Real Capital Analytics on why 2018 will be a hard act to follow

This article is sponsored by Real Capital Analytics

The European commercial real estate market experienced another strong year in 2018. Total investment was close to €300 billion and prices continued to grow in most segments tracked by Real Capital Analytics’ commercial property price indices. Moreover, there is still plenty of equity, markets are not yet overbuilt and attitudes to debt are more conservative since the global financial crisis.

However, the stand-out story of the last quarter of 2018 was the contrast between the UK and Germany, Europe’s two biggest markets. While quarterly investment in Germany reached a new high of almost €26 billion, on the back of a strong showing from the office sector, UK investment volumes fell by a third year-on-year to €15 billion, with Q4 the slowest finish to a year since 2012. The struggles in the UK retail sector and Brexit-related uncertainty have both acted as a drag on investor activity.

In another key trend, the maturity of the cycle led many investors to focus on driving returns while future-proofing their portfolios against a downturn in the business cycle. One way is to buy into sectors of the market that are undergoing structural shifts. For instance, the beds sector – apartments, student housing, senior housing and hotels – garnered a greater share of investor capital in 2018 than ever before.

These housing and hotel types now comprise almost 30 percent of all investment; double the share at the peak of the last cycle in 2007. Similarly, if the purchase of Logicor is excluded from 2017’s totals, logistics investment reached a record high in 2018.

Capital flows

The flow of global capital into Europe slowed in 2018 – as did investment by domestic capital providers. However, cross-border capital flows within Europe increased to the highest level since 2007 on the back of German institutions spending record amounts at home and abroad.

The 30 percent drop in capital coming into Europe from elsewhere means Europe’s share of the global cross-border market has shrunk back towards its long-term average, while both North America and Asia gained share.

A major reason behind the fall in global inflows was a rapid slowdown in outbound investment by Chinese and, to a lesser extent, Hong Kong investors. Acquisition volumes by Chinese buyers fell by 80 percent year-on-year, following the government crackdown on overseas purchases of non-strategic real estate.

In contrast, South Korean and Singaporean players increased their European acquisitions in 2018. South Korean institutions focused on prime, mostly single-let assets with long-term income streams and have refocused on London, in part due to lower hedging costs.

US-headquartered investors scaled down their acquisition activity in 2018, but they remain the most active overseas investors in the market, investing close to €40 billion. The UK was the major recipient of these funds, although US investors sold around twice as much as they bought, making them net sellers for the third year in a row.

Within the European cross-border investment market, German investors increased their volumes by 50 percent last year. This is driven by institutions, which spent a record amount both at home and abroad, as well as due to M&A deals in the listed sector. The UK slipped to fifth place in the list of German investors’ favoured European markets, from first in 2017. Anecdotally, some German investors have said the UK remains off-limited while Brexit-related uncertainty remains.

Where next?

It is likely 2019 will be a more difficult year in which to deploy capital than 2018. Political uncertainty is feeding into the real economy and, while property market conditions remain healthy with plenty of equity, a competitive debt market and a decent outlook in major occupier markets, it is unlikely real estate can escape the effects of a general economic slowdown.

At the time of writing, the nature of the UK’s departure from the EU is undecided and UK volumes will lag while that is the case. RCA recorded just over €2.5 billion of completed deals in January, half both last year’s figure and the 10-year average.

However, Brexit is something of a side issue in comparison with the macro-trends affecting the global economy. The slowdown in global trade and economic growth has affected European economies; GDP growth across the eurozone fell away in H1 2018 and an Economic Sentiment Indicator produced by the European Commission has fallen for 10 of the last 12 monthly releases. There is a strong correlation between the indicator and property investment volumes, and should it continue to fall, it is likely European property investment volumes will follow suit.

There are signs that commercial property investors are modifying their strategies in view of the challenges. Investors reoriented themselves towards the major metropolitan centres last year, which speaks to two drivers: an attempt to exploit an ongoing trend for urbanisation and that these larger metros are more liquid and maintained liquidity better than smaller markets during the last downturn.

Similarly, the volume of value-add deals across Europe has fallen every year since 2015. This partly confirms that investment managers are following ‘same risk, lower return’ strategies as they try not to overstretch. In previous cycles, some have chased higher returns and come undone. However, a majority of funds raised last year were for value-add and opportunistic strategies, suggesting there could be a disconnect between the realities of the market, 10 years into the cycle, and investors’ return expectations.

The changing economic outlook means central bankers have started to adopt a more dovish stance. This is supportive of real estate pricing and we should continue to see funds being raised and allocated to the sector. However, the high pricing in many markets and uncertain macro-outlook, with political risks aplenty, may act to keep more of a lid on total investment volumes than we have seen so far this cycle.