The risk that the downturn in manufacturing might spread to the rest of the Eurozone economy has receded. Short-term indicators suggest that manufacturers’ export orders have stabilised and confidence among businesses in the services sector has increased since last September. Its forecast that the Eurozone economy will grow by 1.25% p.a. through 2020-2021, in line with recent progress. The main driver should be consumer spending, supported by higher real wages and increasing employment in the services sector. In addition, pressure from populist parties is likely to lead to higher government spending in France, Italy and Spain. Inflation in the Eurozone is likely to remain subdued at around 1% p.a. and its expected that the European Central Bank (ECB) will cut the deposit rate from -0.5% to -0.6% in the first quarter of this year and continue its programme of QE through to the end of 2021.
Prime office rents in continental Europe rose by 4% on average in 2019, reflecting the growth in employment in tech and professional services. The current upswing in rents began in 2013/14 and while it is now one of the longest on record (the average is five years) we see no immediate reason why it should end, assuming the economy continues to grow. Office vacancy rates in Amsterdam, Brussels, Paris, Stockholm and the major German cities are at their lowest since the early 2000s and the recent upturn in building has been measured in most cities. Furthermore, while serviced offices are expanding and could be vulnerable in a recession, they are still a small part of the market, except in Amsterdam. Our forecasts suggest that Berlin, Madrid and Munich will see the biggest rise in average grade office rents over the next two years of 3-4% p.a., but most other cities will see rental growth of 1.5-2.5% p.a. The exceptions are Milan and Warsaw where there is a risk of over-supply.
The logistics market is also seeing strong demand as e-commerce companies, traditional retailers and logistics firms take additional space to support on-line sales. The main difference with the office market is that logistics has seen a much bigger increase in new building, reflecting the greater availability of industrial land and the willingness of occupiers to move to smaller towns and cities, provided there are good road connections and an adequate labour force. (Robots can move goods, but have not yet mastered picking and packing). Over 6 million square metres of new warehouses was built in the core markets of Benelux, France and Germany in 2019, a 50% increase since 2016. Although most of this new space is pre-let, it has taken some of the pressure off rents and its anticipated that prime logistics rental growth will average 2% p.a. over the next few years.
By contrast, the growth in on-line sales particularly clothing is undermining the demand for retail space. E-commerce now accounts for 15% of total retail sales in Germany and 10-11% in France, the Netherlands and Sweden and forecasts suggest that its market share will increase by around 1% p.a. over the next few years. Although some of the space vacated by traditional retailers has been taken by discount formats (e.g. Action, Flying Tiger, Rossmann, Primark), bars and restaurants, they typically pay lower rents. In general shopping centres have seen the biggest increase in structural vacancy and we expect that prime shopping centre rents will fall in most European cities over the next three years. The most defensive retail types are likely to be convenience food stores close to major transport hubs and out-of-town retail warehouses with affordable rents.
The zero, or negative level of bond yields in the Eurozone means that that there is fierce competition among investors for real estate. While the retail sector has suffered a sharp drop in liquidity, investor appetite for apartments, hotels and niche types such as student accommodation and care homes has grown. The German open ended funds are seeing high inflows and the uncertainty over Brexit has encouraged US and Asian investors to favour the continent over the UK. Its expected that office and industrial yields will fall by a further 0.25% in 2020 and that yields on hotels and other types will also compress. The downside is that this leaves capital values more exposed, should bond yields rise at some point further in the future. Shopping centre yields will probably increase by 0.5-1.0% over the next 12 months, as investors price in lower rents.
In the office market we currently see most value in either re-development projects in central business districts, or in stabilised assets in adjacent areas where yields are higher. In the industrial market its favored multi-let estates and smaller distribution warehouses where it is still possible to buy good assets on yields of 5%, or higher. Its also good to see value in hotels with management agreements. Caution about most retail assets, because we do not believe that current yields reflect the risks of higher vacancy and falling rents.