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Marketing Material Research Report Europe Real Estate Strategic Outlook February 2016 Please note certain information in this presentation constitutes forward-looking statements. Due to various risks,
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Marketing Material Research Report Europe Real Estate Strategic Outlook February 2016 Please note certain information in this presentation constitutes forward-looking statements. Due to various risks, uncertainties and assumptions made in our analysis, actual events or results or the actual performance of the markets covered by this presentation report may differ materially from those described. The information herein reflect our current views only, are subject to change, and are not intended to be promissory or relied upon by the reader. There can be no certainty that events will turn out as we have opined herein. Certain Deutsche AM Real Estate investment strategies may not be available in every region or country for legal or other reasons, and information about these strategies is not directed to those investors residing or located in any such region or country. For Professional Clients (MiFID Directive 2004/39/EC Annex II) only. For Qualified Investors (Art. 10 Para. 3 of the Swiss Federal Collective Investment Schemes Act (CISA)). Not for distribution. Institutional Investors only. Table of Contents 1 Executive Summary 3 2 European Real Estate Strategic Themes 4 3 The Economy 6 4 Real Estate Performance Occupier Fundamentals Capital Markets and Pricing Commercial Real Estate Returns Market Positioning Calls 15 5 Office Market Outlook and Strategies Current Conditions Outlook Strategies 17 6 Retail Market Outlook and Strategies Current Conditions Outlook Strategies 19 7 Logistics Market Outlook and Strategies Current Conditions Outlook Strategies 21 8 Residential Market Outlook and Strategies Current Conditions Outlook Strategies 23 9 Real Estate Securities Overview of Key European Markets 26 Important Information 34 Research & Strategy Team 35 2 Europe Real Estate Strategic Outlook February 2016 1 Executive Summary Our outlook for Europe remains one of gradual recovery. However, unlike previous years and notwithstanding macro shocks, Europe seems on a firmer footing due to a combination of factors, namely; Quantitative Easing, a weaker Euro, the stimulating effects from immigration, lower energy costs and structural reforms in certain labour markets. Although the continent hasn t been immune to recent global uncertainty, consumers and businesses seem so far undeterred, leading to an acceleration of GDP growth in The underlying drivers of the real estate occupier market continue to improve. The market balance remains fragile and there are still risks to the recovery, but occupancy is improving across a number of locations and rental growth is starting to accelerate. Across the major commercial sectors, development activity has been exceptionally low for a number of years now. For both offices and shopping centres, the past four or five years have represented the lowest levels of net completions for more than two decades. And while activity in the construction sector is slowly beginning to pick up, it is still subdued by historical standards, and therefore vacancy rates should continue to decline over the coming years. The real estate investment market showed signs of ongoing strength in 2015, with all property transaction volumes exceeding 270 billion 2, a rise of more than 23% year-on-year. Given this weight of capital, yields across a large number of markets continued on their downward path in the final quarter of Despite this, property still looks attractive on a relative basis, with government bond yields remaining near record lows. However, as total real estate investment volumes begin to show signs of peaking and with bond yields expected to pick up in the medium term, we are forecasting property yields in the majority of locations and sectors to reach a floor over the next two years. Annual pan-european property returns for 2015 are not yet available from MSCI, but signs from those markets that report quarterly data are positive. In the prime market, returns also continued to strengthen. We estimate all property prime total returns last year were 17%, up from the 14% recorded a year earlier and the strongest performance since We are still expecting returns to moderate gradually over the coming years. That said, given the outlook for bonds to remain lower over the medium term, we do not foresee any significant downward correction to our return projections, despite recent outperformance. All property prime returns are set to average 6% 3 over the next five years, with the logistics sector performing slightly better than both offices and retail. Total returns are forecast to increasingly be driven by rental growth over the rest of the decade as the impact of yield compression lessens. On a risk adjusted basis, we believe Spain, the Netherlands and the Top 7 German cities are currently offering the most attractive returns, with Regional France and Sweden also presenting interesting opportunities. While Central London and parts of Central Paris are currently seen as relative underperformers on a five year average, both are likely to have returned to prominence by the end of the decade. Strategically, core real estate remains an attractive investment, offering a stable and relatively high income return at a time of continued global uncertainty. Here we see the greatest opportunities in the residential sector, parts of the logistics markets, and across central retail and office locations where assets cannot be easily replicated. While the improving demand environment may open up opportunities to take on additional risk, given a plentiful supply of space in secondary locations, this strategy should only be undertaken very selectively. 1 Oxford Economics, January Past performance is not an indicator of future results. 2 RCA, February Past performance is not an indicator of future results. 3 Deutsche AM, January Past performance is not an indicator of future results. Europe Real Estate Strategic Outlook February 2 European Real Estate Strategic Themes 4 The Alternative and Real Assets (ARA) Research team has developed a proprietary quantitative model that forms the foundation of our understanding of future real estate market performance and how it reacts to economic developments. This is combined with the qualitative insights from our investment teams and also considers a number of risks (e.g. political risks) and sentiment, and provides in total the basis for our market views. Status Quo: Core real estate saw strong capital value growth during 2015, but despite taking some of this upside, the rationale for investment remains intact, with the asset class still offering attractive returns relative to other parts of the real estate market and when compared to asset classes such as bonds. Our current Top 5 investment recommendations include a sell strategy, while also cautioning against specific actions at this time in the cycle. Some strategies (German residential, refurbishments of standing investments) should offer options throughout the cycle. While the current outlook for Central London is one of weak risk-adjusted returns, this should change within the forecast period, offering attractive counter-cyclical entry strategies with high capital growth potential before the end of the decade. We are conscious of political risks that make certain themes vulnerable to review over the next six months. Our resulting forecasts and house views are presented in terms of a number of executable strategies that facilitate detailed discussions with our investors regarding European real estate over the next six months. The following five recommendations represent our top calls for the European market: 1. Supply scarcity in German residential: We recommend a focus on the low-to-medium price segment where tenant demand is hugely outweighing supply, as capital values are still some way below replacement costs. The pressure on the residential market has been high for 12 months, but with the large number of refugees this should further increase demand for affordable space in a number of large and medium sized cities. This strategy does not focus on a significant capital growth element, as rent regulation has become a political battleground and the discussion is often sensitive. When looking at Top 7 locations, investors may only achieve modest cash returns over the holding period. However, those looking for a stabilising element in their portfolios should appreciate the exposure to defensive investments where void risks are as low as they can get in the context of European real estate. 2. Higher income and long-term change in the logistics sector: While the most attractive entry period in this sector has likely passed, given that yields have dropped sharply over the past 24 months, the sector still offers some of the highest risk-adjusted returns over the next five years. Income returns in France, Italy and Benelux are still above 5% and provide a healthy risk premium over sovereign bond yields. More importantly, the logistics sector provides a compelling investment outlook for a few key reasons. The rise of e-commerce in combination with increased urbanisation will continue to drive demand for space in locations with easy access to large and expanding conurbations. Currently the logistics sector is seeing polarisation between infrastructure-linked large mega-distribution / e-fulfilment facilities and smaller edge-oftown urban parcel delivery centres. Over time, available land will become scarcer, which will increase competition for the best located schemes. Long-term prospects are favourable, which could result in narrowing spreads relative to more established sectors. 3. Underweight London today but prepare for a return: ARA Research is currently underweight to Central London given affordability constraints, rising supply and a projected interest rate rise. With this in mind, there is a high risk of a large capital value adjustment. However, the long-term fundamentals of London are good and we anticipate a strong bounce back after the adjustment, as is typical in this market, supporting outsized returns. While our underweight call remains valid over the next 12 months it s already time to prepare to move back in once market adjustments/corrections materialise. The current forecast suggests this could be as early as 2018 although key indicators should be closely monitored to evaluate the cycle on a regular basis. The coming correction should be less severe than in previous cycles, but nonetheless large enough to reward investors with elevated returns during the up-cycle. 4. Avoid the value trap: It s a common feature in the later stages of a real estate cycle that investor start to explore higher yielding segments to achieve projected returns above their hurdle rates. This can work but 4 Any forecasts provided herein are based upon Deutsche AM s opinion of the market at this date and subject to change dependent on the market. 4 Europe Real Estate Strategic Outlook February 2016 it is very risky, in particularly, when Investors targets lack competitiveness. In particular assets in out of town office parks are vulnerable to long-term void periods when major lease events collide with new development completions and tenants are poached. Also the segment remains illiquid in large parts of the cycle, which makes the holding period anything but flexible. Also rents are typically exposed to (at times significant) downward adjustments when occupiers prolong their lease or new leases are agreed. Investors should rather look at this segment at the beginning of a cycle, shortly after values got punished by capital markets fleeing into haven assets. This is when replacement costs are way above current values, the yield spread vs. prime is close to its peak and owners can aggressively price out competition for tenants throughout the holding period if needed. 5. Use the favourable investment market for disposal of non-core assets: The non-core segment has finally become liquid again. We advocate using the strong influx of overseas money to dispose of those buildings that will deteriorate further in coming cycles due to age, location or general quality. This opportunity doesn t materialise often and large fund managers should use this window for serious portfolio optimisation. A detailed hold and sell analysis should identify those assets that could even be sold at a loss, as additional time will most likely not cure major deficiencies. Portfolio sales could be an efficient way to carry out this strategy, as in particular USD investors seem to have a strong appetite for Euro assets at the moment. In addition to those detailed above, we see a number of other compelling investment calls. These include, buy calls on prime retail on the major high streets which continue to attract international retailers looking to showcase and brand build, and in the Iberia markets where a strong rental rebound is now being realised. A call for caution against style drift, and a Sell call to realise gains in those markets that look to have reached the top of their cycle. Top 5 Theme Type Sector Country Focus Main rationale Supply Scarcity Buy Resi Germany Multi-Family Regional migration; massive shortage of supply Higher Income Buy Logistics Pan-Europe Growing Metros Exploit impact of megatrends; population and urbanisation Prepare to Return Buy Office London Prime Pitch Buy counter cyclical from 2018 onwards Value Trap Caution Office Pan-Europe Out-of Town Caution towards out of town locations with structurally high vacancy Portfolio Sales Sell Office Pan-Europe Underperformer Take advantage of short time window to dispose non-core assets Buy Caution Theme Type Sector Country Focus Main rationale Prime Office Buy Office Pan-Europe Prime Pitch Stable income allowing asset to be held across cycle Highstreet Buy Retail Pan-Europe Highstreet Supply constrained. Demand for brand building / showrooming Regional Hubs Buy Various Pan-Europe Late recovery markets Exploit good value in regional late recovery markets Iberia (Top 3) Buy Office Iberia Central locations Take advantage of improving occupancy and rent growth potential Refurbishments Buy/Hold Various Pan-Europe Refurb/Lease Up Create value improving well located standing investments Spec construction Buy Various Pan-Europe Spec Construction Exploit low availability in major office, residential and logistics hubs Theme Type Sector Country Focus Main rationale Prepare to move Caution Office CEE Prime Pitch Yield spread looks attractive but political risks haven risen sharply Style drift Caution Office Pan-Europe Non-prime assets Caution against assets with risk in excess of portfolio strategy Economic Risk Caution Various Finland All Economic weakness and emerging political risk Political Risk Caution Various Various All Growth of non-mainstream parties; regional separatism; stresses to E.U. Theme Type Sector Country Focus Main rationale Sell Markets at Peak Sell Office Pan-Europe CBD Realise strong capital gains of current cycle Source: Deutsche AM, January The comments, opinions and estimates contained herein are based on or derived from publicly available information from sources that we believe to be reliable. We do not guarantee their accuracy. This material is for informational purposes only and sets forth our views as of this date. The underlying assumptions and these views are subject to change without notice. Europe Real Estate Strategic Outlook February 3 The Economy Our outlook for Europe remains one of gradual recovery. However, unlike previous years, Europe seems on firmer footing due to a combination of factors, namely; QE, a weaker Euro, the stimulating effects from immigration, lower energy costs and structural reforms in certain labour markets. Although the continent hasn t been immune to recent global uncertainty, consumers and businesses so far seem undeterred, leading to an acceleration of GDP growth in Despite financial market volatility and some moderation in January, many lead indicators continued to show solid growth in early This was evident in the Purchasing Managers numbers which showed private sector growth in the Eurozone still expanding at a decent pace. 6 And with the European Commission s Economic Sentiment Indicator still well above average in January, this suggests that this growth should be sustained throughout the early part of The acceleration of growth is being driven by the consumer and exports. Household balance sheets are benefitting from the continued fall in fuel prices and the creation of an additional 2.5 million European Union jobs over the past year, while the weakening of the Euro supported export growth of around 5% in Going forward business investment is set to become an increasingly important part of the recovery story, having been hampered by banking sector deleveraging, as credit conditions are now easing. 8 Euro depreciation has come on the back of further easing by the ECB. The ECB has not been alone in loosening, with rate cuts seen in both the Nordics and the CEE. With inflation running close to zero, record low bond yields remain with 5-year yields negative in countries such as Germany and Sweden. This return to growth is not expected to be highly inflationary. Although the drag from falling oil prices will likely fade this year, there remains considerable spare capacity and monetary policy should thereby remain accommodating for the rest of the decade. With this, the relative attractiveness of real estate income returns should be favourable for some time. Even in the United Kingdom, where policy rates may rise as early as 2016, rates are forecast to be less than half their pre-recession level at the end of the decade. 9 Annual Average GDP Growth (2016f-2020f, %) Source: Oxford Economics, December Note: f = forecast. There is no guarantee that the forecasts will materialise. 5 Oxford Economics, January Markit, February European Commission, February European Central Bank, October Oxford Economics, January Europe Real Estate Strategic Outlook February 2016 GDP growth in Europe is still tending to be strongest in countries outside the Eurozone, although the gap is closing. Although on average the outlook is little changed from six months ago, countries such as the Netherlands and Sweden have been modestly upgraded. Of the three largest economies accounting for half of E.U. output Germany is doing well and is likely to benefit from additional spending to support recent inflows of refugees, while the French recovery may now gather pace in 2016 on the back of a more business friendly policies environment. Having slightly disappointed in 2015, the United Kingdom is set to remain one of the better performers over the coming years, although uncertainty over E.U. membership could dampen activity in the run up to the referendum. Across the rest of Europe, Spain saw some of the highest growth in 2015, and should continue to benefit from previous reforms and cost adjustments, while Italy is showing signs of outperforming expectations. The exporting countries of the Benelux are set to benefit from the weaker Euro, while Sweden is the stand out performer in a Nordics region buffeted by lower commodity prices and required structural adjustment. CEE countries should further converge with Western Europe, although recent moves by the new Polish government have increased downside risks to the outlook. The unemployment rate fell across virtually every country in the European Union during 2015, 10 and on aggregate is forecast to trend lower over the rest of the decade. Despite projections of an almost unchanged working age population, the revival of the labour market is set to create an additional six million jobs by 2020 and will be one of a key driver of real estate demand. 11 Employment Growth ( f, % p.a.) Source: Oxford Economics, January Note: f = forecast. There is no guarantee that the forecasts will materialise. Political risk remains evident across the continent. Elections
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