An early holiday for European commercial property markets?

6 Aug, 2008, Amsterdam

• Trading volumes fall to €25.6bn in quarter two, their lowest since 2003
• Prime yields on average increase 16bp to stand at 6.5%, their highest for two years
• Western yields average 5.9%, up 53bp since last June, equivalent to a capital fall of 9%
• Out-performance of Eastern markets continues – but at a slower pace
• Occupier markets remain firm but rental growth is easing
• An upturn in investment turnover is likely by the year end

The correction in the European commercial property investment market gathered pace in the second quarter, with yields increasing to their highest since 2006 and investment volumes down 63% on the same period in 2007, according to new research by Cushman & Wakefield.

“The market took an early holiday” said Michael Rhydderch, head of the European cross border capital market group at Cushman & Wakefield. “Deal volumes have slowed not so much because of a shortage of demand or supply but because of the sheer uncertainty over financing and hence pricing. This continues to hit larger deals and portfolio sales more than other segments of the market. However, demand is still healthy for prime product and there are more buyers who now see good value emerging in the market.”

The west has seen a fall of over 50% in trading this year versus the quarterly average for 2007 but eastern markets are up slightly due to growth in Russia and Bulgaria. The larger markets are clearly suffering, with the UK down 60%, Germany 55% and France 51%, but the worst declines have been in smaller markets such as Greece, Ireland, Hungary, Austria and Luxembourg. Belgium and the Netherlands have held up well while falls in the Nordics (-41%) and Southern Europe (-43%) have been less than the average. For the Nordics this is due to the resilience of Denmark and Finland, while in the south, Spain is holding up the average, with deal volumes down less than 10% on last year. Arguably the re-pricing under way in Spain (behind only the UK and Norway in its severity) and the more immediate signs of distress are opening up opportunities at a faster rate.

On average, European prime yields rose 17bp in the second quarter, taking their increase since last June to 39bp Yields in the west are up 53bp, compared to a 20bp increase for central Europe and a 57bp fall for eastern markets. Industrial and office yields are out around 50bp compared to a 25bp rise for shop units.

“With yields up in most areas, it’s clear we’re heading into a market with much more rational pricing” said Rhydderch. “The issue is, some buyers don’t know how to handle their new found power and the choice available to them while many vendors are still not in sufficient discomfort to accept the new pricing on offer.”

International buyers remain the more cautious, with cross-border investment falling 55% this year versus a 44% fall in domestic spending. “This may not continue given the weight of international capital waiting on the sidelines”, said Rhydderch. “The picture is mixed at present, with demand coming from local as well as international players in most markets. By far the most active players overall are the German open ended funds. The sovereign wealth funds are also still there in some number, but are proving selective about the opportunities they will pursue. In nearly all cases prime property is the order of the day.”

At the same time, new funds continue to emerge. However, that does not mean they are ready to invest according to Rhydderch. "We are seeing more new fund announcements but few have actually closed. The majority who have successfully raised money are targeting the opportunistic spectrum of the market. Most believe that pricing is still adjusting and more distress will be seen in the months ahead and are therefore focusing on investment towards the end of the year or in 2009. There is no strong geographical focus as to where they are looking – with the position of the vendor a stronger determinant of what makes a good opportunity. Activity is therefore focusing on those situations where vendors have a time-defined need to sell. "

“Prime yields may look increasingly attractive but investors must factor in a weaker rental growth outlook” said David Hutchings, head of European research at Cushman & Wakefield.

“We are forecasting prime rental growth of 3-4% in 2008 but just 1-2% next. At the beginning of the year, growth of around 4% pa had been expected for 2009. Nonetheless, with inflation expected to peak in most markets in the third quarter and, at least in the west, this opening the way for a fall in interest rates, yields for prime space should start to stabilise in the final quarter, probably some 25-35bp higher than reported figures as at the end of June. This however is not too far from where off-market deals are already taking place and it is secondary stock which is most vulnerable to a more sustained increase – particularly as occupier markets weaken.”

"Whilst no one can know for sure of course, we do anticipate an improvement in market conditions towards the end of the year despite the risks facing the occupational market and the limited appetite of the finance markets” added Hutchings. “Initially, this change in market conditions will be driven by distress, however, and will be manifest in an improvement in market activity rather than performance."

“With interest rates now more stable, the risks going forward are spreading from finance to the economy but this may actually be the catalyst the market needs to generate more acceptance of pricing and more willing vendors. To a degree therefore, this will be a healthy sign of a correcting market” concluded Rhydderch. “More well-priced opportunities should therefore emerge after the summer and as a result, while the current quarter will be weak, the final quarter could produce better results and we anticipate trading for the year to total €150-155bn. Indeed, those investors waiting until the year end before re-entering the market may well find a more competitive landscape than they had anticipated.”

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