European revival gathers pace
There seem to be two schools of thought on continental European offices. The optimists see the current difficulties as purely short-term cyclical swings, and are already preparing themselves for the recovery. The pessimists are focusing more on structural shifts that are predicting the long-term decline of the office. As with all these things, the truth probably lies somewhere in between.
It is often overlooked that offices are historically more volatile than other property types and that performance is highly correlated to changes in economic conditions. In the face of the recent economic slowdown demand for offices has fallen as companies have sought to cut costs. Figure 1 shows how the vacancy rates of offices in five of the Euro-zone’s largest markets have changed over the last few years and also how they are forecast to improve as the markets start to recover.
Typically vacancy rates of around 10% are synonymous with falling rents and whenever they reach 15% rents are likely to be in free-fall. In Frankfurt, overbuilding, in the expectation of a substantial increase in demand from the financial services sector, coincided with severe cutbacks from banks and insurance companies as global economic growth took a nosedive. A protracted general economic slowdown in Germany has meant that the outlook for this market continues to remain poor. In contrast, Paris, which saw massive overbuilding at the end of the 1980s has witnessed considerable restraint in development through this last cycle. Banks have been very cautious about lending to developers thereby restricting their ability to build. This, together with a highly diversified economic base, means that Paris is currently much closer to recovery and therefore attracting particular interest from investors.
The rate at which vacancy rates fall and the markets stabilise also depends on the amount of new buildings that continue to be constructed. It takes time for the construction pipeline to slow once vacancy rates rise. Madrid saw some of the most significant overbuilding in the last cycle as developers sought to capitalise on rental growth which exceeded 30%pa between 1998 and 2001. In contrast, the principal Italian markets have seen relatively little development over the last few years, although this reflects more the difficulty of finding suitable sites and the time it takes to work through the various administrative processes than it does any lack of appetite for new development.
As economic growth slowly returns to the Euro-zone and demand for office space increases, then the office markets will begin to recover. The pace of the recovery in each of the individual markets will influence when rental growth turns positive (figure 2). This will mark the growth phase of the next real estate cycle.
But what will this next growth phase look like? How long will it last? Which markets will fare the best? Part of the answer to these questions will depend on traditional factors such as the pace of economic growth and the supply of new office properties. However, and more intriguingly, what will be the effect of ‘offshoring’ or outsourcing and changing demographics be on our office markets? Every decade seems to have its theme; in the 1980s it was the introduction of the personal computer and in the 1990s it was hot-desking and working from home. Both have undoubtedly had an impact on the demand for offices although their full effect has essentially been masked by the trend in most developed economies of an increase in office employment to the detriment of more traditional industries.
Moves to ‘offshore’ large sections of the service sectors of our economies are likely to be more difficult to hide. Although most of what has happened so far has been confined to call centres or data processing functions in English speaking countries there are examples of this happening elsewhere, notably in Germany. We could see an increasing trend for relatively low skilled office jobs being lost from western Europe to other parts of the world and that as a result we will see more empty office buildings. However, given that most of these jobs are located in non-traditional office centres (where costs are already lower) then the immediate impact for the traditional office centres in Europe will probably be limited. Outsourcing undoubtedly makes good headlines but it is unlikely to spell the death knell for traditional European office markets.
While the outsourcing debate has been around for a few years the most recent phenomenon that is increasingly being discussed concerns demographics. A recent study published by the European Public Real Estate Association (EPRA) entitled ‘Demographic Contraction and European Property Markets’ highlights the shrinking labour population across most of continental Europe. Spain, Italy and Germany are all forecast to see significant falls in the working population during the period to 2050 and the peak in the labour population has either occurred or is close to so doing. Taken at face value these data clearly have implications for the future demand for office space. The report describes these markets as now being ‘replacement’ markets (as opposed to growth markets) and goes on to suggest that the supply of office properties will have to fall to maintain rents and prices at current levels. If labour markets shrink more slowly than the annual obsolescence rate, then falls in rents and values should be more modest.
The report is thought-provoking but potentially alarmist. A number of things can happen to change the outcome. Birth rates can and do change, but their consequences have an obvious time lag. Ageing populations are moving rapidly up the political agenda across Europe as governments start to face up to a looming pension funding crisis. Raising the retirement age is one of the possible solutions which is being touted and this would have an immediate impact on the size of the labour market. Immigration is another potential factor that will influence outcomes
Where does all this leave us? If the asset class wants to appear as a long-term feature in investors’ portfolios, it has to show that it can cope with both short-term economic cycles and long-term structural trends. The structural shifts referred to earlier certainly shouldn’t be ignored but they need to be kept in proportion.
Simon Foxley is an executive director and fund manager at UBS Real Estate Europe