Two-storey market

An escalating sovereign debt crisis has triggered the emergence of an increasingly polarised European office market. John Danes looks at the diverging fortunes of north and south

A worrying escalation of the sovereign debt crisis took place in the summer. However, there are significant divergences in growth dynamics in Europe, reflecting large structural economic differences. We expect Northern European countries to show steady growth in the years ahead, even as economies of the south stagnate or go back into recession.
Southern Europe and Ireland have suffered from a combination of housing/construction booms and busts and a loss of competitiveness. Moreover, a false sense of security over long-term economic prospects, within the shield of the euro, encouraged excessive debt accumulation (at the private and or public level) at very low real interest rates.

There is a stark contrast with much of northern Europe and the Nordics, where economic fundamentals are much stronger. Germany, Benelux, France and the Nordics generally have a combination of lower government and private sector debt, and are more competitive, as labour costs have grown at a slower pace than that of their main trading partners. Most northern European economies run a current account surplus. Only France has a modest deficit. In contrast, all southern European economies have ongoing large foreign trade deficits, despite depressed demand conditions in recent years.
Pressure on southern European economies is forecast to intensify into 2012 as aggressive fiscal tightening is pursued, prolonging the weakness in activity. Northern Europe also faces a short-term slowdown, due to softer growth in the US and emerging markets, but is better placed to rebound by the end of 2012. However, robust growth in emerging Asia, a strong domestic profits rebound and low European interest rates all point to balanced risks for the rest of Europe, despite decreases in consumer spending over the next 12-24 months in Europe, and the potential for a financial shock instigated by southern Europe.

Despite the escalating sovereign debt crisis, the office occupational market has continued to gradually improve across Europe in the first half of 2011. Prime rents have stabilised in almost all markets over the past quarter, with the exception of Spain, Greece, Ireland and Portugal. In many locations, prime rental growth has resumed. Examples include London, Paris, Stockholm, Oslo and most German cities. There remains a pronounced difference between prime and secondary (as well as CBD and non-CBD) rental trends, with secondary and average rents at best stable, or continuing to fall in some markets. Vacancy rates have also stabilised in the majority of cities, aided by a gradual pick-up in occupier demand and development levels remaining very low. Take-up has increased across Europe, although only London has experienced a substantial fall in vacancy levels.

The shortage of new supply is likely to continue, hindered by the lack of development finance. This is projected to aid the eventual return of more widespread rental growth, despite the weak pace of the economic recovery.

Prime yields have continued to fall in the majority of markets across Europe over the past quarter. Yields have fallen as the occupational market recovery has given investors more confidence in prime property, while government bond yields and interest rates have remained low in the core European economies, making property look attractive from an income perspective. The UK has been an exception, as prime yields have now stabilised following an increase in capital values of 17% since the bottom of the market. Investors remain keen on prime assets, let to strong covenants with long income streams - although demand has waned again for more secondary assets. As a consequence, the pricing gap between prime and non-prime assets has continued to widen.

Investors and lenders remain risk averse and investment and lending activity remains focused on prime property. Non-prime property is forecast to see further falls in values over the next year. Banks remain reluctant to provide finance for new investment, even with low funding costs and the high margins now being charged. Banks are projected to continue to gradually reduce their over-exposure to the sector. Nevertheless, we anticipate a gradual increase rather than a sudden glut of investment property coming onto the market from the banks, despite capital covenant breaches. Banks have generally tolerated such capital breaches, as long as interest payments are being made. Low funding costs, and the high cost of breaking swap contracts tied to property loans, often means that banks are under little immediate pressure to dispose of assets.

Weaker economic growth, compounded by the sovereign debt crisis and further public spending cuts and tax increases across Europe is likely to lead to a modest correction in capital values in 2012, although this is projected to be predominantly for secondary assets. Well-leased assets are most likely to outperform during this period. The correction in secondary assets may well be more prolonged, as eventual increases in interest rates across mature economies should compel banks to cut their exposure to poorer quality loans, as debt servicing becomes more difficult.

Debt is not necessarily required to support property market values, as equity can, as it
has done in the past, step up as a key source of capital. However, equity is seeking an appropriate return for high-risk assets, which does not look attractive at today's market prices given the very moderate outlook for occupier demand outside of prime segments of the market.

We are projecting a sharp divergence in performance across Europe. The core European markets such as France and Germany are forecast to perform well. The Nordic markets are also expected to deliver strong performance, aided by generally low levels of public and private sector debt, and the flexible nature of their economies, resulting in stronger rates of rental growth.

One cautionary note is that for absolute prime office properties in the Nordic countries, yields have fallen back to low levels and are starting to look expensive. Nevertheless, Nordic rental growth prospects are among the strongest in Europe. With a stronger occupational market, the higher income return of secondary assets is forecast to look more attractive, especially if investment managers can exploit asset management opportunities.

The UK, aided by an independent monetary policy, has benefited from the depreciation of sterling. The UK is forecast to be a marginally above-average performer in a European context. However, it has dropped down our ranking, partly because property values have recovered much more rapidly than in most other European markets.

Ireland and some of the southern European economies are struggling with large and rapidly increasing government debt levels, and do not have ability to let their currencies devalue. Economic growth in these markets is projected to be held back by the public spending cuts being implemented. The weakest performers in terms of total returns are Greece, Portugal, Spain, Ireland and Hungary, hindered by weak economic growth, high and rising government debt and modest investment demand.

John Danes is head of European office research at Aberdeen Asset Management