Source: CBRE European Valuation Monitor, Schroders. November 2019. Rebased to 100 at Q1 2015 CS2248
Demand driven by key themes, not just economic health
This divergence reflects two trends. First, while demand for commercial space is still sensitive to the economic cycle, it is not the sole driver. Demand is also being shaped by long-term structural forces or themes, such as an ageing population, sustainability, technology and urbanisation. The key change driving a wedge between retail and warehouse capital values is the growth of on-line retail sales at the expense of physical stores.
The split between city centre and out-of-town office parks can be partly explained by the tendency of technology to simultaneously increase the number of high skilled jobs and reduce the number of mid-skilled jobs in call centres and back office administration. In addition, many office parks lack the amenities which employers increasingly need to attract employees, and they are often poorly served by public transport and rely on people commuting by car.
Market demand is highly fragmented
The second feature of European commercial real estate is that, despite the large amount of money - both domestic and global - trying to enter the market, we have not seen a widespread return to the indiscriminate buying of 2005-2007. Retail yields are rising (as prices fall), in contrast with the flat, or falling yields (as prices increase) in other sectors.
Furthermore, there is still a gap of 0.5-1.0% between yields on prime and secondary assets in many parts of the market, though not all. Primary and secondary assets refer to the value or quality of different classes of commercial investment property. Investors remain cautious of debt, which should help to limit distressed sales, if values fall in a weaker economic environment. The average loan to value ratio – the amount of borrowing relative to the property’s financial worth - in European unlisted funds is far lower (25%) than it was in 2008 (40%). Most real estate investment trusts (REITS) have also reduced debt levels.
Which markets do we favour?
We continue to like offices in “winning” cities, those with diverse economies such as Amsterdam, Berlin, Copenhagen, Paris, Munich, Manchester, London and Stockholm. Vacancy rates in many of these cities are at their lowest in 15 years and although development is increasing, it is unlikely to halt the growth in office rents. While city centre, prime office yields look expensive (or low) at 2.75-3.0%, yields in neighbouring areas are higher and we believe that refurbishment projects should deliver attractive returns.
The London office market is complicated. On the plus side, the tech and media sectors continue to expand, office yields are higher than in Paris and Berlin - which is unusual - and new supply is limited. On the downside, Brexit could potentially have a negative impact on office space demand from financial services, and interest rates are higher than in continental Europe. In addition, struggling shared workspace firm WeWork is the second biggest occupier in London after the government. Our strategy is to focus on areas which have a bias towards tech, media and life science occupiers such as Bloomsbury, Shoreditch, the South Bank and Soho and avoid the City and Docklands.
The retail sector is difficult. While the sector overall is re-pricing, the current yield of 7-8% today could quickly disappear as leases expire and retailers fall into insolvency. The real opportunity is to convert redundant retail space into other uses including hotels, offices and residential. That should be viable in locations where there is demand from competing uses. We see good potential to re-develop old stores in city centres and retail parks in affluent parts of southern England. It will be much more difficult to re-purpose secondary shopping centres in towns and cities with weak economies.
Retirement and social supported housing
Outside the main sectors, we are enthusiastic about hotels with management contracts, retirement villages and social housing. We think there is potential demand for around 150,000 units in private retirement communities in the UK, three times the existing stock. This reflects an ageing population, the wealth of many over-65s and the need to reduce loneliness among older people. We also expect demand for social supported housing to grow as the government enables more people with learning disabilities and autism to live in the community. Adults who move into social supported housing generally enjoy a better quality of life and often gain in confidence.
In conclusion, not every part of the European real estate market is late cycle. Developers continue to take a measured approach and there is a generous gap between real estate and bond yields. While retail is struggling and some offices and logistics now look expensive, we believe that offices in certain inner-city locations and regional cities, multi-let industrials, value add projects, retirement villages and social supported housing have the potential to deliver attractive returns