Further Deterioration in European Property Values Expected.
Countries like Italy, Spain and France expected to suffer most according to a recent Capital Economics update.
On the positive side, Dublin better placed to absorb reduction in occupational demand due to existing low office vacancy rates across the city.
Further deterioration in values across all sectors with Retail taking biggest hit.
- Prime euro-zone rents and yields held broadly steady in Q1, with many agents noting it was not possible to provide a robust reassessment of values. This marked the end of period of positive rental growth and yield declines in many markets. Indeed, there were already signs that occupier demand slowed, even though lockdowns were not fully in place until the end of March in many countries. (See Chart 1) With economic activity at its lowest in Q2, we think that a more substantial deterioration in rents and increase in yields is on the way. Although lockdowns are being loosened, the recovery is expected to be slow and uncertainty will remain elevated, which we think will prevent property values from bouncing back quickly.
- Euro-zone economic indicators highlight that the collapse in economic activity reached its nadir in Q2. But activity will likely take time to recover, even though countries have started to loosen lockdowns.
- Country-level economic indicators show that economic activity has been hit hardest in Italy, France and Spain. Despite large monetary and fiscal stimulus, inflation is likely to be below target for some time.
- Commercial property investment market indicators suggest that, after holding up in Q1, investment activity is likely to have collapsed in Q2, driven by a deterioration in sentiment. An increase in yields appears inevitable, particularly in the retail sector.
- Commercial property occupier market indicators revealed that, although rental values held broadly steady in Q1, weak occupier demand across all sectors will weigh heavily on rents going forward.
Chart 1: Euro-zone Office Take-Up (M Sqm)
Investment Market Indicators
- While investment was strong in Q1, the deterioration in investor sentiment since points to a collapse in activity in Q2. Pan-European (ex. UK) investment rose by nearly 60% in the year to Q1, while euro-zone investment recorded its strongest Q1 to date (14). The strength was broad-based across countries, most notably in Ireland and Germany. At a sectoral level, while we expect investment activity to fall in all sectors this year, retail, which had started to tick up in Q1, is likely to be hit the hardest (15).
- RICS surveys revealed widespread falls in investor sentiment during Q1 and, given that the disruption from the virus had not peaked yet, we think that sentiment will worsen in Q2 (16). That said, even in markets where sentiment was weakest, it was still nowhere near the lows recorded during the GFC. Moreover, there was a deterioration in the perception of market pricing (17).
- The sharp drop in investment enquiries so far points to a decline in capital value growth at the euro-zone level (18). In turn, with investor sentiment deteriorating, even further loosening of credit conditions in Q2 due to large-scale ECB bond purchases will not be enough to support investment activity (19).
Chart 14: Euro-zone Investment (€Bn)
Chart 15: Pan-European Investment by Sector (4-qtr Mov. Avg, €Bn)
Chart 16: Investment Sentiment Index (Net Balance, %)
Chart 17: RICS Euro-zone View on Current Market Valuation Levels (Net Balance, %)
Chart 18: Euro-zone* RICS’ Investment Enquiries and All-Property Capital Value Growth
Chart 19: Changes in Euro-zone Credit Conditions for Loans to Firms (Net Balance, %)
Sources: CBRE, Refinitiv, RICS, Capital Economics
Investment Market Indicators
- Market uncertainty and the lack of liquidity due to the lockdown have meant that movements in prime data in Q1 have been muted. (See our Update.) Indeed, the euro-zone all-property yield was flat in Q1 (20). Nevertheless, given the higher risk aversion and lower rental expectations due to the virus, we expect yields to increase in Q2, before reversing some of the gains by the end of this year. This is despite the widening yield gap between property and bonds (21).
- At a regional level, yields held steady even within the peripheral markets, which tend to be more volatile (22). The greater direct hit from the virus and stricter lockdown measures mean that yields in southern Europe will rise by more than the rest of the euro-zone, widening the existing divergence between the regions (23).
- Quarterly yield movements in Q1 were mainly concentrated in the office sector (24). As the retail sector is the most vulnerable to lockdown measures, we think that retail yields will increase in all markets and by more than offices and industrial in 2020. As a result, we expect retail yields to rise above office yields in the coming years (25).
Chart 20: Change in Weighted Euro-zone All-Property Prime Yield (Bps, q/q)
Chart 21: Euro-zone All-Property Prime Yield & German 10-Year Bond Yield
Chart 22: Change in Weighted Regional All-Property Prime Yields (Bps, q/q)
Chart 23: Weighted Regional All-Property Prime Yields & Yield Spread
Chart 24: Change in Prime Yields by Sector, Q1 2020 (Bps)
Chart 25: Euro-zone Yields by Sector (%)
Occupier Market Indicators
- It was the weakest Q1 for euro-zone office occupier demand since the GFC. Take-up totalled less than 1.5m sqm, pulling the four-quarter rolling average to its lowest level since 2016 (26). And, with the more substantial disruption to activity from COVID-19 likely in Q2, take-up will weaken further. Indeed, uncertainty remains high and more job losses are inevitable, which will weigh on occupier demand (27).
- Declines in take-up were broad-based across markets. However, some markets were in a better position prior to the outbreak. In particular, take-up declined from a higher base in Milan, Lyon and Berlin, reflecting strength at the end of last year (28). That said, no market will be immune from the weakness in activity to come. Indeed, surveys suggest that occupier demand has fallen significantly across markets. (29). The exception was Greece, but this may just reflect survey lags.
- Even so, there has yet to be much movement in the availability of space. But given the size of the hit to demand, we think that it will be just a matter of time before vacancy rises. In turn, although prime rents generally held steady in Q1, we expect office rents to fall across the board in coming quarters (30). However, markets in Germany, the Netherlands and Dublin may be better placed to absorb the reduction in demand as vacancy is low compared to its pre-GFC lows (31).
Chart 26: Euro-zone Office Take-Up(M Sqm)
Chart 27: Euro-zone Employment Growth and Office Take-Up
Chart 28: Office Take-Up by City, Q1 2020(4Q MA, % y/y)
Chart 29: RICS Surveyors Reporting Rising Office Occupier Demand (Net Balance, %)
Chart 30: Prime Office Rental Values Growth, Q1 2020
Chart 31: Office Vacancy Rates (%)
Sources: RICS, Capital Economics *Latest data for Q4 2019
Occupier Market Indicators
- Retail rents fell on a quarterly basis in Rotterdam and Frankfurt in Q1 (32). However, falls are expected to extend to all other markets this year. Even as shops are opened, caution and damage to household balance sheets will mean footfall and spending will take time to return to pre-crisis levels (33). We think that rental falls could be more substantial in the Italian markets, Athens, Barcelona, London and Budapest. (See here.)
- The industrial sector has not been immune to the drop in economic activity. Rents have not fallen, but only one market reported an increase in quarterly growth in Q1 (34). Although there has been an increase in online food spending and some occupiers have taken more space, demand has not been broad-based and is unlikely to be sustained in the long term. In addition, supply chain issues have limited activity (35).
- At the euro-zone level, little change in rents over the quarter meant that annual rental growth slowed across all sectors, pulling all-property rental growth to 3% y/y, from 3.7% y/y in Q4 2019 (36). And with yields also flat, the Q4 pick-up in all-property capital value growth was reversed (37). With broad-based rental falls and yield rises on the way, we expect capital values will fall steeply in coming quarters. Even as the economic recovery gets underway, the improvement in capital values is only likely to be gradual.
Chart 32: Prime Retail Rental Value Growth (% y/y)
Chart 33: Daily Footfall in Selected German City Centres (% Difference from Level Normally Expected)
Chart 34: Number of Markets Where Industrial Rents are Rising
Chart 35: Suppliers Delivery Times PMI (Inverted)
Chart 36: Euro-zone Prime Property Rental Value Growth (% y/y)
Chart 37: Contributions to Annual Weighted Euro-zone All-Property Capital Value Growth (%-pts)
By Andrew Burrell Chief Property Economist
Capital Economics email@example.com
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