Our Forecasts: What Direction is Europe’s Commercial Real Estate Taking?
If the outlook is still positive and long-term nominal interest rates are likely to continue to fuel investors’ confidence, growth in capital values could come to an end, more or less abruptly. As such, investors should be selective.
What would happen if the nominal and, more importantly, the real interest rates, were to rise in the coming months?
In our opinion, much would depend on the health of the economy in general and the occupier markets in particular. Higher interest rates would not pose a serious threat to investors if they emanated from better fundamentals and stronger demand for goods and services.
Higher demand inflation would result in stable real interest rates indeed. But if nominal rates were to climb above threshold levels (3-4%) without being backed by any serious economic growth, this would certainly induce falling net rental income returns and hence lower values.
We believe that the current low GIYs have touched bottom, or will reach their lowest point soon.
Therefore, growth in capital values could come to an end, more or less abruptly, unless specific occupier markets were to have a very good ride for whatever reason. As such, investors should be selective, spotting those sub-markets with growth potential.
We think of new (and cheaper) sub-markets away from the central gateways (CBDs) in combination with new core districts, which should be better connected to public transport one way or another. As always, it is essential to cap the cost of borrowing to avoid any higher financing costs in the event of higher real interest rates.
Having said this, we believe investors “seeking value” will continue to test Europe’s more troubled markets that have been recovering in recent months (Southern Europe, the Netherlands, Central Europe). However, it is not always easy to find products in these relatively small property markets, or assets are simply not attractively priced enough to offer IRRs above 10% because of abundant capital being available. Consequently, a good manager is a prerequisite for identifying the hidden “off-market” deals. In addition, core markets, such as the U.K., France and Germany, could complement the recovery markets; properties with embedded value can still be found in the regional cities and the more distant districts of the various capitals (Paris, London, Berlin).
This “value-added” investment strategy is less aggressive than a pure “opportunistic” approach …
… in the sense that assets should still be capable of offering both an income return (if not at the beginning then after a year or two) and a capital appreciation component based on a realistic exit scenario. We believe any IRR from 10% derived from an European value-added investment strategy is attractive for investors today. International investors calculating in U.S. dollar (or any currency correlated to the greenback) could possibly benefit from a strengthening euro in the years ahead, though currency movements in themselves should not be a primary investment goal for real estate buyers.
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