Sovereign debt is among the factors weighing on Europe's fair value score, as Tony McGough and Ben Burston report

In the final quarter of 2010, the DTZ Fair Value Inde x score for Europe fell to 40, with the UK score falling to 33, indicating that the investment market has become less attractive relative to Q3, when the scores were 55 and 48 respectively.

The fall in the index scores comes as a result of three factors. First, shifts in the bond market have raised the return available on government bonds, and made property look relatively -unattractive. Yields have risen across the board, with the five-year UK gilt yield to maturity rising 60 basis points to 2.2% at end Q4, the German yield up 36bps to 1.8% and the Swedish yield rising by 63bps to 2.7%.

Secondly, yields in several markets compressed further in Q4, thus lowering income returns for prospective investors and weakening the outlook for capital growth over the medium term.

Thirdly, the rental growth outlook has weakened, with the pace of recovery expected to slow during 2011 following a sharp uplift in several markets during 2010, resulting in a weaker outlook for returns over the next five years than was the case in recent quarters.
These factors have been most apparent in office markets, with the European office score falling to 25 and the UK score falling to 29.

Core office markets less attractive
Although we have previously strongly advocated the major core markets, such as prime London City and Paris CBD offices, on the grounds that they were set to benefit from a stronger and earlier rental recovery and did not offer a significantly lower yield than other markets, we now consider that pricing in these markets has adjusted to appropriately reflect the outlook for recovery.

For instance, the London City office market has shifted from HOT to WARM. The immediate rental growth outlook remains strong, but the yield has now shifted in to 5.25%, a level at which the positive rental growth outlook is fully priced in. Likewise, in Paris, the office market has shifted from WARM to just turning COLD, as a result of further yield compression to 4.75% and lower expectations for future rental growth following a strong uplift in the second half of 2010. Figure 1 highlights these and other key changes to our Index results in Q4.

Stepping outside the core
With a large rental uplift and yield compression having driven a strong recovery in core markets during 2009-10, it is not surprising that they have been favoured by most investors. However, following this strong and rapid recovery in values, the case for targeting these markets specifically at the current higher pricing is less clear-cut.

This is not to say that the markets are overvalued, with most core markets rated as WARM, but rather that they do not offer higher prospective returns than non-core markets, with their stronger rental growth fully priced in. Hence, for outperformance, investors could benefit from broadening their scope.

We see two dimensions to this: first, a sectoral dimension to take advantage of opportunities in prime retail and industrial markets. Whereas many European office markets look fully priced, as indicated by the Fair Value Index score of 40, retail and industrial markets are generally offering better value, as indicated by Index scores of 52 and 54 respectively.

Industrial markets in particular are offering solid income returns, which stand out as appealing in an environment of weaker prospective capital growth. As a result, markets such as Brussels and Copenhagen industrial are rated as HOT.

Secondly, several opportunities are presented by locations outside the traditional core, such as Moscow and Prague. In Moscow, the office market was hit hard by the crisis, but is now beginning what we expect will be a robust upswing, supported by rental growth and yield impact as the market recovers. With strong annualised capital growth expected over the next five years (7.2%) adding to a high income return, investors buying now can position themselves to benefit from the recovery that has already begun.

German markets outperform
The divergent European growth pattern that emerged in 2010 is set to continue throughout the first half of 2011, with recent indicators pointing to a continuation of the robust German recovery, in contrast to continuing weakness in the southern European economies.

This stronger economic performance is feeding through to the occupier market, where we see outperformance in Germany relative to the UK and other European countries. Rental growth prospects look solid in the Berlin, Hamburg and Munich markets, and yields in the major German cities have barely compressed in contrast to the sharp inward movement we have witnessed in Paris and London.

As a result of these forces, and a relatively low return on government paper, all German markets are rated as either HOT or WARM, presenting it as more attractive to investors than other European countries.

On the other hand, in this quarter there have been several downgrades in the ratings for markets in the heavily indebted euro-zone economies such as Ireland and Spain. Government bond yields have shifted out once more and these markets remain supported by direct and tacit intervention by the European Central Bank. As a result of this troubled and uncertain economic environment, investors are demanding higher compensation for the risk of entering these property markets, and this is weighing on the European Fair Value Index score.

UK held back by yield compression
Amidst strong competition for prime UK property, yields in several markets compressed further in Q4 2010. With bond yields rising and the outlook for rental growth remaining subdued, this led to downgrades in our assessments of investor value in UK markets and correspondingly a lower Fair Value Index score than for Europe as a whole in Q4.

Heathrow and Glasgow industrial yields compressed and shifted in to 5.75% and 7% respectively, while the outlook for rental growth continues to undermine the case for several regional office markets.

However, the majority of markets are still rated as either WARM or HOT indicating that there remain opportunities for selective buyers. The Manchester market is rated as particularly attractive, with the combination of higher yields and stronger rental growth prospects leading to higher expected returns than in other UK markets.

Tony McGough, Global Head of Forecasting & Strategy Research, and Ben Burston, Associate Director, Forecasting & Strategy Research, DTZ