Market in ‘demand shock’

Residential property continues to hold up, but watch out for offices, writes Roxane McMeeken.

The European property market has suffered from a demand shock in the past year. Rents have dropped and even flattened, while the number of empty buildings has soared. But with average returns of 8 per cent, few are complaining. For affluent investors looking to buy a direct stake in this market, the key is to get the sector and location right. The demand shock has created the illusion that sectors and countries are irrelevant in property, but in fact supply conditions vary widely in Europe. So says Nick Tyrrell, director at Deutsche Bank’s European real estate operation. Thus, he adds, when the market picks up, as commentators predict before year-end, real estate markets will desynchronise. According to Mr Tyrrell, markets that were already close to the top of the property cycle – London, Frankfurt, Madrid, Stockholm – will continue to slide in the face of growing new supply. But where the real estate supply cycle was far from completion before the macroeconomic downturn, or supply is limited by legislation, a rapid return to growing rents and healthy returns is likely. This includes Berlin, Brussels, Milan and Paris. In terms of sectors, residential, a one-time underperformer, has been holding up best during the economic downswing and seems set to remain a good bet. Mr Tyrrell attributes this to falling mortgage rates, particularly in Italy. He says rates are unlikely to rise “more than gently” once the economic recovery is in full swing – the worst that can be expected being a flattening-off of prices over the next couple of years. There remains the old argument that anyone with their own mortgage already has sufficient investment in the residential sector. But William Hill, managing director of Schroders’ property arm, stresses the importance of distinguishing between renting and buying markets. The former, he says, can be a good source of diversification, and creates an income stream correlated with wage rates. This can prove to be an excellent match for an investor’s liabilities. “If you were looking to fund a research programme, it would be a good idea to invest in rented property,” says Mr Hill. But he warns: “People in the buy-to-let market make the mistake of buying the sort of building they would like to live in themselves.” In fact, renters would settle, in exchange for lower rents, for slightly less – perhaps a flat with a smaller garden, for example. In a wider context, residential property looks set to lose its lead as the offices, retail, and industrial sectors catch up. Offices, until now suffering from rent declines and flattenings, are set to bounce back, although only in markets that were not close to the top of the property cycle before the macroeconomic slump, according to Mr Tyrrell. Thus offices in Berlin, Brussels, Milan and Paris are good bets, but London, Frankfurt, Madrid, Stockholm are less so. Retail yields have drifted upwards in recent years, reflecting uncertainty and fears of over-valuation in what Mr Tyrrell says was “previously viewed a copper-bottomed sector”. This all changed in the past nine months as the decline ran its course and consumer spending remained healthy. “In the longer-term, competitive pressures in the retail sector will remain”, says Mr Tyrrell. But he adds that tight supply should continue to ensure impressive returns “for investors dogged or lucky enough to find opportunities” in central locations in Paris and Vienna, as well as shopping centres in Milan or Brussels. Industrial property was the worst hit by the slowdown, but Mr Tyrrell argues that real estate held for long periods in “key nodes in the developing European distribution system” – London, Paris, Brussels, Amsterdam – still offer attractive opportunities. This is due to their potential for capital appreciation. Also, with yields still higher for property than for other asset classes, a higher proportion of total income comes from rent and this means you are protected from cyclical ravages.