Although all real estate sectors saw a severe slide during the recession, it was the office sector where rents initially tumbled as job losses occurred in the financial services industry. But evidence over the last few months suggests that offices are starting to escape the bear's claws. While we may not yet be on our way to the next bull run, there are indications that the office market is on the turn.
Over the past year, the focus has moved away from job losses in financial services to government-led austerity measures, which are likely to affect jobs in the public sector. Most public-sector roles are still office-based. In addition, the proportion of public sector jobs is higher in the regions rather than in major capital cities. As a result, a two-tier market is starting to open up: capital cities that were hit early on by jobs losses but where rents have now troughed; and regional markets, where the brunt of job losses may only just be beginning.
Despite the caution over regional office markets, activity volumes suggest that the investment market is improving in key locations, with the number of transactions in the direct market rising each quarter in 2009.
In the final three months of 2009, €24.6bn of European property changed hands, which was up significantly from the €11.6bn registered for the first quarter (Source: JLL). London offices, particularly in the West End, have seen a significant amount of activity, with prices pushed up by a large number of investors chasing a limited number of properties.
For example, Derwent London, a listed London office specialist, reported strong performance over the first half of 2010 with capital values rising 10.3 per cent as a result of falling property yields.
Although investment demand is increasing, risk aversion and restricted bank lending have discouraged investors from venturing beyond their own domestic market. As a result, there is less cross-border investment than before the downturn. London (and Paris to a certain extent) has bucked this trend, with 54 per cent of its activity coming from overseas investors.
Valuation declines have been extreme in London during the downturn, which has provided good opportunities for equity-rich investors looking for capital growth. Overseas investors also benefitted earlier in the year from sterling weakness.
Property and sterling against CPI benchmark over 1yr
Source: Financial Express Analytics
Rising prices are good news, but the key to a long-term recovery in the property market is rental growth. Overall rents are now stabilising across Europe; pockets of office rental growth have emerged in central London, while Paris and Düsseldorf have reportedly seen small improvements during the second quarter.
Other indications of a near-term return to growth include fewer incentives such as rent-free periods being offered by landlords, particularly in central London. Meanwhile, annual net absorption (the balance between demand and supply) has been positive, meaning more space is being let than vacated, and levels are now in line with the average over the last ten years. As many new projects were put on hold during the recession, a shortage of new supply in key cities such as London and Paris is likely to be beneficial for rents.
While all the signs are encouraging, sustainable growth in the European economy will be what really gets the property market moving. European economic growth accelerated in the three months to the end of June, led by export-focused Germany, which expanded by 2.2 per cent compared to the previous three months (the fastest rate since reunification in 1990). A two-speed recovery still exists, however, with the outlook for more vulnerable countries such as Spain, Greece, Ireland and Portugal looking bleaker in the short term.
Looking ahead, the office sector in Scandinavian cities is likely to benefit from the region's stronger economic recovery. Most German cities are also likely to see their office markets moderately accelerate, with the exception of over-supplied Frankfurt; office markets in France and the UK should also benefit from economic growth. Capital cities and major financial centres will continue to be the main beneficiaries, though, with regional towns struggling in the short term.
With property yields still attractive relative to other asset classes and the availability of credit improving, the trend for greater international investment should also accelerate. And as investors' appetite for risk increases, and banks start to release more stock onto the market, the volume (and size) of deals in 2010 should continue to increase. Clearly, some good pockets of opportunity exist in the office market and, as Derwent London has shown, there are good rewards for those who are in the right place at the right time.
Vicky Watson is investment director of European equities and fund manager of the SWIP European Real Estate Fund. The views expressed here are her own. No recommendation is implied.