Further yield compression expected in 2018
The story of European investment since 2013 has been one of continued yield compression and accelerated capital growth, supported by record transaction volumes. As we move into 2018, the cycle in Europe broadly is likely to be at a point of inflexion.
Solid take-up, but diverging demand outlook
Demand for office space across Europe has been robust with an average growth of 7.4% in each of the past three years. 2017 has been no different and we anticipate that the year as a whole will record a similar level of growth. Of course at city level the momentum and volatility differ because of the different stage of the property cycle. For example cyclical differences in the two largest markets, Paris and London, mean that over the next 3 years whilst Paris is likely to see reduced take-up after two good years of demand, London will begin to see a recovery from Brexit induced slowdown over the past four years.
A contrast may be made with the German cities where demand is projected to fall back over the forecast period, on the back of historical highs in most of the markets. The other cities such as Milan, Rome, Amsterdam and Brussels are showing demand momentum on the back of improving European economy. These markets belong to a set of countries whose economies have taken longer to improve in the European context.
Stock addition may outstrip net absorption
The high level of space overhang in the post financial crisis European market is all but a distant memory. Much of Europe’s vacant space then has been absorbed, helping to drive down the vacancy rate in most markets. Again here there is a wide variation across markets from the low of 2.2% in Berlin to the highest 14.0% in Helsinki. These are reflective again of demand momentum and local supply/demand conditions. In Berlin for example regulations make speculative construction difficult, helping to constrain supply. Milan had many projects underway for the Expo exhibition. The lack of grade A space in the CBD area is a common feature across many European cities (London being an exception).
In some markets there is the case for increased developments to replace ageing buildings Among the top 15 European markets net addition as percentage of stock has been falling, gradually, from the high of 2.4% in 2008 to 0.2% in 2016. This situation is encouraging development and we anticipate that these markets will see growing net additions to the stock over the next five years (+ 1% pa), that may outstrip net absorption. That is certainly the case for London, Paris and East European cities whilst German cites ought to see vacancy reduce again before rising.
German cities likely to stay mid-priced and see the fastest rental growth
Cost of space mirrors vacancy patterns and economic growth. The largest cities will remain the most expensive in terms of prime rents; London and Paris. The German cities, despite a fall in the vacancy rate do not command the highest rents however they will post some of the fastest rental growth over the forecast period, most of it front loaded; Berlin (7%, pa), Frankfurt (4.2%, pa) Hamburg (2.2%) and Munich (2.0%). This is driven by a continued stable economic environment. The CEE nations post the lowest rents and are seeing substantial amounts of development occurring. Although prime rental growth is likely to remain low at best, the effect of the increased supply will be felt most in average rents, as tenants take advantage of low prime rents. Average rents may fall across the period, while prime rent holding steady.