Yield-hungry investors seek European commercial real estate with highest rental growth potential

Investor demand will remain high, as returns on commercial real estate in Europe are more attractive in the low interest rate environment than alternative investments, according to Moody’s Investors Service.

“With little prospect of declining yields, investors will be seeking those markets that offer the highest rental growth potential. It’s a balancing act between the defensive attributes of low yielding prime properties and searching further afield for additional yield pickup,” said Andrea Daniels, an Associate Managing Director at Moody’s.

“CRE fundamentals are stable, but returns will not be uniform. Rebound markets like London, Ireland and Spain and retail logistics properties will achieve the highest rental growth. The property yield spread over government bonds is high, despite prime yields being at historic lows in core markets - even below levels seen in 2007. This gap will remain through to 2018,” said Stephen Hughes an Assistant Vice President at Moody’s.

The rating agency said a large segment of CRE investors will continue to focus on prime office and retail properties in the major European cities. These properties are typically sought after by real estate investment trusts (REITS), sovereign wealth funds and insurance companies due to investor perception of being highly liquid, with less downside risk in the short to medium term. A second group of investors, notably private equity companies and various property funds, will move up the risk curve to purchase good-quality secondary properties. These properties will require a more hands-on approach to property management, but do offer higher returns when turned around. However, we expect little demand for tertiary properties.

At the CREFC Europe Spring Conference last week, Moody’s found that many participants echoed the rating agency’s view that the commercial real estate lending landscape will remain competitive, with a greater diversification of lending sources going forward.

Interest rates being close to zero will constrain any further downward yield movements. Yields will remain divergent between prime, secondary and tertiary properties. This contrasts with the peak of the market in 2007, where investors barely differentiated between property quality. In 2007, spreads between the best and worst properties in a given market were negligible; typically less than 1%. This has now widened to over 5% in many markets. Although we believe that pricing of good secondary properties can potentially move closer to that of prime properties, we still expect a pronounced yield gap to remain in place up to 2018.

The bulk of new CRE lending is heavily weighted towards the main markets of UK and Germany, with fewer lenders looking towards more peripheral countries. Current lending terms appear relatively conservative with all property LTV ratios at around 60-65%, and margins below 200bps in most core European cities.