European Commercial Real Estate - Investment Market Update, July 2010

21 Jul, 2010, London

Sovereign Debt Worries Impact – But Performance Has Still Turned Positive

Trading volumes hit €25.2bn in Q2, 19% up on the first quarter.
Core markets again dominated – with France, Germany and the UK accounting for 64% of all trading – but buying demand has spread to new areas, notabl Norway and Sweden in Q2.
Central & Eastern markets have also come back into favour, with volumes rising 61% vs a 16% increase in the West, led by Poland, Russia and Turkey in particular.
Overseas buyers increased their activity by 26% on the quarter versus a 15% increase in domestic investment, taking their market share to 38% versus 35% in 2009.
Retail slipped back from its market leading levels of Q1, with 30% of trading in Q2 versus 43% for offices. Industrial moved up from 7% to 13% over the quarter.
Prime retail remains strongly in demand from a growing range of buyers nonetheless and activity will increase further as yield compression brings more stock on to the market.
Prime capital values rose 3.7% on the year, the first annual increase since Q2 2008. Their quarterly increase of 1.8% was the highest since Q2 2007.
Prime yields averaged 7.1%, a fall of 12bp on the quarter, on a par with Q1, taking the fall since the market trough to 37bp.
Occupational markets stabilised significantly, with rents falling just 1.9% on the year and actually increasing on the quarter (0.4% pa) for the first time since Q3 2008.
Peak to trough capital values fell by 22% while rental levels fell 9.4%.
Attractive pricing versus historic averages and other asset classes is expected to keep investment demand ahead of supply for prime product.
Interest in non-prime product will steadily improve but following the sovereign debt crisis, investors will remain wary of increasing their risk tolerance too quickly.
A modest improvement in supply should support investment activity, with volumes expected to increase 20-25% in the second half, to hit €105bn for the year overall.

On paper the last quarter saw a further improvement in the European real estate market, with dealing volumes rising 19%, yield compression continuing, capital value growth accelerating, better sentiment spreading away from just core countries and occupier markets stabilising – with prime rents registering their first quarterly increase since Q3 2008. However, while the period started well, the market hit a bump mid-quarter as the sovereign debt crisis caused greater uncertainty and a fall in risk appetites. This led to a stabilisation in property yields and sentiment. At the same time, the still restricted supply of affordable bank debt was also not supportive of a deeper recovery in demand.

Nonetheless, according to Michael Rhydderch, Head of the Cross Border Team of the EMEA Capital Markets Group at Cushman & Wakefield, “While the second quarter has blown hot and cold, we are somewhat more optimistic about the outlook for the second half of the year given that supply should improve and the attractions of property investment, if anything, are now greater than they were thanks to the fall in bond yields.”

“The largest and most active part of the market is still made up of low risk investors focussed on core product in large, liquid markets, but there have been indications recently that more investors are willing to look towards value-add areas, at least in the most competitive and demanded markets, the UK and France. However this is set against the background of an increasingly diverse marketplace, with rental growth, tenant and investor demand and yield trends all varying by city and by property quality. In particular, investors are keenly aware of the risk of smaller, more peripheral and less liquid markets following the fall-out in Greece.”

“Recent events may lead to stronger property investment demand from risk-averse buyers seeking relatively secure incomes” added Rhydderch, “and there are also signs of increasing availability, aided by the recent market hiccup, reminding some potential vendors that a strong ongoing recovery in pricing is not guaranteed. A pick-up in foreclosures is also slowly starting to feed stock to the market and while banks generally are still under little pressure to force sales, stress tests and increasing reserve requirements may bring more banks in to the market after the summer.”

“Yields are likely to take a little longer to compress than we had expected” concluded Rhydderch. “but the very best assets and markets will see strong demand still driving yields down – particularly if bond yields remain as low as they are today. For the average market however, the over-dependence on equity rather than debt should lead to a more demanding view on the price of risk.”

David Hutchings, Head of European Research at Cushman & Wakefield, added “All in all, while investor trends have been weaker than hoped, occupier markets are performing better than most expected, with offices showing the best signs of recovery to date. Office and industrial property may also benefit from an improving level of corporate demand later this year but they will still be more driven by supply shortages as Grade A availability reduces. Quality retail will remain in demand from risk-averse investors but consumer markets are likely to be subdued in the short term as public sector cut-backs are introduced. Nonetheless, lower inflation, low interest rates and improving private sector job prospects will help to offset this.”

Concluding, Hutchings said “We look to be about to lose some momentum in the economic recovery and public sector consolidation will certainly subdue growth in 2011 – possibly threatening a renewed downturn in some areas. These cutbacks will also bring opportunities however, most obviously from the sale of public sector assets. It’s also worth noting that other than in very strongly public–sector driven cities, performance in most prime property markets is more a factor of private than public sector growth and hence not only will public sector cutbacks have less impact than might be expected, the cuts may in fact stimulate demand in some cases, reducing competition for staff and other resources for example and reversing the “crowding out” of private sector investment often seen when public sector spending is running at too high a level.”

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