New research from global real estate investment manager AEW suggests that while stagflation is now the 'base economic scenario', Europe's markets are largely ready to deal with the challenging economic outlook.
AEW's mid-year European outlook, which contains updated forecasts following the outbreak of the Ukraine conflict, analyses the short term view for occupier markets, looking at different assets classes in some depth.
Said Hans Vrensen, managing director, head of research & strategy at AEW, added: 'The world is in a very different place to when we published our previous outlook in November last year.
'The Ukraine conflict and supply chain disruption caused by both the sanctions against Russia and the continued Covid-19 lockdowns in China are both slowing the post-Covid global GDP growth recovery and leading to higher levels of inflation. As a result, our economic base case assumes a period of stagflation with lower for longer bond yields.'
As above-target inflation endures, the report notes that Eurozone bond investors have now priced in some rate hikes for 2023 and tapering of quantitative easing for late 2022.
AEW’s base case assumes only limited and modest rate rises – given hikes are ineffective against imported commodity and energy inflation – and that government bond yields will remain lower-for-longer. The upside and downside scenarios assume more pro-active central bank tightening and bond yield normalisation.
Occupier outlook promising
In terms of occupier markets, post lockdowns, some normalisation is returning. This is evident from a partial reversal from record levels of online sales share as consumers return to physical stores. The most recent UK mobility and occupancy data also confirm a return to the office.
The report notes that prime rental growth across all sectors came down by half from 1.8% pa to 1.2% pa for the 2022-26 period. Prime rental growth across residential and logistics markets – sectors less sensitive to GDP growth - shows continued strong momentum at just above and below 2.5% for the next five years.
On the other hand, prime office rental growth halved from just over 2% pa to 1% pa and forecasts for prime shopping centres also reduced significantly.
Added Vrensen: 'With slower GDP growth expected to reduce future rental growth, our analysis forecasts that prime property yields will remain broadly flat over the next five years.
'Importantly, the European real estate market remains robust with low vacancy rates and limited risk for oversupply of space or excess financial leverage. Recent capital raising data confirms that the stability of real estate income remains in place and still appeals to many investors. However, in this period of stagflation, a selective and disciplined approach to investment will be crucial.'
Sector breakdown
Prime logistics is projected to have the highest average return (just above 6% pa) of any sector in the next five years, due to the sector’s strong rental growth.
Prime shopping centres are the second ranked sector with a forecasted total return of just under 6% pa over the next five years due to the high current income return. The significant re-pricing in retail recorded over the last 3-4 years did not take into account the difference in quality between prime and secondary assets.
In a cross-country comparison, the UK comes out on top showing consistently higher income and total returns, as yields did not tighten in as much in the UK compared to most Continental European markets post-Brexit. Germany shows significant capital growth despite lower income returns compared to other countries.
Focus shifts to income with no capital growth increases expected in France, Spain and Italy for the next five years and negative capital growth in CEE markets.
AEW’s updated risk-adjusted return approach shows an average positive excess spread of the expected rate of return (ERR) over the required rate of return (RRR) of 25 bps for the 168 European markets covered. This represents a significant decline of 165 bps in the excess spread versus the previous September 2021 base case.
