DTZ Foresight European Fair Value Q Non-core markets drive temperature rise

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1 DTZ Foresight European Fair Value Q3 Non-core markets drive temperature rise 18 November Contents Overview 1 Fair Value Index 2 Fair Value Classifications 3 European Market Classifications 4 European versus Global Forecasts 5 Office Market Forecasts 6 Retail Market Forecasts 7 Industrial Market Forecasts 8 Economic Drivers 9 Authors Ben Burston Forecasting & Strategy Research +44 (0) ben.burston@dtz.com Matthew Hall Forecasting & Strategy Research +44 (0) matthew.hall@dtz.com Contacts Magali Marton Head of CEMEA Research magali.marton@dtz.com Tony McGough Global Head of Forecasting & Strategy Research +44 (0) tony.mcgough@dtz.com Hans Vrensen Global Head of Research +44 (0) hans.vrensen@dtz.com The DTZ Fair Value Index (FVI) score for Europe has risen to 55, indicating that there are, on balance, better investment prospects than in Q2, when the score was 49. Across Europe, the number of HOT markets has increased from 20 to 23, while the number of COLD markets has fallen from 21 to 14. Additionally, the number of WARM markets increased from 49 to 62. The changes in the FVI were most heavily influenced by improvements in the office sector, where the score rose from 35 to 46. The industrial sector is also increasing in attractiveness, with the FVI score having risen to 63. Prospects for investment in the retail sector remain similar to Q2, with the FVI score broadly stable at 62. Six markets have seen upgrades over the last quarter by moving from WARM to HOT: Warsaw retail, Manchester industrial, Warsaw offices, London West End offices, Madrid offices and Copenhagen industrial (Figure 1). Additionally, 10 markets have moved from COLD to WARM. The list is dominated by four regional UK office markets along with other non-core European office markets including: Lyon, Oslo, Malmo, Bucharest and Barcelona and one industrial market - Bucharest. Among the major European office markets, only London City offices remain HOT. However, nearly all of the major markets including Paris and Frankfurt offices - are classed as WARM. While the European FVI scores improved in Q3, they remain lower than in the US and Asia-Pacific, where investors are benefitting from higher growth prospects over a five-year holding period. Figure 1 Selected changes in Fair Value rating Q2 to Q3 Q2 COLD WARM HOT Q3 COLD WARM HOT Lyon office Lyon retail Manchester office Budapest office Oslo office Barcelona office Amsterdam office Edinburgh office Paris CBD retail Frankfurt office Rotterdam ind. Dublin office London WE retail Berlin retail Amsterdam retail Warsaw retail Madrid office Warsaw office London WE office London City office Milan retail Antwerp industrial 1

2 Fair Value Index European Fair Value Index score rises above 50 in Q3 The DTZ Fair Value Index score for Europe has risen to 55, indicating that there are, on balance, better investment prospects than in Q2, when the score was 49 (Table 1). Table 1 European Fair Value Index scores Q3 Q3 Q2 Europe all-property Europe office Europe retail Europe industrial Global all-property Global office Global retail Global industrial The increase was most significant in the office sector, where the score has risen from 35 to 46. The industrial sector is also offering more opportunities, with the index score having risen to 63. Prospects for investment in the retail sector remain similar to Q2, with the index score broadly stable at 62. While Europe is now presenting more attractive investment opportunities, it remains less attractive than the other regions globally. Table 2 European market classifications Q3 HOT markets Change since Q2 COLD markets Change since Q2 Europe allproperty Europe office 6 10 UK all-property 4 5 UK office 2 4 Germany allproperty France allproperty 1 1 CEE allproperty 7 3 Nordic allproperty 2 3 Rest of Europe all-property 7 2 Source: DTZ Research Across Europe, the number of HOT markets has increased from 20 to 23, while the number of COLD markets has fallen from 21 to 14 (Table 2). This shift has occurred across several countries, such as the UK, France and the Nordic region. The improved investment outlook has come about because several markets have become HOT in Q3, some as a result of an improved rental outlook, and some because of an outward yield shift which has made pricing more attractive to investors. Box 1: Guide to the DTZ Fair Value Index The DTZ Fair Value Index is intended to provide investors with insight into the relative attractiveness of current pricing in global commercial property markets. Fair Value Index scores reflect the proportion of HOT and COLD markets, with higher scores implying more HOT markets. Index Page 2-3 Markets are categorised by comparing expected and required returns. Markets estimated to be more than under-priced are classified HOT; markets more than over-priced are classified as COLD; and, markets between this range are classified as WARM. The DTZ Fair Value Index is a forward looking index based on econometric forecasts incorporating local econometric drivers and local market knowledge. Fair Value Classifications Property Forecasts Economic Forecasts Page 4 Page 5-8 Page 9 For further information on the methodology used for classifying different markets and calculating Fair Value Index scores, see the DTZ Research report: DTZ Fair Value Index TM Methodology 2

3 Fair Value Classifications Figure 2 Regional Fair Value Index scores Q Figure 3 DTZ Fair Value Index Score Global Europe Asia US UK Pacific Cold Warm Hot European Fair Value by sector Q Figure DTZ Fair Value Index Score All property Offices Retail Industrial Cold Warm Hot European Fair Value Index: change from Q2 to Q DTZ Fair Value Index Score Published Q2 Restated Q2 Q3 Cold Warm Hot European market broadly balanced relative to other regions While the European Fair Value Index scores improved in Q3, they remain lower than in the US and Asia-Pacific, where investors are benefitting from higher growth prospects over a five-year holding period (Figure 2). Core European markets are generally more highly priced as investors are seeking high property quality assets in an environment of low risk-free returns. This behaviour has driven down yields in several core European markets. With lower yields, investors will be more reliant on income returns in coming years, as capital growth prospects are subdued. Office sector upgraded, but still less attractive While several office markets have improved ratings this quarter, the sector remains less attractive than the retail and industrial sectors (Figure 3). As investors re-entered the market following the sharp downturn in and, yields in the office sector shifted inwards more markedly, notwithstanding that, rental growth prospects remain subdued outside of a few core centres. Box 2: Why do we restate previous quarters DTZ Fair Value Index scores? Mixed prospects place DTZ European Retail Fair Restatement Value Index of well previous above quarter 50 scores is mainly needed because the DTZ Fair Value Index (FVI) TM is a 5-year forward looking index. Restatement is required to incorporate actual market pricing and forecast changes each quarter. This ensures that the index is a true indicator of market attractiveness, rather than what was perceived at the time. Consequently, previous quarters index scores will mature over time, as pricing and forecasts are updated. Restatements for earlier vintage FVI scores will be less significant as a smaller portion of the 5-year assumed holding period is left in the future. After 5 years, a FVI score will no longer need to be restated, as it has then become 10 historic with no forecast element. Furthermore, the addition of new markets to the index coverage over time is likely to lead to slight restatements to the historical FVI scores. Increased transparency will trigger these additions, as forecasts become feasible for more markets. This will further support the robustness of our FVI. For instance, this quarter we have added four office markets to our coverage: Paris Western Crescent; Paris West Bank; Geneva and Gothenburg. For the above mentioned reasons, our restated Q2 FVI score will be different from the previously published one, as illustrated in Figure 4. For the avoidance of doubt, when comparing individual market classifications, we use the originally published ones. 3

4 European Market Classifications Several changes in classification in Q3 As previously highlighted, there have been several upgrades to European market classifications this quarter. Six markets have moved from WARM to HOT and ten markets have moved from COLD to WARM (Figure 5 and Table 3). The office and retail markets of Warsaw are now classified as HOT, owing largely to upward revisions to rental growth forecasts. These markets are gaining more acceptance as mature markets, and investors stand to benefit from a yield premium coupled with a relatively strong occupier market. The London West End office market is now classified as HOT, notwithstanding a relatively low yield (4.), owing to strong forecast rental growth. Rents are rising given a shortage of supply as demand recovers. The Spanish office markets have been upgraded on the back of stronger rental growth and expected yield compression over the next five years. Some major markets continue to provide buying opportunities Among the major European office markets, only London City offices remain HOT. However, nearly all of the major markets are classed as WARM (Table 4). The Milan retail market also remains HOT, owing to solid rental growth and an attractive yield relative to other prime European retail locations. The market has proven resilient during the downturn, with rents having held up throughout. Interestingly, the London West End market is now classified as WARM, with the prime yield now having fallen to a low 4.2. A number of core industrial markets continue to offer attractive opportunities in a low interest rate environment. The market outlook looks stable, supported by the recent strong upswing in global trade, and yields remain high promising solid income returns. Other core markets are classified as WARM, indicating that the market outlook is generally positive for the major European centres. Figure 5 Selected changes in Fair Value rating Q2 to Q3 Q2 COLD WARM HOT Table 3 Q3 COLD WARM HOT Lyon office Lyon retail Manchester office Budapest office Oslo office Barcelona office Amsterdam office Edinburgh office Paris CBD retail Frankfurt office Rotterdam ind. Dublin office London WE retail Berlin retail Amsterdam retail Ranking of biggest movers: change from Q2 to Q3 Table 4 More attractive Madrid office Barcelona office Manchester office Warsaw office Oslo office Warsaw retail Madrid office Warsaw office London WE office London City office Milan retail Antwerp industrial Less attractive West End retail Dublin office Amsterdam office Berlin retail Amsterdam retail European Fair Value Index: major market classifications Top 5 Office Markets Top 5 Retail Markets Top 5 Industrial Markets Market Category Under/over valuation London City HOT - Madrid HOT -8% Milan WARM -3% Paris CBD WARM -2% Frankfurt WARM 1% Milan HOT -7% Barcelona WARM -3% Paris WARM -1% Munich WARM London West End WARM 2% Antwerp HOT -12% Hamburg HOT -6% Rotterdam WARM -2% Warsaw WARM -1% London Heathrow WARM 4

5 European Versus Global Forecasts Figure 6 Europe vs Global All Property Rental Growth % Europe and global rental outlook remains subdued Global rental outlook remains subdued as a slow economic recovery acts as a drag on rental growth. Current forecasts don t anticipate jobs lost during the crisis to be recovered during the next 5 years. Over the short run, Europe keeps up with global rental growth due to outperformance driven by temporary supply constraints. But towards the end of the period, Europe starts to lag behind the global recovery (Figure 6). -10 Capital growth in driving returns before stabilising Figure 7 Europe Global Europe vs Global All Property Capital Growth % Figure 8 Europe Global Europe vs Global All Property Total Returns % European capital growth demonstrates that Europe was one of the first to experience a slowdown in capital growth as the credit crunch began to bite (Figure 7). Similarly, it was also around 12 months ahead of the global correction. As rental growth is limited, capital value growth continues to be dominated by yield movement. reflects this as capital growth in Europe rebounds rapidly. However, after a capital growth boom driven by yield compression in, growth levels out and underperforms global values, albeit very closely. Europe returns outperforming in before tailing off European total returns bottomed out in, ahead of global figures in. Along with this returns in are quite strong, driven by strong speculative investor interest and the associated yield compression (Figure 8). Total returns for Europe in are expected to be 14.9% compared to 11.7% globally. After strong results in, returns level out and become dominated by rental income during the later years of the forecast period. 5-year average rental growth for Europe is expected to be 9.2%, slightly above the global figure of 8.9%. Europe Global 5

6 Office Market Forecasts Office rental growth forecast to be subdued, but stable European office rental outlook remains subdued as austerity measures begin to drag on economic forecasts. 5-year outlook is forecast at 3.3% pa as a result (Figure 9). Outperformance in the near term continues to be dominated by markets with supply constraints. However, austerity issues are becoming more prevalent and are becoming the dominant factor behind rental performance towards the end of the forecast period. Markets without sovereign debt issues are anticipated to be the outperformers whilst those undertaking austerity programmes are anticipated to show limited growth. Office yield compression in key markets almost at bottom European office markets continue to progress through the yield cycle and remain on target to bottom out during. Despite limited prospects for further yield driven capital growth, the flight to quality continues to drive money into major European markets. Investors continue to be attracted by relative liquidity and stable returns. European office yields continue to be dominated by the major developed markets. Developing and less stable markets are expected to experience more compression towards the end of the forecast period as risk perception subsides and investors seek higher returns (Figure 10). Strong office returns for Aggregated total returns in European offices continue to show strong performance in on the back of punctuated rental growth and yield compression. However, this is forecast to be a short boom in returns as prospects for further significant yield compression and rental growth are limited. Performance over the remainder of the forecast period will be driven by income. Yield impact will be limited as rental growth takes over as a performance driver. As a result, total returns will remain in single digits, albeit with great stability, throughout the forecast period (Figure 11). Figure 9 European Office Rental Growth Forecasts Figure 10 European Office Yield Forecasts 11% 9% 8% 7% 6% 4% 3% 2004 CEE UK France & Germany Nordics PIGS Figure 11 European Office Components of Total Returns Rental Impact Initial Yields Yield Impact Total Returns 6

7 Retail Market Forecasts Figure 12 Europe Retail Rental Growth and Private Consumption Weak private consumption holding down rents Pressure has been building in the retail sector as private consumption remains subdued. Consumers have been feeling the pinch across Europe and spending volumes remain depressed. Rents have begun to recover, albeit in unspectacular fashion. Rents are forecast to level out in, posting a -0.3% fall and returning to growth in with 2.3%. However, overall growth throughout the coming 5-year period is anticipated to be weak, with 2% pa forecast (Figure 12) Private Real Consumption (LHS) Retail Rental Growth (RHS) /Oxford Economics Key centres continue to perform well as markets such as London and Paris show strong results. Moscow retail continues to lead the way with a strong bounce back of 9.8% pa forecast until. Figure 13 European Retail Yield Forecasts 9% 8% 7% 6% 4% 3% 2004 Budapest London (WE) Milan Munich Paris (20 districts) Warsaw Figure 14 European Retail Total Returns 16% 14% 12% 8% 6% 4% 2% Office Retail Industrial Major market yields reaching bottom, but developing experiencing continuing compression In terms of retail yields, little has changed during the past three months. Investor demand remains firm, despite limited prospects for rental growth. Yield compression remains to be related to investor flight to quality and low relative returns in other asset classes. European retail markets remain divided on grounds of perception of risk. Lower risk, mostly western European, markets saw yields quickly chased down. The profile of yield forecasts in these markets demonstrates upward movement towards the end of the forecast. Developing, mostly central European markets demonstrate higher current yields, but with continued compression throughout the forecast. Some markets, such as Warsaw, continue to make the transition to align with western European markets (Figure 13). Retail still expecting the lowest returns of the three major asset classes In line with the Q2 forecast, expectation remains for retail to be the worst performing sector over the next 5 years. The reason remains to be that of the three major sectors, retail pays the lowest proportion of returns through income. With yields bottoming out and rental growth remaining subdued, performance is forecast to be weak (Figure 14). Strongest performance is forecast to be in Moscow (25.8% pa), Bucharest (19.1% pa), Warsaw (13.6% pa) and Istanbul (13. pa) over the forecast period. 7

8 Industrial Market Forecasts Further industrial rental falls for Weighted European industrial rental forecasts have been downgraded slightly for to -2.7%, down from the -2.1% forecast in the previous quarter. The reason behind this is the continuing deterioration in core markets. Elsewhere, Dublin continues to experience significant falls and a -12.4% fall is expected by the end of the year, while Madrid and Barcelona are anticipating -7.7% and -12. respectively. While the industrial sector has been struggling throughout Europe as manufacturing output falls, German and UK industrial production has begun to recover. Lower exchange rates have helped to increase the attractiveness of UK products as some consumer markets begin to recover. Industrial rental growth continues to lag behind both the office and retail sectors, showing the largest falls of the three major sectors in (Figure 15). Industrial yields not forecast to see same levels of compression as office and retail Figure 15 Europe Rental Forecast Comparison Office Retail Industrial Figure 16 European Yield Forecasts Comparison 9% 8% Investor interest in the industrial sector has not matched office and retail. Yield compression in the industrial sector during the downward phase is not expected to match that witnessed in the other two major sectors (Figure 16). 7% 6% 4% Industrial yields have reduced volatility in comparison to office and retail property. Stability is mostly a result of lack of compression in the short term as investors shy away from the industrial sector. 3% Office Retail Industrial Industrial property offers least volatile returns Returns in the industrial sector continue to suffer negative rental impact in. Combining this with a comparatively low yield impact has resulted in total returns of 9.4% in. Total returns in the industrial sector are dominated by high yields and low rental growth. As a result a large proportion of total returns are paid through income. Although this has resulted in low performance forecast for, it also results in relatively stable returns throughout the forecast period (Figure 17). Figure 17 European Industrial Components of Total Returns Initial Yields Rental Impact Yield Impact Total Returns 8

9 Economic Drivers Figure 18 European Gross Debt (Maastricht Measure) % of GDP Source: Oxford Economics Figure 19 Eurozone Office Employment growth by Sector 4% 3% 2% 1% -1% -2% -3% Public administration employment Finance and Business services employment Total growth Source: Oxford Economics/DTZ Research Figure Year Government Bond Yields % Greece Italy Spain UK France Germany Europe split by measure of debt Austerity measures continue to dominate markets as Europe is divided by those with a debt problem, and those without. The hangover of the big bailout is already proving to be a drag on the entire region (Figure 18). European GDP growth is forecast to be sluggish in comparison to the US and Asia Pacific as governments cut back on spending in an attempt to roll back national debt to pre-crisis levels. Some countries are in a stronger position than others; Germany, Sweden and Denmark do not have either particularly high national debt, or high budget deficits. Private sector employment forecast to compensate for public sector job losses Government spending continues to come under scrutiny as many countries seek to reduce both budget deficits and national debt. Austerity measures have continued to evolve and impact on occupational markets. Economic forecasts from Q2 saw the first indication that public sector employment was coming under pressure. European office employment growth forecasts demonstrate a strong reduction in public sector employment. However, private sector employment is forecast to compensate for this (Figure 19). The full multiplier effect of public sector cuts on the private sector has not yet become apparent. But at this stage private sector employment forecasts remain strong. Government bonds highlight risk perceptions Risk perceptions continue to split Europe through government bond pricing, reflected in property through relative pricing models. Initial risk perceptions are evolving as more information becomes available. Core Eurozone countries, such as France and Germany have seen bond prices hold as the flight to quality continues. These are joined by the Nordics, Poland and the UK where investors also see reduced risk. Some CEE markets along with the usual suspects of Greece, Ireland and Spain continue to see a margin in bond spreads over core countries (Figure 20). Source: Oxford Economics 9

10 Disclaimer This report should not be relied upon as a basis for entering into transactions without seeking specific, qualified, professional advice. Whilst facts have been rigorously checked, DTZ can take no responsibility for any damage or loss suffered as a result of any inadvertent inaccuracy within this report. Information contained herein should not, in whole or part, be published, reproduced or referred to without prior approval. Any such reproduction should be credited to DTZ. DTZ November