
'98–'03
'87–'92
'03–'08
'01–'06
'99–'04
'00–'05
'94–'99
'04–'09
'88–'93
'05–'10
'93–'98
'09–'14
'89–'94
'92–'97
'06–'11
'91–'96
'90–'95
'08–'13
'07–'12
-5.0
-2.5
0.0
2.5
Eurozone output gap:
5.0
<0
0–2%
7.5
10.0
12.5
>2%
Source: Oxford Economics, May 2015.
The above chart shows total returns on continental European real estate over five year rolling
periods in real terms, adjusted for inflation. The five year periods have been ranked from
strongest (1985–1990) to weakest (2007–2012) and divided into roughly three equal groups:
investment periods when at the start, the economy was operating at full capacity and the
output gap was above 2; investment periods when initially the economy was broadly in
equilibrium and the output gap was between 0 and 2 and third, investment periods when at the
beginning, there was a lot of spare capacity in the economy and the output gap was negative.
The historical evidence strongly suggests that investing in continental European real estate
when the economy is emerging from recession has been a successful strategy. Four of the
five best performing investment periods were ones which started when there was significant
slack in the economy (1985, 1986, 1996, 1997) and on all occasions investors who bought
real estate when there was a negative output gap saw positive real total returns over the
following five years of at least 3% per annum. Conversely, it is clear with the benefit of
hindsight that buying when the economy is running at full tilt has generally turned out to be
a poor strategy. Four of the five worst performing periods were ones which began when the
output gap was above 2% (1990, 2006, 2007, 2008). The only occasions when investing
in real estate when the output gap was above 2% delivered respectable real returns were
2000 and 2001.
Part of the rationale for buying real estate when the economy is emerging from recession
is that generally rents have stabilised and are relatively affordable for occupiers. In addition,
in many locations capital values are too low to make new development viable, so there
is little risk of a building boom. If the economy then continues to grow over the following
few years, the overhang of vacant space left by the previous recession declines, demand
and supply get back to equilibrium and rents start to rise. Furthermore, the prospect of
a recovery in rents typically attracts more investors into real estate and the increase in
competition among them leads to a favourable fall in yields which gives a further boost to
capital values and total returns.
There is of course no guarantee that history will repeat itself and that investing now in
continental European real estate will deliver similar returns to those enjoyed by investors
who bought in the mid-1980s and mid-1990s. We expect that this cycle to differ slightly
from previous upswings in two respects. First, a lot of the favourable decline in yields
which normally occurs just before rents take off appears to have already happened. Low
government bond yields have encouraged investors to switch into other assets including
real estate and we have seen a significant fall in yields across western Europe over the last
two years. At the moment yields on average investment grade offices in continental Europe
typically range between 4.5–6.5%.
Schroder Real Estate Investment Management European Real Estate: Into the Upturn
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Although not an immediate risk, there is clearly a possibility that a future rise in eurozone
government bond yields could have a knock on effect on real estate yields. Over the last 15
years eurozone real estate yields have averaged 1.5–2.0% above government bond yields,
so in theory real estate yields ought to be immune to a rise in bond yields, if the gap were
3%, or higher. However, a lot would depend on the factors pushing bond yields higher. If the
increase was mainly due to an improvement in the outlook for the eurozone economy, then
real estate yields would probably be unaffected, because investors would simultaneously
upgrade their expectations for future rental growth. If, however, the increase in bond yields
was due to an inflationary shock, without an attendant improvement in the economy, then
real estate yields would probably rise.
Second, we think this cycle will be slightly different, because we anticipate that there will be
less new building than in previous upswings. In part, this is because we think that eurozone
banks will continue to ration development finance. Although they are now lending more to
individuals and companies, new regulations mean that banks have to hold a lot more capital
in reserve for developments than they did before the financial crisis and that is likely to inhibit
lending to property developers. In addition, another by-product of the ECB’s low interest rate
policy is that house prices have risen sharply in many cities over the last few years and the
higher value of residential projects is encouraging developers to convert obsolete offices into
apartments and discouraging them from pursuing new commercial schemes.
As a result of these constraints on new building and assuming steady economic growth, we
anticipate a broad based upswing in commercial rents across the eurozone over the next few
years. We have already seen an increase in office rents in Berlin, Stuttgart and Munich where
vacancy rates are relatively low and we expect the recovery in office rents to spread to the
other big German cities, Amsterdam, Brussels, Paris and Madrid through 2016–2017. While
in general we are more cautious about retail rents, given the rapid growth of on-line sales
in Europe, we see attractive opportunities in certain dominant shopping centres and retail
parks, in tourist destinations where there is strong demand from retailers for big “flagship”
stores and also in the convenience sector, which should be relatively immune to the internet.
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