By Iryna Pylypchuk
Despite many believing the European real estate sector has entered the mature stage of its investment cycle, the last few quarters have revealed several anomalies. This promoted a review of where we are in the current cycle and the possible implications this might have on decision-making process. Every cycle is different and it’s becoming clear to us this one is not over just yet…
What anomalies?
Weight of capital: supply and demand imbalance
Core eurozone commercial real estate investment activity is slowing even though investor sentiment and pricing continues to edge sharply upwards. This paradox is easy to explain by the influx of capital. The last few years reveal a steady increase in target real estate allocations, with the 2017 global average target expected to hit 10.3%1. We expect short-term allocation increases of European institutions alone to translate into a remarkable $150 billion of new capital,2 mostly targeting core eurozone. As investors, both domestic and international, continue to expand their allocations, supply is becoming the key obstacle leading to a constrained investment market.
Political uncertainty
The real estate industry has duly embraced lessons from the past – no overleveraging, limited development (very little of which is speculative), with vacancy below long-term structural levels. But political uncertainty remains the key challenge – resulting in yet more capital allocations to safe haven markets such as core eurozone, and Germany in particular.
Downward return expectations in other asset classes
Future multi asset return expectations are being adjusted sharply downwards. According to McKinsey Global Institute, even in the unlikely growth-recovery scenario, Western European annualised equity returns are expected to fall to somewhere between 5.0% and 6.0% over the 2016-2035 period, with the fixed income expected to be in the 1.0-2.0% range.3 Underpinned by a real asset, with a relatively stable income stream and higher return expectations (Fidelity Real Estate forecasts 5-year core eurozone market level total returns of 7-9%), real estate is looking rather attractive.
What does this mean?
The weight of capital is driving the European real estate investment market performance, and after 16 consequent quarters of yield compression there is no sign of a reversal. The end result is that the core Eurozone investment market cycle will continue extending, as long as the real estate fundamentals are positive and QE is in place.
Due to low risk appetite, investors will stick to core and value-added strategies with second-tier markets and alternative real estate asset classes benefiting the most. Brexit and political and economic uncertainty around it will bring more volatility to the UK real estate market. The US presidential election results will also mean short-term financial markets and exchange rate volatility, prompting a likely pause in cross-regional capital flows until there is more clarity on Donald Trump’s future policies. In the short to mid-term, this is likely to divert international capital toward the safe havens of Germany and core eurozone.
The real estate markets are slowly coming to a realisation that in this prolonged risk-averse, low growth and low interest rate environment, the weight of capital will continue to push real estate pricing up, with prime office yields likely to fall to a new ‘accepted’ threshold of circa or just below 3.00%. The significant growth in cross-regional capital flows in core eurozone investment market is also contributing to this pricing shift by brining even more diverse strategies and highly competitive pricing models. This also means that the 2016 and 2017 returns will get pushed higher than investors themselves are expecting.
The investment cycle is far from over and Germany, the perceived safe haven in times of global macro volatility, is likely to remain the key beneficiary. Its institutional universe looks set to substantially expand, and it already overtook the UK commercial real estate investment activity in Q3 2016.
I personally think that current market conditions should cause an extended investment cycle.
Iryna Pylypchuk is senior European real estate analyst at Fidelity International
