European investment: signs of stability in a mis-matched market

- European trading volumes stabilised at €11.97bn in the second quarter, 2.5% up on q1

- Volumes for the first half of the year, at €23.6bn, were 66% down on the same period of 2008

- Prime yields rose just 7bp on the quarter, the smallest quarterly increase since late 2007

- Occupier markets remain highly negative, with rents down in 26 of the 32 countries examined

- However, the rate of rental decline has eased somewhat, with prime values registering a 1.9% fall on the quarter - half the loss seen in the opening 3 months of the year

- Increasing investor demand is not being met by increasing supply – at least of the right space

- Nonetheless, market momentum is building and an increase in activity in H2 is expected

Investment Activity

Investment volumes in the second quarter rose 2.5% on the first 3 months of the year, driven by increased activity by foreign buyers (up nearly 16%), in core Western markets.  At €11.97bn, volumes were nonetheless just 41% of the average for 2008 and, more sobering still, only 19% of the average for the market’s peak year in 2007.  This stirring in activity has however been accompanied by a more stable picture for yields, with the all-sector average for Europe rising just 7bp compared to 28bp in the opening quarter.

“The numbers on the market make for better reading than they did earlier this year”, commented Michael Rhydderch head of the European Cross Border Capital Market Group at Cushman & Wakefield. “Although there remains a fundamental mismatch between what many buyers want and what is available for them to buy, the allure of historically high income yields is tempting increasing numbers back into the market”.

Average prime yields across Europe now stand at 7.52%, with Western yields (excluding the UK) averaging 6.65% versus 6.97% in the UK, 8.63% in Central Europe and 12.86% in Eastern markets.  The yield differential between west and east therefore stands at 621 bp versus 423bp one year ago.  Despite the opening of this yield differential,  investor activity in Eastern markets remains very subdued.  Across the sectors, investors are still very much focussed on core Western markets with demand most evident in markets such as the UK which have seen the most extensive pricing corrections.  This is not a universal trend however and is not yet evident in Spain and many of the Nordic markets for example, where, despite a greater than average shift in yields, increased interest over recent months has yet to translate into deals, as investors await evidence that pricing is set to stabilise.

“Demand is broader now than at the beginning of the year. A number of markets relied almost exclusively on domestic investors earlier this year but this past quarter has seen growing international demand from institutions and private investors” commented Rhydderch. “More of the German open-ended funds have now re-opened and are buying again and some opportunity funds are also now ready to step into the market after sitting on the sidelines for much of the past 2 years.”

“Equity players remain in the ascendancy and, although debt markets are slowly opening again, finance is still expensive and availability reduced.  This is particularly affecting larger lot sizes, with yield premiums for property over €100mn likely to remain for some time.” continued Rhydderch.

Offices have been the chief beneficiary of increasing activity to date, with volumes up 30% on the opening quarter compared to a stable performance from retail and a 26% decline for industrial.  Foreign buyers meanwhile took a 32.5% share of activity, down on the 43% seen in 2008 but up on the opening quarter (28.7%).

Performance Trends

Across Europe, prime yields rose just 7bp in the second quarter, the smallest increase since the final quarter of 2007.  All sectors enjoyed a greater degree of stability, but retail more than most, with just a 4bp increase. This reflects greater faith in the low risk nature of retail, which is leading many owners to be reluctant to sell.  Offices meanwhile saw a 7bp increase, while the industrial sector was hit by a more significant shift of 15 bp.  Since the onset of the Credit Crunch, this takes the all-sector prime yield shift to 146bp, led by industrial (180bp), offices (168bp) and then retail (106bp).

The average yield increase across Europe was held down by falls in some markets, notably the UK (in all sectors) and Norway (offices), but a number of other markets saw yields stabilising, ranging across emerging markets such as Russia and Turkey, to more mature markets such as Sweden and Germany.  Those markets which saw the most marked outward shift were largely to the East however, including Bulgaria, the Baltics and the Ukraine (see figure 5) but while Central & Eastern Europe saw a  more marked increase overall than the West (17bp vs 6bp), this was still a significant improvement on the average 100bp increase seen in each of the previous 2 quarters.   

In the occupational market, rising supply and weak demand continued to hit rental values, with an overall decline of 6.9% on June last year. Most markets and sectors did however at least see the pace of decline ease from earlier in the year, with rents falling 1.9% on the quarter compared to 3.8% in Q1. Office rents continue to lead the way down, with a 10.9% annualised fall on the quarter versus 5.6% for retail and 4.4% for industrial.

With rents declining at such a rate, the impact of a slower yield increase was lost on capital values, which fell 19.4% on the year, up from -18.3% in the year to March.  Again however the quarterly pattern was improved, with values falling 2.9% as against a 7.4% drop in q1 , the smallest quarterly decline for a year.

The Outlook

“With banks seemingly ready to slowly manage down their exposure rather than dump stock at any price, those awaiting a rash of “fire sales” may continue to be disappointed” suggested David Hutchings, Head of European Research at Cushman & Wakefield.  However, together with the broad rise in demand, a slow increase in supply as investors and banks unwind their positions should lead to more activity in the second half of the year, with a current C&W estimate for total trading this year of €65bn.  “Office property will remain dominant but given the risk aversion of many investors, an increase in retail activity may be seen if stock can be found.  Industrial activity has been subdued meanwhile, but the pessimism of some investors may be over-done given the yields on offer and the potential for occupier demand to benefit from an economic recovery driven by trade as well as pressure on businesses to ensure they have a state of the art logistics platform.”

Commenting on the balance of the market,  Rhydderch said “There are undoubtedly some great opportunities to buy quality property for the long term and there are too few of these available for the number of investors looking, while much of the stock available is still at too low a yield to compensate buyers for the risks they perceive.  At the same time, some poorer quality property is still largely un-saleable and it could be some considerable time before that changes.”

Hutchings agreed. “There has been an understandable expectation that yields would over-shoot fair value but this isn’t happening.  Available quality supply has remained relatively limited and, alongside lower interest rates, many investors (and their banks) are happy to hold quality real estate at current yields.  For higher quality assets this is understandable in light of the alternatives on offer, but for much of the rest of the market, the weakness of the letting market, the lack of debt for larger and less secure assets and the difficulty facing those needing to refinance, should signal a further rise in yields.  Hence, while the correction in pricing is clearly well-advanced and has stabilised in recent months, in our opinion it still has further to run.”

Capital values are now down 21% in Europe, with the UK down 40% and the rest of Western Europe down 16%. “In our view, prime UK values do not have much further to fall”, continued Hutchings, “but other markets may face a further 10-15% drop depending on the degree to which rents need to correct.  Investors should not only focus on rental values however – with income and income security of more importance than the theoretical re-letting value. In that regard, occupancy levels are critical while the terms being agreed by landlords, such as shorter leases or increased break clauses, may also impact on values going forward.”

“Courtesy of its deeper re-pricing and potentially earlier economic recovery, the UK continues to offer some of the best opportunities in Europe” concluded  Rhydderch. “However with yields now starting to adjust and increasing competition for a limited supply of quality stock, other markets are quickly gaining more attention, with France in favour for the risk-averse and Poland for the more return-hungry.  We also believe the Nordics are likely to see increased activity in light of their stable markets, forecast economic recovery and improved pricing.”