UBS: significant capital risk to prime pan-European real estate evident

Total quarterly investment volumes of €266bn were still below the long-term average and in terms of individual deals, according to RCA data, and 2018 was broadly comparable with the previous year.

UBS said the main difference (in the first quarter of 2019 as well) has been the lack of portfolio deals, which reflects lower levels of overseas capital targeting Europe.

However, UBS says there are signs that investors are becoming somewhat spooked by late-cycle dynamics and high prices; greater political risk and a weaker economic outlook.

“This is further exacerbated by weakness in the retail sector which saw investment volumes decline by -62% compared with the previous quarter and -62% compared with the previous year. Industrial volumes also fell 26% over the year, however this is largely attributable to the ‘Logicor effect’ and an overall decline. More resilient, however were the so-called ‘alternative’ sectors; residential saw volumes increase by +10% while hotels (-1%) and senior housing (-3%) only saw very moderate declines.

“The consequence of this rotation out of retail and into the alternatives offers one perspective on why volumes have been declining. Considering the ‘alternative’ universe is incipient in most countries and retail is almost uniformly the largest and most liquid sector, the result of this strategy shift means the opportunity set is significantly reduced. This is further driven by regional shifts in focus, as investors pull back from the larger markets with the UK (-16%), Germany (-10%) and France (-11%) all seeing volumes drop in 1Q19 (YoY), while more peripheral markets such as Ireland (+45%), Sweden (+15%) and Norway (+12%) all saw volumes increase.

“Besides this there is the very straightforward problem of high pricing combined with weak economic fundamentals. 1Q19 has seen slightly more positive data than was anticipated, however the GDP growth forecast for the Eurozone was still a very moderate 1.3% at the time of writing. When we consider the combined EU-15 prime yield is currently 3.74%, it is hardly surprising investors are struggling to underwrite transactions. Over the 12 months to 1Q19, the majority of European cities saw stable prime yields, although there was still compression. Munich compressed by a further 10 bps to reach 2.9%.”

This represents the first time a European city (excluding Switzerland) has broken the 3% boundary, says UBS. While Munich is the most expensive, all the other German cities are standing below 3-3.5%, a level significantly below the long-term average. The highest inward mover over the past 12 months was a 100 bps compression in Porto, however prime yields are still at 6% meaning there is certainly (prima facie) value compared with most other cities. No centers saw an outward yield shift in the 12 months to 1Q19, indicating an ongoing strength.

A big determinant of whether or not this pricing is sustainable will be the decision of the ECB regarding when and by how much to raise interest rates. The decision of the Federal Reserve in May to delay further rate rises for the foreseeable future has given the ECB further breathing space in this regard. If interest rates are to remain and hence government yields at such low levels, UBS says we are less likely to see large outflows from core real estate.

UBS concludes:

“However, as a liquid asset class, government bonds can reprice overnight, and a sudden shock could push yields out and impact valuations. Therefore, we consider there to be a significant amount of capital risk to prime real estate in the current market and are reiterating the value of strong asset management and durable income returns.”

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