European Commercial Property

The value of the office sector and diversification of European markets.

Investment activity in Europe's commercial property markets slowed in the second quarter, with €26.2bn traded, 11.5% less than in the opening three months of the year. However, trends were far from uniform market by market, with offices fighting back against retail and core markets gaining at the expense of the peripheries.

Michael Rhydderch, Head of European Capital Markets at Cushman & Wakefield, said: Quarterly trends can be hard to read given the time it takes for property to trade and the changing conditions we see month to month. What cannot be denied though is that less stock has been sold than we had expected, with volumes in the year to June actually dipping slightly to €122.4bn. What we have noticed in particular is that average deal times have lengthened due partly to very thorough due diligence by sponsors and extended credit approval processes.

Another notable feature of the quarter was the renaissance in the office sector, which saw its share of activity rise from 36% in Q1 to 46% in Q2, with trading up 10% compared to falls of 35% for retail and 46% for industrial.

According to David Hutchings, Head of European Research at Cushman & Wakefield, the economic picture has become more favourable for offices. Investment spending by companies is rising and recruitment is up in some cities. What is more, while corporate Europe is not in such a bad shape, consumer expenditure will face pressure for some time to come and will be slower to benefit from the economic recovery than many had hoped.

Investors are very much focused on prime office markets as they look to squeeze risk out of the equation and the best long-leased stock may yet see yields fall further as a result. However, while secondary demand is weak, some investors are now ready to take a calculated risk to achieve higher returns, for example on occupancy levels or development as they look to take advantage of supply shortages which are starting to emerge.

Another reason for a fall in the retail market share has been the fact that fewer large deals have completed than in the opening quarter. According to Rhydderch, While a range of investors seem to have rediscovered their faith in the office market, retail remains in high demand but the patterns we see country by country and sector by sector are getting more and more variable. The UK, France and Germany are top targets for most investors but their relevance in each sector differs, as does the nature of the other targets being pursed. The Nordics are back in vogue, with Sweden re-emerging as a strong favourite across the board while Norway and Finland have seen stronger office demand. Russia is seeing good demand from risk taking office buyers, while Poland remains particularly popular for retail. Looking forward meanwhile, the Czech Republic is set to see more retail activity while the Netherlands should break into the top five markets for industrial activity.

Domestic funds have been a key driver of activity in most markets but international investors are a growing source of demand, with their share of activity up to nearly 35% in the first half of the year versus 31% in the second half of 2010.

There has also been further evidence of a shift back towards core markets. The big three: the UK, Germany and France, maintained their market share at 64% - with Germany the stronger, France stable and the UK down a little, but the West overall saw better growth, with Austria, Denmark, Norway and Sweden leading the upturn. The Nordics did particularly well; with volumes up to €4.4bn in quarter two from €2.4bn in Q1.

At the same time, many emerging markets saw their share of activity fall back. Central and Eastern European activity fell from €3.9bn to €2.1bn. As in the West however, emerging markets should not be viewed in one light - Turkey and Russia saw good office demand while Poland is frequently ahead of some western markets in investor risk assessments.

What was more marked was a fall for the markets most mired by concerns over sovereign debt. The so-called PIIGS saw activity drop 42% between Q1 and Q2 while in the rest of the Eurozone, trading actually rose by 6.7%.

According to Hutchings, such diversity in the market is going to increase. Whether you look at economic numbers for output or demand, employment or pricing we see an increasing divide between European markets. Even if sovereign debt fears start to settle now that a second rescue package is in place for Greece, the pricing of country risk in bond, equity and property markets is likely to remain steep.

The fundamental strengths of markets such as Sweden, Germany and France are set to keep them high in investors' minds continued Hutchings, but attitudes towards other markets may become more divergent from the underlying economic or macro trends, particularly as more investors look to take advantage of what may be overly cautious pricing in some areas. Each country has its own unique overlay to consider - such as the current relative under supply of quality stock in Italy, the availability of high quality stock at high yields in Portugal or the high tenant demand and high yields of Moscow.

Many of our teams have been reporting increasing levels of demand over the past few months but while some countries will post strong growth in the second half of the year, others will struggle to match last year's level of trading," stated Rhydderch. "Nonetheless, a steady easing in nerves over the sovereign debt crisis may open the door back into markets which are off the list for core investors now. Our expectations are still for a pick-up in activity in the second half of the year based on current deal activity and the fact that more property is coming on to the market, particularly from the banks. Our current forecast is €133bn, up from €117bn last year. However, while there is enough demand and now product to reach this figure, with deal times stretching longer, there are clear risks that the market may fail to hit the overall transaction volumes forecast, concluded Rhydderch.

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