There is great diversity in the long-term growth trends of European markets. Understanding historical trends is crucial in determining future growth trends and pricing levels, as Petra Blazkova reports
Understanding the dynamics of the recent correction in commercial real estate prices and predicting when and which markets will start to recover, are issues currently pre-occupying the real estate research community.
It seems that capital values have fallen faster and deeper than at any time in recent real estate investment history, at least since comparable records began in the early 1970s. Given that we are also in one of the worst economic recessions since the 1930s, this should not come as much of a surprise.
However, comparisons with previous cycles could provide some additional historical evidence to support recent reports of markets finding their pricing trough, and give some perspective as to when positive capital growth may return, while acting as a graphical check on current forecasts.
In this paper, we look at the historical patterns of capital value performance across Europe's prime office markets. We give an indication of where markets are currently positioned in their cycles relative to previous ones and to long term trends, with the aim of providing guidance and visual evidence for investors looking to make market entry timing decisions.
The data used in this analysis is derived from Jones Lang LaSalle's prime capital value series, which tracks the top achievable capital values that could be expected for a notional office unit of the highest quality and specification in the best location in a market.
For this type of long-term analysis we believe a prime series provides two major benefits over a series based on average valuations or from aggregated transaction data: first, it gives a consistent and transparent definition over time and across geographies, and secondly it provides a mark-to-market approach which is more sensitive to turning points and also accommodates periods where there is limited transactional evidence.
To adjust for changes in prices we initially looked at real prime capital values over the entire length of our data series. Inflation or the lack of it, accounts for much of the correction in values in the current market, with high inflation accounting for the majority of capital value falls in the early 1970s and early 1990s. Low inflation in the 2000s has meant that nominal values have taken most of the decline in value in this cycle, and to a large extent accounts for the apparently unprecedented correction in capital values compared with previous cycles.
Figure 1 shows prime office real capital value evolution in London West End from 1972. Since 1972 there have been five clear market cycles, three major cycles peaking in 1972, 1988 and 2006, and two smaller peaks in 1981 and 2000. What is remarkable is the similarity between the major cycles, and particularly between those in 1988 and 2006. Additionally, the gap between these major cycles is also broadly similar at 16-18 years peak-to-peak and with the two smaller mid-cycles having a 19 year peak-to-peak gap.
It is somewhat surprising that these cycles should be so similar given the continuing maturity and internationalisation of the sector in recent years and also the vastly different macro-economic conditions in 1973, 1988 and today. Interestingly, real capital values at the end of 2008 were broadly similar to where they were in 2001 or 1986, or even 1973, demonstrating the cyclical nature of the sector.
We have added Jones Lang LaSalle's capital value growth forecasts to the historic series to get a sense of our predicted recovery against the recoveries in previous cycles. Overall we are forecasting a return to growth in London West End in 2011 after a year of relative stability in 2010 and following the fastest rates of decline in 2009 (most of which we believe has already occurred). Broadly, our forecasts look to be on the mark when set against either of the previous cyclical recoveries. Our forecast for real capital values in 2010 is within 1% of the lows seen in previous market troughs in 1993 and 1976, each time reaching a floor within four to five years of the market peak.
We layered onto these long-term time series data linear growth trends to provide a view not only of which markets have the highest real trend growth rates (positive or negative) but also allowing us to see where markets stand today against these trends, where they will be against this trend for the forecast period and how this compares with previous market cycles.
Figure 2 (selected key markets out of a total of 27) presents the long-term real capital value change and the linear growth trend for four of Europe's main office markets (taken from a common starting date of 1985, at roughly mid-cycle so as not to distort the trend). Two of these markets, Paris and London West End, show positive trend growth, whereas London City and Frankfurt show negative growth. Out of a total of 27 Western European markets (historic data for CEE markets only goes as far back as the 1990s) we identified seven markets which had a negative growth trend and 20 with a positive trend, with growth rates ranging from +7.82% in Dublin, to -3.96% in London City.
For those markets with a negative growth trend we are able to explain the historic pattern. For example, real capital values in London City (see figure 3) have never recovered to the levels seen in the late 1980s, where the subsequent downturn was caused by both an oversupply in the City market and the development of neighbouring Canary Wharf.
At a similar time the German markets saw their peak in the late 1980s extended by a reunification boom where pricing levels were driven higher by domestic demand and, in real terms these German markets have never regained these high pricing levels in real terms. Nonetheless, even if markets do have negative trends this does not mean that values will not rise in future or that these markets are not already running significantly below long-term trend.
Looking at where markets stand today against the long-term trend reveals some interesting observations. London West End first broke through its long-term trend line in 2005 (the point at which capital values were growing faster than that indicated by the long-term growth trend) and at its peak was almost 45% above its long term trend. This situation has quickly reversed and London West End is now forecast to be 45% below trend in 2010 at which point real capital values are expected to reach their maximum discount against trend. A similar situation is repeated in London City, Paris and Frankfurt despite the very different cyclical trends (Frankfurt's maximum discount will be in 2011).
Looking at the broader picture across Europe (see figure) most markets are already below trend at the end of 2008, with almost all markets showing a maximum discount against trend by 2010. Compared with the last downturn the picture looks broadly similar, with 1992 signalling the start of discounts against trend and 1994 showing their maximum discounts.
Those markets which appear to be furthest below trend in 2010 are Madrid, Barcelona, London West End and Dublin, driven by heavy re-pricing but also reflecting strong long term trend growth rates.
Although German markets are not expected to show the largest discounts in Europe during 2010, within a German context they do represent the deepest discounts against trend on record.
Although not a complex or sophisticated approach, this analysis does provide a useful context for the current market, and provides some compelling visual evidence of historic patterns. While providing reassurance that we have been here before, the analysis also gives some additional support that markets could see their troughs next year. The historical evidence also validates our own forecasts that most markets will return to real capital value growth from 2011.
Europe's markets also show a wide diversity in their respective long-term growth trend, with a significant number of markets showing negative real growth trends. Although some of these can be accounted for by structural changes or individual events, it demonstrates that markets have a diversity of cyclical patterns and that understanding these historical trends is crucial in determining future growth trends and fair value pricing levels.
Finally, markets are moving into a period where between 2010-11 real capital values will be significantly below their long-term growth trends — a situation that has occurred in only a handful of periods since 1970.
Although we are not suggesting that this chartist approach should be the sole basis of an investment decision, we believe that often simple graphical explanations can be powerful and persuasive tools in the decision making process.
John Gardiner, associate director, EMEA capital markets research, Jones Lang LaSalle, assisted in the preparation of this article
Petra Blazkova is head of EMEA capital markets research at Jones Lang LaSalle
No comments yet