European average prime office yields have now edged below 3.60% for the first time, while logistics yields were down by an average of 10 basis points in the first quarter alone, also hitting a new low of 4.85%, according to data cited by DWS. Prime shopping centre yields, on the other hand, have risen by 20 basis points over the past year, as investors increasingly shun the sector. And the picture is even more challenging for secondary retail, where yields are up by around 40 basis points.
But investors are still sitting on significant capital; Europe-focused dry powder in the private equity space reached a record €68 billion in June 2019. At the same time, borrowing costs are low, long-term bond yields have fallen again in the early part of the year, occupier fundamentals are healthy and the supply pipeline remains in check. And compared to other fixed income investments, real estate continues to look attractive, with an average prime office yield spread of more than 250 basis points over 10-year government bonds.
The combination of these factors mean that we still expect to see a further decrease in property yields over the next 12 months or so, says DWS.
Simon Wallace, Head of Research, Europe, at DWS, explains:
“Beyond next year, in our central case scenario we see bond yields beginning to edge higher, slowly narrowing the real estate yield spread. And at the same time, below trend economic growth and a rise in the amount of new space being completed are set to act as a brake on rental growth. With this in mind, we would not expect further yield compression after 2020, although with a more dovish stance from the ECB suggesting a lower future path for interest rates, we have revised down our outlook for future outward yield movement. We now expect office yields to move out by just 20 basis points and logistics yields to remain broadly flat over the next five years.
“That said, while slower yield expansion is typically good news for capital values, it is likely to come at the expense of lower trend rental growth. Capacity constraints and weaker demographic trends mean that we see relatively limited upside for long-term economic growth, and should interest rates remain lower for even longer, this is likely to be accompanied by a reduction in the outlook for inflation and economic growth.
“Following some initial volatility, UK yields have actually been relatively flat over the past two years, and while we do foresee some further short-term outward movement in Central London, the United Kingdom should actually be an outperformer in the medium to long term as already elevated yields give more breathing room and also equate to a higher income return. Nevertheless, this view is highly dependent on the [UK] prime minister overseeing an orderly Brexit, and clearly there are downside risks here.
“Yields continue to trend downwards in Germany and France, but the strongest compression is currently being seen in CE offices as investors look for additional income return, as well as Nordics logistics, attracted by the region’s strong consumer fundamentals. Overall, logistics and shopping centres are now priced similarly, and we expect that in the second half of the year, logistics yields will dip below shopping centres for the first time. Logistics has also significantly closed the gap over offices, with the spread between the two sectors narrowing from 200 basis points five years ago to just 130 basis points currently. We expect the popularity of logistics to be reflected in a further narrowing of this spread over the next five years.”