European Real Estate Quarterly Q2 2014

AEW Europe Real Estate Quarterly Q2 2014 1

Economy & Capital Markets Prospects for global GDP growth have cooled slightly since the beginning of the year. Japan, China and a number of

developing countries were the main drivers of this deterioration. A slowing China appears to already be negatively affecting levels of global trade and industrial production. The Chinese PMI has fallen below the neutral 50 mark, to its lowest levels since mid-2013, indicating one likely source of global trade weakening;

We reported last quarter that global exports seemed to be growing once again after of their recent three-year period of weakness. This growth was a result of the recovery in Eurozone, but global export levels appear to be slowing once again. With the Eurozone and Asia comprising approximately equal proportions of global trade, further Chinese weakness is likely to offset any ongoing improvement in the Eurozone;

There has been a slow, but steady improvement in the Eurozone’s current account balance over the past two years, as Figure 1. shows. Export growth in the region began to accelerate from early in Q1 and has been amongst one of the more positive economic developments in the region. More critical to the Eurozone's recent current account surplus, has been the reduction in Eurozone imports;

This improvement is set to continue with business surveys suggesting that a further rise in Eurozone exports can be expected, and imports are unlikely to substantially grow in the immediate-term with the Crisis Countries1 still undergoing internal devaluation;

Indeed, despite the lag, it seems that Eurozone growth is set to gradually improve and follow the recoveries seen in the US and the UK. The Eurozone composite PMI rose to 54.0 in April, its highest level for nearly three years and consistent with GDP growth of around 0.4% q-o-q;

However, this clear improvement in Eurozone economic performance recovery has not eliminated the threat of deflation. The input prices component of the manufacturing PMI fell for a fourth successive month in April and is well below its US equivalent. This survey indication has unsurprisingly already shown up in manufacturing producer prices as Figure 2. shows;

Figure 3. shows that headline inflation has continued to fall at Eurozone level throughout Q1, reaching its lowest level since November 2009 of 0.5% y-o-y in March, well below the ECB’s target rate of 2%. The rate climbed 20bps to a record 0.7% in April, but some analysts have suggested that this rise is likely to prove an anomaly from the vagaries of Easter retail trading, and that the trend is for further disinflation;

As worrying as this trend of disinflation and very low inflation rates might be, Ireland and Portugal have already dipped into outright deflation, with their rates of headline inflation going negative in March. And Greece has been experiencing outright deflation on this measure for well over a year now;

With other measures such as producer prices, consumer and business inflation expectation surveys, the break-even rate of inflation, inflation swaps, and the GDP deflator, all indicating further disinflation, the threat of deflation at Eurozone level is an increasingly real prospect;

Figure 1. Eurozone current account balance

Source: Oxford Economics

Figure 2. Eurozone producer price growth (y-o-y)

Source: Macrobond

Figure 3. Eurozone inflation (y-o-y)

Source: Macrobond

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The strong current EUR/USD at around 1.39 is one commonly cited cause of this disinflationary trend, of which a hawkish ECB and its shrinking balance sheet is in turn a cause. Other causes include the ongoing (albeit slowing) Eurozone fiscal consolidation, Crisis Country internal devaluation, the continuing fall of commodity prices, ‘Abenomics’ and Japan exporting deflation to the rest of the world via falling import prices, and the lack of positive real wage growth in Germany;

The increasingly real threat of deflation has now spurred the ECB into further action. The governing council meeting in early June resulted in a number of measures: i) a 10bps cut in the main refinancing (base) rate to 0.15%; ii) a cut in the deposit facility rate from 0.0% to an unprecedented -0.1%; iii) another round of LTROs2, labeled “targeted” or TLTROs; iv) a partial start of QE by ceasing to sterilise the cEUR170 billion of 2010 Securities Market Program Crisis Country government bonds held by the ECB; and v) an intensification of preparatory work on ‘credit easing’ via future outright ABS purchases;

Future QE and/ or ‘credit easing’ by the ECB are likely to boost the prices of both perceived risk assets (such as equities) and non-risk assets (such as government bonds). As long as sustained outright deflation is avoided, real estate is likely to broadly perform well under an ECB QE scenario. However, its effects may be unevenly felt in the complex system that is the European financial markets. As ever, we will be carefully monitoring developments and flow-on effects to real estate.

Investment Markets Q1 2014 saw the strong momentum of European property investment activity of Q4 2013 continue. A total of EUR37.9 billion

was transacted during Q1, representing an 18% increase y-o-y. The marked change by investors seeking higher levels of risk that began during H2 2013 has gained pace, particularly towards Spanish, Irish and Italian markets. Some of the most active investors taking an interest in these markets continue to be opportunistic US investors;

Helpfully, this change of sentiment has not been to the detriment of the traditional core markets of western Europe, which continue to experience strong investor demand. Quality secondary properties in these core markets continue to experience yield compression, and occupier activity is strengthening noticeably. French and German property investment activity increased strongly y-o-y (by 37.3%/ EUR3.5 billion and 47.4%/ EUR9.9 billion respectively). This highlights the continued investor interest in these core markets. After somewhat disappointing investment volumes in 2013, these figures for France show somewhat of a resurgence in investor interest. However, this increase was partially driven by the EUR1.2 billion Coeur Defense deal (an office complex in La Defense) during the quarter;

Q1 investment volumes in the UK market decreased slightly, by 3.1% y-o-y. This was likely due to a limited supply of investment product being offered for sale in central London. Conversely, a significant rise in investment activity occurred outside central London, underlining this shift in risk perception with investors broadening their geographical investment horizons;

CEE saw a drop in investment volumes during the quarter, largely due to weaker activity in Russia, from a slowing Russian economy and recent events relating to the Ukraine. Despite this decline, Polish volumes increased 40% q-o-q, with EUR893m transacted;

Across Europe, investor interest is increasingly gathering pace further from the core markets. Available supply is likely to increasingly become an issue for occupiers as well as investors, with a lack of development completions affecting choice and leading to higher pricing;

Figure 4. Forecast total returns, required return and liquidity (investment volumes)

Source: PMA, AEW Europe This chart compares forecast office total returns with the respective required return an investor should demand, by market. The size of the bubbles represents the average three year office investment volume. A significant number of markets lie below the break-even line, implying that these underperform their required return to compensate for the risk taken. Dublin, Madrid, London City and London Docklands form part of the most attractive markets on this measure.

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AEW Europe Real Estate Quarterly Q2 2014 3

Outlook Improving economic conditions and broadening investor interest in non-core markets across Europe are expected to

underpin a further increase in investment activity during the remainder of 2014. Such an increase is likely to be not only driven by investors seeking income producing assets (core assets in core countries), but also assets that benefit from improving economic performance (core assets in non-core markets) and assets offering active management or repositioning opportunities in anticipation of future evolving tenant and investor demand (in both core and non-core markets);

Whilst European economic outlook has improved considerably over the past two quarters, the ongoing recovery in many countries is likely to be a slow one. Challenges remain for investors in seeking investments in an environment where central banks’ decisions may cause unanticipated volatility and plausible cases exist for not only higher government bond yields, but lower bond yields too;

Pricing is likely to continue to see support from weight of capital chasing a limited pool of institutional grade stock. With the perceived relative value attraction that remains on offer between core real estate and bonds, large insurance companies and pension funds are expected to continue to increase their allocations to real estate. Such increases, whilst only a small incremental percentage increase in allocation of overall assets under management, represent a large quantum in aggregate when compared to annual property investment volumes.

Office Market Following a very strong final quarter of 2013, office take-up across Europe fell during Q1 2014. However, there were clear

differences between markets. Western Europe saw strong letting activity, boosted by a double-digit increase in take-up across Germany’s top six markets and a rebound of large letting deals in Paris. Conversely, CEE recorded a decline in activity, with Q1 take-up falling by 27% y-o-y;

Many markets continue to suffer from a lack of available, prime space, alongside still rising supply in secondary locations. The vacancy rate remains high in the Crisis Countries while the level of new space coming to market is limited. A notable feature of the current supply situation is the ongoing changes of use. Conversion of office space to other uses is expected to result in a reduction in supply in some markets, most notably in Amsterdam and Frankfurt;

Development activity has started to pick up since H2 last year, but most schemes tend to be in a small number of core western European and CEE markets, including London, Paris, Warsaw and Moscow. Central London in particular will experience high levels of completions during 2014, but the volume of space being delivered is expected to fall again in 2015, most significantly in the City market;

The improved European economic outlook combined with depressed capital values and potential rental growth, has piqued foreign investors’ interest in the Crisis Countries. Investment volumes in the Madrid office market rebounded strongly to reach cEUR200m during Q1, compared with just over EUR50m in Q1 2013;

This increase in investor interest in the Crisis Countries has resulted in further yield compression during the quarter, led by Dublin and Lisbon where prime yields moved in by 50bps q-o-q and 125bps y-o-y in both cities. However in some Crisis Country markets, yield compression is occurring without a commensurate jump in liquidity;

Occupier trends diverge in London and Paris As Figure 5. above shows, occupier market

performance differed between central London and central Paris during 2012 and throughout much of 2013. However, take-up in central Paris during Q1 has seen an increase and converged towards the level of take-up in central London;

Figure 5. Take-up (rolling annual as % of stock)

Source: PMA

Figure 6. Vacancy rate (% of stock)

Source: PMA

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A lack of large deals and more lease renegotiations have had a negative impact on letting activity and rental values in central Paris during 2013. Conversely, robust tenant demand and a falling vacancy rate has supported strong rental growth in the central London sub-markets during 2013; this trend is set to continue throughout 2014;

The outlook remains more subdued for the Paris office market, with the vacancy rate relatively high in La Defense and the Western Business District. Future supply remains an issue, with a large amount of new space expected to come online during 2014, albeit at lower levels than 2013;

Outlook

Europe-wide, the office occupier market is forecast to see a broadening improvement in demand as the year progresses. Occupier demand for grade A space is expected to remain strong for the remainder of the year, and thus likely to see increased competition for the best buildings in those markets exhibiting under-supply;

2014 is expected to see modest recovery in rental values across Europe, with Dublin and central London continuing to experience the strongest growth. Despite the strong rental growth expectations for Dublin over the next five years, rental values are likely to remain some way below their previous peak at the end of this period. Only a few centres are expected to see declines in rental values during 2014, most notably in Warsaw and Paris La Defense, where high levels of completions are imminent;

Most markets across Europe are forecast to see positive capital value growth over the next five years, with Dublin (+8.1%), Madrid (+7.5%), and City of London (+3.8%) expected to be the top performing cities. Negative capital value growth is set to continue in central Europe, with prime capital values expected to fall in Warsaw and Budapest by an average of 3% and 2.1% pa respectively for the 2014-2018 period.

Logistics Market Logistics occupier demand has been increasingly driven by the retail sector, with retailers accounting for a growing

share of logistics take-up over the last two years. The growth of online retailing has had a positive impact on demand for warehouse space and is expected to be an important driver of future occupier demand. This is evident, for example, from Amazon opening two distribution centres in Czech Republic and three in Poland. Looking ahead, occupier preferences are expected to remain strong for modern and well located logistics units into the medium-term;

Although the occupier market saw signs of improvement during 2013, the level of logistics letting activity across Europe has been limited by lack of available space in the core markets, most notably the German centres;

A significant improvement in retailer and consumer sentiment across Europe since the end of last year, combined with a more positive economic outlook in the Eurozone is expected to translate into greater demand for logistics space. However, the European logistics market continues to be characterised by a north-south divide, with falling vacancy rates and strong letting activity in northern markets compared with rising availability and declining take-up in southern areas;

2013 saw a marked increase in the level of logistics space under construction by the big five developers, the highest level since the GFC3. However, development activity is mainly driven by built-to-suit projects while speculative development activity remains limited in most markets;

Prime logistics rents have remained largely stable in most markets since mid-last year, supported by a continuing lack of new supply. A modest rental recovery is expected over the medium-term across Europe, with rental value growth likely to be stronger in the supply constrained markets, such as the UK and central Europe;

The core western European markets (UK, Germany and France) continued to account for a large proportion of investment transactions during Q1 2014. Germany in particular saw Q1 investment volumes increase sharply by 99% y-o-y to reach EUR1.3 billion. This was predominantly driven by the industrial production, manufacturing and export-oriented sectors of economy, and the stability of the letting market;

The growing investor interest in the logistics sector is set to continue during the remainder of 2014, with total returns for logistics assets expected to be more attractive than offices in some markets, such as in central Europe, France, and the Nordics;

As Figure 7. shows, prime net yields have stabilised and started to compress since the beginning of 2013, with UK and France experiencing strong yield compression during the last 12 months. Yields are forecast to contract slightly over the next two years, particularly in areas with high investor demand. Despite this, the yield gap over retail and office yields is expected to remain in place;

Growth prospects are likely to remain strong in the CEE region as logistics operators are expected to build further efficient distribution networks and benefit from cheaper

Figure 7. Logistics prime net yields

Source: PMA

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labour costs vis-a-vis western Europe. Poland in particular is expected to become a key investor target due to its growth as a key logistics hub in Europe.

Retail Market Germany’s unemployment rate remains at a post-reunification low and the country has relatively moderate levels of

household debt, so the need for household sector delevering has been considerably less in Germany than many other Eurozone countries;

The considerable growth in house price inflation of recent years has helped underpin more positive household and consumer sentiment. Moreover, real wage growth, whilst still not high has edged upwards over the past six quarters or so. All of these factors positively contribute to the outlook for consumer spending;

Private consumption is forecast to grow by 1.1% during 2014, and with the introduction of minimum wage regulations from next year, this is expected to increase to 1.7% for 2015;

Figure 8. Shopping centre openings in Germany (centres >20,000 sq m)

Pre-1980s and pre-1990s 1990s Post-2000

Against this positive economic backdrop, German retail property investment volumes have been buoyant, with almost EUR8.7 billion invested during 2013. Over EUR3 billion of this (almost one-third) was invested in the five biggest German investment destinations of Berlin, Dusseldorf, Frankfurt, Hamburg and Munich. Compared with 2012, around 34% (EUR770m) more was invested in retail property in these top five locations during 2013;

With an investment volume of almost EUR3.6 billion, or 41% of total German retail volumes, shopping centres continue to be in demand from investors. This focus on prime assets in core locations has caused prime yields in the retail segment to compress, falling from 4.75% to 4.60% between the end of 2012 and the end of 2013 for prime shopping centres;

There are some interesting trends that emerge from scrutinising historical development of shopping centres in Germany. Figure 8. above displays German shopping centre openings by periods. The following trends are evident:

– Before Germany’s reunification in 1990, all shopping centres openings occurred in West Germany, including Berlin. Schemes were mostly developed around large cities;

– In the decade after reunification, the subsequent economic restructuring and reconstruction of eastern Germany resulted in significant resources transferred from west to east. In the retail market, this resulted in the development of new shopping centres with western standards in eastern Germany, particularly in the Berlin, Dresden and Leipzig regions;

– After 2000, the pace of openings slowed down in the east, and the focus of development activity shifted from larger to medium and smaller sized schemes in 2nd and 3rd tier cities. This shift was particularly evident in western Germany and on activity related to extensions/ new phases to existing malls. The pipeline suggests this trend is likely to continue until at least 2016;

As core retail assets in the large German cities are becoming expensive, dominant retail schemes in secondary cities are becoming an increasingly attractive investment proposition. This is particularly so in western Germany or in cities in eastern Germany with positive population growth such as Dresden and Leipzig;

In prime locations around the large German cities, financially rewarding opportunities still remain in successfully refurbishing and/ or modernising dilapidated and obsolete buildings. However, caution is required in eastern Germany in those centres and regions most at risk of population decline.

Source: AEW Europe, PMA

AEW Europe Real Estate Quarterly Q2 2014 6

Residential Markets

The housing market in southern Europe has yet to see any substantial recovery, with house prices in Spain and Italy falling by 6.3% and 4.8% respectively during 2013. However, the rate of decline has started to slow in some regions off the back of improving economic conditions and rising demand from international buyers. Overall, the European housing market is expected to return to positive growth during the remainder of 2014;

United Kingdom

The housing market recovery continues to gain momentum across the UK, with average house prices rising by 2.6% q-o-q and 9.2% y-o-y during Q1 2014. Although house price growth has spread to the wider market, average house prices in many regions have yet to surpass their pre-GFC peaks. London continues to outperform the rest of the UK, with average house prices now 20% above their 2007 peak, as Figure 9. indicates;

The number of new houses built in England in 2013 reached a six year high. This increase in housing starts was partly as a result of the government’s HtB4 scheme, which is expected to boost the supply of new dwellings in response to continued strong demand;

Confidence remains strong in the central London development market, with the number of units under construction rising by nearly 50% during 2013. A lack of supply in central London has encouraged more international developers to enter the market, which is expected to deliver more new dwellings in the medium-term;

France House prices declined by 1.4% y-o-y in France and

fell by 0.4% y-o-y in Ile-de-France during 2013. In Inner Paris, the average price of existing houses decreased by 1.5% y-o-y to an average of EUR8,140 per sq m during 2013. French house prices are expected to continue to fall modestly during 2014, mainly due to the weaker than hoped for macroeconomic backdrop, which is likely to have a negative impact on household purchasing power;

Sales volumes in France remained low during 2013, with cancellations of purchase reservations rising, and marketing periods increasing. In Ile-de-France, developers reduced new house supply by delaying projects as illustrated in Figure 10.;

Sales volumes in France (including Ile-de-France) are expected to remain stable throughout 2014. However, a potential increase is expected if house prices continue to fall;

Interests rates are expected to remain low during 2014 due to the threat of deflation across the Eurozone, which is likely to provide more favourable lending environment for house buyers;

Germany German house prices are set for further steady growth for the remainder of 2014, although at a more modest pace than

in 2013. Prices for newly-built apartments are expected to rise faster than single-family houses, driven by the high level of demand in Germany’s seven largest cities;

Housing construction activity continues to increase in response to rising housing demand, with construction permits for residential buildings still on the upward trend that began in mid-2009;

German residential investment volumes increased by 30% y-o-y to reach EUR4.9 billion during Q1 2014, mainly driven by three large transactions. Q1 also saw increased investment activity in smaller cities, which is partly due to the government’s initiative to cap rental increases in bigger cities, thus likely to boost the appeal of class-B locations for investors.

Figure 9. UK regional house prices relative to their 2007 peak

Source: Nationwide

Figure 10. Paris region construction activity to end Q4 2013 (housing units)

Source: INSEE

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AEW Europe Real Estate Quarterly Q2 2014 7

An affiliate of Natixis Global Asset Management www.aeweurope.com

AEW Europe is a leading European real estate investment manager with 9 offices throughout Europe. AEW Europe is focused on the creation, execution and management of discretionary commingled investment vehicles, separate account strategies and real estate securities funds to both institutional investors and private clients.

The group has over 270 employees who are responsible for over €17 billion of assets under management. The integration of AEW Europe with the resources and capabilities of North American-based AEW Capital Management creates a truly global real estate investment management platform with aggregate gross assets under management of more than €37 billion.

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Holger Zilleken MSc

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