Lender’s guide to Europe: Opportunities and threats

Sentiment towards the continent has improved, but real estate investors and lenders should proceed with caution.

Europe is in growth mode. The European Commission’s winter economic forecast put 2017’s eurozone growth rate at 2.4 percent – the fastest pace in a decade.

The performance will continue this year and next, the EC forecasts, with growth of 2.3 percent and 2 percent, respectively. “Europe began its recovery much later than the US and the UK, so it’s playing catch-up,” comments Walter Boettcher, chief economist at Colliers.

However, the rate of growth is unlikely to last. Projections from Oxford Economics suggest that 2017 will be looked back on as the peak year of recovery for most European countries. However, for now, the European growth story fits into a global trend.

“This is pretty solid, broad-based growth,” according to Ian Shepherdson, founder and chief economist at Pantheon Macroeconomics, speaking in February at an event in London hosted by advisory house JCRA. “This is a global, synchronised manufacturing-driven upswing and there is no sign, at the moment, of any failings.”

Indeed, the International Monetary Fund’s global forecast puts growth at 3.9 percent this year and next, an upgrade of 0.2 percent for each year and up from 3.7 percent in 2017.
On the political front, Brexit remains a cause for concern. Although many believe the most likely outcome is a softer Brexit than originally anticipated, with a long transition period, the UK’s divorce from the European Union is hitting growth. Like the eurozone, the UK economy is growing, albeit losing ground against the US and continental Europe, as firms sit on capital while Brexit plays out.

“A rising tide lifts all the boats. It’s just if your boat is leaking you don’t rise so far,” is Shepherdson’s take on the Brexit effect.

Speaking to PwC and the Urban Land Institute for the 2018 Emerging Trends in Real Estate Europe report, one London-based global investor commented: “[Brexit] is going to weigh on investment sentiment and decision-making by all agents in the economy, ourselves included, for a number of years.”

However, investor sentiment towards continental Europe has improved markedly since mid-2017. The 2016 Brexit vote stoked fears of a domino effect of Eurosceptic opinion. Such fears were quelled to a degree by 2017 election results, most notably centrist Emmanuel Macron’s defeat of nationalist Marine Le Pen in the French election in May.

“The Macron result has been critical in shifting global investor perceptions of the eurozone,” said Bob Janjuah, senior independent client advisor at Japanese bank Nomura, known for his usually bearish views, speaking at the JCRA event.

Angela Merkel’s forming of a coalition government in February, following months of political deadlock, has been greeted as a further boost to European political stability. However, at the time of writing, Italy’s election was looming, bringing with it fears of a populist resurgence.

Monetary shift

In macroeconomic terms, the potential bump in the road is rising interest rates. February’s stock market plunge was sparked by data which showed rapid wage growth in the US, leading to fears the tighter labour market would force the Federal Reserve into faster rate rises to counter inflationary pressure.

“[The Federal Reserve] promised it would raise rates four times in 2015 and only did one. It promised four times in 2016 and only did one. But it hiked three times last year and will hike three times this year, at least, and will probably keep going after that. This is a fundamental shift,” said Shepherdson.

Rates are unlikely to rise as quickly in Europe. In February, the Bank of England froze rates, but warned that it was looking at earlier and faster rate hikes. The European Central Bank is expected to lag US and UK rate rises, although its stepping down of quantitative easing indicates the gradual shift in its monetary policy.

“The ECB is almost certain not to raise rates this year,” says Andrew Burrell, director of forecasting for the UK and EMEA at JLL. “It will continue with QE until autumn, and once it winds that down we could see another year before rates go up,” he adds.

“There is probably another year of good economic growth and then it’s time for a mid-cycle slowdown,” comments Colliers’ Boettcher. “This year and next will be OK, but the ECB is already tapering monthly bond purchases and ultimately by September plans to end the buying programme and begin letting them expire.”

In Janjuah’s view, monetary policy in the eurozone will come under further pressure: “Asset price inflation is running ahead of itself, financial instability is building, so keep an eye on the ECB.”

Property outlook

While the low-rates environment persists, European commercial real estate remains an attractive asset class on a relative-value basis. Investment volumes hit a record high of €286 billion in 2017, up 9.3 percent, CBRE data show. The UK posted an 11.6 percent year-on-year increase to €72 billion, while German volumes increased by 8.4 percent to €57 billion.

“Despite the brighter general outlook in this late-cycle market, there are enough warning signals to prevent confidence slipping into complacency. Historically low yields, a collective pressure to invest and a scarcity of available core assets are all uppermost in the minds of the industry leaders canvassed,” according to the Emerging Trends Europe report.

A total of 45 percent of respondents to the survey said they were targeting the same returns in 2018 as last year, while 34 percent expected them to be ‘somewhat lower’ and an ambitious 18 percent ‘somewhat higher’. Polled on returns targets, 44 percent are looking for within 5 percent to 10 percent. Asked whether investors are taking on more risk to achieve target returns, 53 percent agreed – while an additional 27 percent said they ‘strongly’ agreed.

“It’s a low-yielding environment and there is not much scope for compression, so rental growth is where returns will come from,” says Boettcher.

JLL’s Q4 2017 EMEA office clock report shows that 2018 annual European office rental growth is forecast at 2.3 percent, outpacing the five-year average of 1.4 percent.

“Investors need to be forensic,” says JLL’s Burrell. “They will need to concentrate on those cities attracting occupier groups that will experience genuine growth, such as tech companies. Although yields are very low, there are pockets of rental growth.”

Many agree that European real estate is at, or near, the peak of this extended cycle. However, an increasing number of organisations are competing to provide debt finance, with many taking a continent-wide view as their clients explore markets.

“A lot of our clients are still looking at London,” comments Michael Shields of ING Real Estate Finance, “but I think some are shifting some money to Germany and to Paris especially.”

Dale Lattanzio, managing partner at debt fund manager DRC Capital, adds: “In Europe we still see opportunity in the place where the banks are having to regroup the most from a capital perspective. That means the Netherlands, Italy and Spain. We’re active in those regions and would anticipate being for the rest of the year.”

Across upcoming features, Real Estate Capital will examine the prospects for the main individual markets of Europe, considering the opportunities and threats, as well as who is investing and who is already providing finance. For real estate lenders, Europe presents huge opportunities, although market knowledge is crucial.