What future for real estate?
Economic progress in a capitalist world means turmoil. So said the economist Joseph Schumpeter. From this turmoil fortunes are made and lost. The current strong performance of most European property markets owes much to big structural shifts in the economic and political climate. These have caused a re-rating of asset prices as the advanced economies have adjusted to low inflation, as the former Soviet bloc has begun to embrace capitalism, and as the globalisation of business activity has fuelled cross-border investment.
One response has been an upsurge in interest in real estate as an alternative to equities and bonds. At present, this shows little sign of abating. But other economic, political and social forces are at work that could have a profound effect on the long term market outlook. Performance is driven by a combination of investor demand and the changing needs of occupiers. Both will be affected by unstoppable ‘megatrends’ that will change the global balance of economic power, the European population structures and the approach to investment.
Policymakers are starting to address the questions raised, but their strategic implications are not yet on many investors’ radar. Property is a long-term asset, and an awareness of these issues will become increasingly important.
Consider some startling headline conclusions. By 2030:
n The EU15 workforce will have shrunk by 24 million;
n Italy will have more retirees than workers;
n India will have increased its workforce by 335 million – more than all the existing jobs in Europe and the US combined;
n China will have overtaken the US as the world’s largest economy, and India will have overtaken Japan economically.
n Europe’s workforce will have shrunk by 45 million;
n The median age of Europeans will have risen from 39 to 50;
n The EU’s share of global output will have fallen by 45%;
n If Germany wanted to keep a stable ratio of workers to pensioners, it would need an 80% immigrant population.
Ageing populations: the policy dilemma
The ageing population (so-called ‘demographic time bomb’) is one of the European Commission’s top five policy priorities. Europe’s long term economic prospects are inextricably linked with changes in the size and make-up of its workforce. Fewer workers will mean lower growth, unless productivity can be boosted to compensate.
The framework for savings and investment will need to change to support a burgeoning elderly population, while the proportion of workers declines. The focus of public finances will also have to change. A narrowing tax base, and rising social security and healthcare costs, imply higher taxation. This will be politically sensitive, and damaging to economic growth. A shrinking labour pool may help contain unemployment but will eventually hold back growth.
Defusing the time bomb is difficult. Policy options are limited and controversial. They are to encourage more people to work, make them work for longer, to promote immigration or raise the birth rate.
There is some scope to increase labour participation rates, particularly among women, but in practice these are already high in northern and eastern Europe. Spain and Italy offer the greatest capacity for growth in this area. Efforts will be made to encourage later retirement, as people are living longer, but many will prefer to opt for active leisure time in retirement. Immigration will remain a politically divisive issue. Finally, pro-birth policies conflict with efforts to boost workforce participation and cut state handouts, and would, for a time, increase the number of people not earning an income.
So change is inevitable but will affect countries
differently. Italy, and countries in central and eastern Europe (CEE) already have falling populations, exacerbated by out-migration of younger workers from many of the new EU members. Germany and the UK are important destinations, with migrants stemming a decline in Germany’s indigenous population and swelling the UK’s workforce. The working age populations of France, Spain and the Netherlands are now peaking .
A new economic order
Apart from changes in population, large disparities in production costs between the major G7 economies and the emerging industrial nations of Asia and South America will encourage the transfer of economic activity. It is likely that by 2025, five of the world’s top seven economies will not be members of the current G7. We will see a fundamental shift in global economic geography.
The developing CEE economies also offer relatively low labour costs and a skilled (if shrinking) workforce. Unsurprisingly, this has already meant a transfer of manufacturing, but increasingly the service sector is following suit. The Czech Republic is rated fourth as an outsourcing destination in AT Kearney’s Attractiveness Index, after India, China and Malaysia. Most affected are ‘back office’, call centre and data processing functions. While cost-cutting is the main catalyst, some companies also claim service improvements: most Indian call centre workers are graduates, which is unusual in Europe. India is a popular outsourcing location for UK companies, due to its low labour costs, well-educated English-speaking workforce and tax incentives.
Property market future
Steady changes in the economic and demographic make-up of Europe promise a dynamic business environment, and property investors should consider the implications.
More subdued rates of long term economic growth in Europe, and outsourcing to low cost locations will keep inflation in check, but limit rental growth rates. Nevertheless, the concentration of activity in favoured locations will continue to create some good investment opportunities.
In the office sector, business trends such as globalisation, outsourcing and flexible working practices will dictate where these opportunities lie. Shrinking workforces in the mature western economies suggest that office surpluses will emerge in areas with narrow occupier bases and a diminishing labour pool. An imaginative planning response will be needed, to promote changes of use. Property values will be damaged where empty space is allowed to persist.
Europe’s businesses will need to look for productivity improvements to counter labour shortages. Fortunately, they are relatively well placed to achieve this. Building design will need to evolve to accommodate new technology and more flexible ways of working.
For the time being, however, unemployment rather than labour shortages is a bigger problem for much of the Euro-zone. Demand for offices will increase as the business cycle picks up, helping to erode the overhang of empty buildings and to revive rental growth. Meanwhile, the CEE economies are seeing a surge in office employment as they become more like their western counterparts. The resulting development boom still has some way to run.
Although the EU workforce is set to fall by around 14% by 2030, the decline in population will be less dramatic. Smaller shopper populations will ultimately mean less retail floorspace is needed, particularly in places that are neither regional destinations nor local ‘convenience’ centres.
Ageing populations will bring shifts in spending patterns. Under 40s are the big spenders: family formation means their consumption is high relative to their income. The middle aged are savers, although their leisure spending is increasing. After 65, assets dwindle to pay for retirement. Retail formats will need to change to cater for an increasingly ‘grey’ shopper profile. The need to boost retirement savings will leave less for consumption, so the mature economies of Europe will move to generally slower growth in retail sales, contrasting with the robust performance of emerging countries, where spending power is rising sharply.
Although consumers will remain price sensitive, they will become more discerning on quality and choice. The focus on ‘value’ and ‘branding’ is here to stay. Retailing will remain fiercely competitive, with cheap imports and competition from online shopping keeping prices down, and limiting retailers’ profit margins. This will keep rental growth in check. Nevertheless, retailers will compete for representation in those in-town and out-of-town locations that offer a high quality, distinctive shopping environment, which will offer the best opportunities for investors.
The industrial property market will need to adapt to a continued drift of traditional manufacturing away from western Europe to south east Asia and to South America. However, in the logistics sector, changes in the patterns of production and distribution will create fresh opportunities in CEE countries, including Russia, as modern facilities are developed. Similarly, southern European ports are increasingly important bridgeheads for trade with Asia, and are likely to benefit from this.
Changes in the age profile and the make-up of households will also affect the residential sector. The steady erosion of the nuclear family, and a tendency to delay having children, have increased the number of one-person households, often in areas of net in-migration where population growth is already putting pressure on housing stock. Conversely, in areas of decline, housing surpluses are already occurring. These trends directly affect prices and rental levels. Planning policies will increasingly need to take account of the regional impact of these long term structural changes.
In the UK, demand from first time house buyers has dropped sharply in the past two years. Although this is partly cyclical, falling numbers in the 25 to 34 age group suggests that the market will need to get used to fewer young buyers.
For countries with significant home ownership, like the UK, private housing is a store of wealth. Equity release schemes are likely to develop as a way to supplement pensions and to fund healthcare.
Pensions and property
The discussion so far has focused on supply and demand for property in the occupier markets. However, the trends considered will also affect investment activity. Faced with the escalating costs of state pension benefits and healthcare, governments are working to shift the burden of responsibility to the private sector. There is scope for a huge growth in occupational pension schemes in some parts of Europe. For example, these schemes cover less than 20% of workers in Italy, Spain, Portugal and Greece.
Increasing pension fund maturity in more established markets, such as the UK, Netherlands, France and the Nordic region, will tend to steer asset allocations towards income rather than growth assets. Funds will want more security than was thought necessary during the ‘cult of the equity’ in the 1980s and 1990s. Property’s income, liability matching and inflation-hedging characteristics will be attractive. Its low correlation with equity and bond returns offers diversification. Investment theory suggests that long-term returns from property are likely to be higher than bonds but behind equities. However, the performance of European equities will also be constrained by the redistribution of global growth, and by the need for companies to maintain the solvency of their pension funds.
For very mature pension funds, illiquidity will be a barrier to holding real estate, given their greater need to fund payouts. The likely expansion of a market in listed property securities based on US Real Estate Investment Trusts may help.
During the next few decades, property investors will need to recognise the undercurrent of structural change in Europe, as well as exploiting short term market cycles. This will bring new threats, but also opportunities. Despite the ‘turmoil’ envisaged by Schumpeter, there is every reason to expect the property market will adapt to the challenge, as it has in the past.
Andrew Smith is head of research and strategy at Arlington Property Investors