European Residential Market
- Structural demand and low volatility have attracted institutional investors to European residential markets
- Local expertise is important, given a wide range of regulations and market dynamics
- Larger, dynamic markets offer value-add opportunities
Diversity and disparity
European residential markets are subject to a high degree of diversity, resulting from differences in both institutional and regulatory factors. Local market knowledge and the acceptance of potential political risk are therefore key in building a residential investment strategy. Historically, from an institutional perspective, domestic investment into Europe’s few organically grown, developed rental markets, such as Germany, Sweden and Switzerland, has been favoured. As a result, European institutional stock and, therefore, transaction volumes are relatively concentrated, with Germany and Sweden generating 58% of residential investment volumes across the continent.1
However, the promotion of larger professional rental markets in countries which have historically favoured homeownership (e.g. UK) has attracted international investors, contributing towards institutional market growth.
A pan-European residential investment strategy could thus draw from both relatively liquid markets like Germany or Sweden, and institutionally maturing markets like the UK. Market diversity and disparity in market maturation dynamics should thereby offer substantial diversification benefits. However, the implementation of a successful residential investment strategy requires a thorough analysis of individual residential markets’ sizes and growth potential in terms of rental demographics.
Market size and structure
European markets exhibit a degree of diversity in terms of dominance of housing tenure (renting vs. owning). Markets like Germany or Switzerland are some of Europe’s largest rental sectors, with this tenure type constituting approximately 50% or more of the respective housing market.2 The other end of the spectrum is formed by Southern European markets, including Italy and Spain, where homeownership is the dominant form of tenure. Factors including government policies, planning restrictions, the availability of housing finance and taxation partially explain these differences, and thus, differences in current rental market sizes.
Effects of an aging population
Looking to how market structure may change, at first glance, European rental markets’ growth potential appears to be limited by demographics. UN population projections suggest the number of
older households, those most likely to be owner occupiers, should gain in significance, and the number of younger households, those most likely to rent, are forecast to shrink over the next 15 years.3
However, while national populations are declining in many European countries, urban populations are not. Urbanisation, combined with decreasing household sizes, is supporting household formation and, therefore, rental demand in all major European city markets. This trend is expected to continue over the next 15 years.
In addition, above trend immigration4 into Europe’s economically strongest countries provides additional support to rental housing demand. For example, since 2010, economic migrants have represented, on average, 75% of the net immigration into Germany, more than 50% of which moved to one of Germany’s 20 largest cities.5
Structural growth in urban housing demand outpacing supply growth
While urban demand for rental housing has been relatively strong, supply has been sluggish; despite weak construction cost inflation favoring residential development.6 This has been a result of geographical conditions including supply of zoned land, governmental factors including planning restrictions and underfunded infrastructure. Urban housing unit supply has thus, in most cases, been significantly less responsive to residential price increases than supply on a national level, magnifying the price appreciation stemming from strong demand, while limiting the risk of oversupply. As a result, the set of countries subject to expected annual completions (2017F-2019F) exceeding assumed depreciation of 1% p.a.7 is relatively limited, including only Sweden, Norway, Switzerland and France.8
A focus on major European metros offering both dynamic household formation and a relatively large rental sector, thus providing for both a diverse and dynamically growing tenant base, should offer a strong foundation for attractive risk-adjusted investment returns. Such metros include Leipzig, Dresden, Helsinki, Amsterdam and Manchester, exhibiting gross yields in excess of 4.0% and thus relatively attractive return potential over the next 5 to 10 years.
Capital value growth set to gain in significance
The imbalance between housing demand and housing supply in many European markets has, despite varying degrees of rental regulation both on national and regional levels, generated sustained rental growth. Since 2001, residential rents have, on average, grown at 2.3% p.a., while inflation has amounted to 1.8% p.a.9 As such, residential rental cash flows have exceeded inflation, as have residential capital values, which, according to MSCI, have increased by 3% p.a. over the same period. As a result, pan-European residential total returns have, as shown in Figure 3, benefitted from relatively limited downside.
Individual countries’ risk-return profiles differ significantly and markets historically subject to more volatile total returns have not necessarily generated higher total returns. In addition, ongoing institutional changes, ranging from rental regulation to measures promoting the institutionalisation of the private rental sector, are leading to adjustments in return expectations. Given the low level of income return, currently 3.9%10 on a pan-European level, the importance of capital value growth (CVG) in driving total returns is expected to increase. As CVG gains in significance, so does the focus on potential risk factors, including expectations around interest rates over the short to medium term.
Assuming a continued relationship between European residential CVG and GDP growth, we expect CVG of 2.5% to 3.0% p.a. over the next 4 years, resulting in expected total returns in excess of 6% p.a. until 2021. However, markets including Ireland and the Netherlands, which have just entered cyclical growth phases, are expected to benefit from significantly stronger total return recovery than markets exhibiting elevated valuation levels. This is the case, both in terms of affordability (Price-to-income) and profitability (Price-to-rent) of ownership, in the UK and Sweden.
Residential investment risk-return spectrum
Institutional investors aiming to access the traditional residential segment can choose from a variety of investment strategies, varying both in terms of return composition (capital vs. income return) and risk-return appetite (e.g. assumption of operational risk). Buy-to-rent strategies could involve different combinations of market and sub-market renting. Market renting would involve accepting relatively
low income returns while focusing on capital growth potential. Sub-market renting offers bond-like characteristics with a focus on inflation-linked rents backed by semi-public institutions.
Within the wider residential risk-return spectrum, the traditional residential segment, as opposed to build-to-sell or operator-driven strategies, generally offers a low risk, low return profile aimed at producing stability of income. Such a return profile might become increasingly attractive as risk awareness starts playing a greater role in real estate investment decision making.
Given the difficulty in achieving meaningful scale and relatively low income yields, develop-to-rent has often been considered an optimal strategy. However, securing land at a cost conducive to facilitating such a strategy, which also requires a costly realignment of potential partners’ interests, has often been an issue in achieving the returns required.
Given its return profile, traditional residential real estate should continue to be a sought after asset class. The yield spread over government bonds, in excess of 3%, makes the sector very attractive. Systemic risks to housing markets, and thus capital values, appear to be relatively limited both in terms of bank lending and household indebtedness.
While interest rates rises do pose a potential risk, with rates currently at all-time lows and the first ECB rate like not expected until late 2019, we do not expect the yield gap between residential real estate and government bonds to tighten significantly during our forecast horizon.
We expect total returns to amount to 6% p.a. until 2021 with upside potential in markets entering cyclical growth phases. In addition, value-add strategies in demographically dynamic European metropolitan areas such as Leipzig, Amsterdam or Helsinki should offer a relatively attractive risk-return trade-off, especially compared to develop-to-rent, which often does not appropriately compensate for development risk taken.
1 Real Capital Analytics, AXA IM – Real Assets, data as at Q1 2017
2 Eurostat, AXA IM – Real Assets, data as at Q1 2017
3 UN World Population Prospects: 2015 Revision. Trend does not hold true in Sweden,
the Netherlands, France, Denmark or Norway
4 Defined as economic migrants
5 Societe Generale, “Being tested makes it stronger”: 2017
6 EU19 Construction Cost Index, new residential buildings. 5 years to December 2016
= 2%, average 5 yearly growth prior to 2011 = 14%
7 Age-related annual decrease in housing stock assuming a 100 year lifetime
8 National completion data: 2017
9 Eurostat, AXA IM – Real Assets, as at Q1 2017
10 IPD/MSCI, data as at Q4 2016
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