Demand hits quality barrier
Milan’s status as Italy’s economic capital has made it the most sought after real estate market in the country. The city is the most internationalised Italian market with the highest presence of international/foreign occupiers.
During the last economic downturn, which began in 2001, Milan along with other European markets faced decreasing occupier demand and increasing vacancy rates. However, prime rents decreased only moderately (down 8%) compared with other European cities, which recorded double-digit decreases.
Milan’s resilience was due to very limited grade A supply in the city; only 9% of the existing office stock - 11.4million m2 - is grade A, which is one of the lowest percentage shares in Europe. There was also a low level of construction activity.
Office demand is driven by occupiers seeking efficient and flexible modern offices, upgrading from a lower quality to grade A space. Milan’s grade A vacancy rate has remained among the lowest in the European markets since 2001, making it difficult for occupiers to find the right accommodation without having to make compromises in terms of location, fit-outs or occupancy costs.
Although this has helped to mitigate the negative downturn effects in the market, this narrow supply is also limiting a potential increase in demand. Indeed, Milan was one of the few markets in Europe that failed to record an increase in office demand in 2005. Although the second half of 2005 showed a strong increase in occupier activity, office demand marginally decreased by 3% over the full year. We believe that one reason for stagnating demand in 2005 was the limited supply of grade A space in locations with good public transport access.
Foreign investors drive the Italian investment market and have accounted for 58% of total investment volumes since 2000. However, Italian investors, which hold the remaining 42%, represent the three leading investor groups: Italian private investors account for approximately 20% of the total investment volume, followed by Italian closed-ended property funds (11%) and Italian property companies (quoted and private) with 10%.
German open-ended funds, the strongest foreign investor group, accounted for 10% of total investment over the past six years. However, in 2005 their share decreased to less than 7%. UK and US investor groups each account for 5% of total investments, and Middle Eastern and Australian investors have held approximately 1% over the past six years.
Investor interest has been focused primarily on the Milan market, which has accounted for approximately 37% of total investment volumes recorded over the past six years in Italy. Although institutional investors have also expressed interest in Rome, its share of investment volumes remained at 21% due to limited access to the market - which is dominated by local players - and the less attractive occupier market, which is dominated by public administration and governmental bodies.
Milan’s investment market is strongly driven by the office sector (75% of total investment volumes) followed by hotels (8%), retail (7%) and warehousing (5%). Over the past decade Milan has been among the top 10 European markets in terms of the presence of corporates and new office construction has been readily absorbed during the last few years.
The hotel market historically records only a limited number of transactions, due to the very fragmented hotel offer in Italy, driven by family operations. The few hotel properties transacted in the Italian market were mainly trophy assets and large lot sizes. Investment volumes in the Milan market were boosted by transactions like The Four Seasons Hotel (€174m) and the Hotel Principe di Savoia (€275m).
Across Italy prime yields for shopping centres decreased to 5.5% at the end of 2005, a historical low in the market. There are more than 40 shopping centres in the Milan area, but due to the investment strategy of investors they very rarely come onto the market. Consequently retail’s share of investment activity in the Milan market remained marginal. However, 2005 saw one of the first important high street retail acquisitions by a foreign institutional investor; the purchase of Via Torino in Milan (occupied by Zara) by PruPim.
Although high street retail investments will remain limited compared with other retail formats, we expect to see an increasing number of transactions over the next few years as large retail units are at last developed in town centres - despite planning difficulties - which will provide lot sizes which are appealing to investors.
The logistics sector is also experiencing increasing investment volumes, although it is still an emerging sector with a limited modern supply and hence limited potential investment volumes. Milan, with approximately 4m m2 of warehousing supply, is the largest market in Italy but is facing stiff competition from emerging secondary hubs in Northern Italy, such as Piacenza, Novara and Alessandria, where rental levels are more favourable for occupiers.
Since 2000, investment volumes amounted to some €900m, 4.5% of the total investment volume in real estate. Recent transactions include a forward funding of a logistics development in Biandrate, Novara approximately 50 km south-west of Milan (66,000m2) to CGS, the sale of Milano Logistics Centre at Lacchiarella, Milan (50,000m2) to ING and of Agnadello Logistics Centre in Agnadello (57,000m2) to AXA. Approximately 42% of
the total sector volume was invested in the Milan market.
However, construction activity is focused in secondary locations and investors will follow developers in order to find prime schemes. Prime yields for logistics schemes hardened in 2005 to 7.5% for prime schemes and a further compression is expected for 2006.
Italian real estate funds have grown dynamically since the launch of the first fund in 1998; more than 40 property funds are now active and around 20 more are planned for the near future. So far, their main focus has been the Italian market and since 2000 they have acquired just under €3bn-worth of domestic assets; 45% of this volume
was generated in the Milan market, making real estate investment funds the strongest investor group with a share of roughly 18% of total market turnover.
Milan’s investment market peaked in 2003 with turnover of over €2bn, but has recorded decreasing investment volumes over the past two years. This trend is driven by the limited supply of quality assets. However, investors are still keen to invest in Milan and due to a slight increase in quality supply over the next 12 months and beyond, plus a number of real estate portfolios in the market, product will increase and we expect investment volumes to increase in 2006.
Milan is destined to remain high on property investors’ wish lists. Improving transparency and liquidity - which has been driven by the steady increase in institutional investor activity - can only bring further benefits.
Alexandra Tornow is head of research for Jones Lang LaSalle in Italy