ºÚ¶´ÉçÇø

Investors who have been stung by the prospect of plummeting rents and capital values in the City of London are finding respite in northern Europe. An influential report published by Moody’s Investors Services at the end of April showed that continental European office markets had outperformed the UK since the onset of the global credit squeeze in August 2007.

Investors were impressed, said the report, by Frankfurt and the backbone of a ‘relatively robust German economy’. Paris also fared well, as a backlog of developments fuelled a record forecast for completions by the end of 2008.

The report, however, sounded a warning.

‘Looking ahead, we regard the growing supply pipeline to be an important threat to the European office occupational markets and, unless the current demand-supply imbalance is redressed, the overall balance could deteriorate further in 2008. In addition, occupier demand could be negatively affected if the financial turmoil in the global market continues for the next few quarters.’

Sounds familiar? The key question is how long it will take before the same affliction spreads to the financial services markets of London’s European neighbours. And it could be sooner rather than later, thanks to an increasing burden of legislation from Brussels (see boxes).

London falling

Jonathan Hull, executive director of CB Richard Ellis and head of capital markets Europe, says that, while London has been hardest hit so far, many of its rivals are at risk from the same fate.

‘In many ways London acts as a bellwether for all of the other major office markets in Europe,’ says Hull. ‘None of them will be immune from what London has been experiencing, even if it does take some time for it to filter down. It always starts with London, but it takes time for the ripple effect to follow through.’

Henderson Global Investors, which has £8.8bn of property under management in Europe, says the European market is characterised by a strange mixture of optimism and denial: optimism because the full effects of the global credit crunch have yet to filter through the eurozone economies, and denial because there is still widespread belief in cities such as Paris, Madrid and Frankfurt that they will be somehow immune to the storm clouds that have become a fixture on the City skyline since last summer.

Andy Schofield, research manager at Henderson Global Investors for the Paris and Madrid markets, believes that both will still feel some pain.

‘Neither Paris or Madrid will be immune from the global credit crunch and the wider economic problems that the world is facing,’ he says. ‘Out of the two, Paris will fare better and I think Madrid will be much worse.’

Pain in Spain

Spain, he says, faces a turbulent economic downturn compounded by a collapse in the housing and construction markets. ‘The problem with Spain is that the fundamentals of the economy are in distress, which is feeding through to the office sector because Spanish employers do not have that much confidence at the moment,’ he says. ‘If you look at France, the economy is still relatively strong, so I don’t think we will see problems there of the same nature.’

Up to 8% of Madrid’s office stock is under construction, half of which has secured prelets. Schofield says that last year yields in Madrid were 4.5% but it was ‘untenable’ that they would remain stable.

‘You are looking at yields moving out by at least 150 basis points,’ he says. ‘We still have about 75 basis points to go through 2008 and 2009. It will certainly start to feel like a recession there.’

Prime office rents in central Madrid are around €40/sq m/month, while out-of-town rents hover at €24.50/sq m/month. Vacancy rates have reached 4.5% in Madrid, reports Cushman & Wakefield. It says that in the final quarter of 2007 transactions in Madrid totalled 196,000 sq m – a rise of 3% on the previous quarter.

For Schofield, however, the general tactic of investors will be to wait. ‘There are not a lot of opportunities in Madrid at the moment and the reality is there is a fair amount of denial in all European markets about the extent of the problems they are facing,’ he says. ‘At some point there is going to have to be a reality check.’

Henderson is more confident about the Paris market. Yields in the showpiece office district of La Défense last year were 4.5%. Schofield reckons that could fall by 25 basis points to 4.25% – a modest fall and nowhere near as alarming as the yield shift taking place in Madrid.

‘La Défense will always be strong and you don’t get the sense in France that there are any real problems or doubts about the overall economy,’ he says. ‘That is always a crucial factor for people’s confidence. The economy may grow by slightly less in France next year, but there is not a sense that anything drastic is going to go wrong.’

Schofield says the Paris market is ‘much more mature’ and less volatile than its Spanish counterpart. ‘It has not run away like London has. Commercial property has been much more realistic, so the come-down will not be as hard.’

Neither Paris or Madrid will be immune from the global credit crunch and the wider economic problems the world is facing

Andy Schofield, Henderson Global Investors

Prime office rents in the centre of Paris are €820/sq m/month – up 12.3% from last year – while at La Défense they stand at €520/sq m/

month – unchanged from 2007. Yields in central Paris were unchanged between the fourth quarter of 2007 and first quarter of 2008 at 3.8%. This was from last year’s level of 4.25%

Cushman & Wakefield predicts that the occupational market ‘will continue to return strong growth with demand expected to reach between 2.3m sq m and 2.6m sq m in 2008’.

Schofield says the evidence on the ground concurs with this analysis. ‘The occupiers still seem very confident,’ he says. ‘The threat to the Paris office market will be if they start to feel the pain that a lot of others are feeling in the financial services sector in London.’

Hull also singles out Paris as an office market that should escape the worst of the fallout from the global credit squeeze and a worsening economic climate.

‘There has not been so much upheaval in Paris over the last few years,’ argues Hull. ‘It has been very defensive and those are the types of markets that are more attractive now. You have had a massive correction in office yields in London, but in Paris the correction has been that much smaller, and that makes people more confident.’

The situation in Frankfurt is more clouded. The German city, like London, is heavily exposed to the financial services sector. A two-tier market has developed as banks and other financial powerhouses abandon the collection of 1960s and 1970s office blocks on the outskirts of the city and gravitate to the centre of the city.

However, cultural differences between Germany and the UK mean that those banks are less unlikely to lay off staff in the kinds of numbers that are being witnessed in the City of London.

‘It is not culturally acceptable to make swathes of people redundant in Germany,’ says Henderson’s Stefan Wundrak, a research manager based in Frankfurt. ’The banks are more likely to grow slowly during the good times and can then hold on to the people they have got.

‘When times get bad, they just don’t replace the ones that leave rather than making a lot of job cuts. It would not be acceptable to the people that are left working there, and it would not look good for the banks with the public.’

As a result of this, Wundrak does not expect to see office space dumped back on to the Frankfurt market. Prime office rents there are €37/sq m/month and yields at 5%, unchanged from the final quarter of 2007.

Frankfurt surplus

Of more concern to Wundrak is the proliferation of old office stock that is becoming empty on the outskirts of Frankfurt.

’It is difficult to see what is going to happen to those buildings and I do personally wonder what investors think they are gaining from keeping them,’ he says. ’They have no tenants but yet they hold on to them. Perhaps they think that in time the chances of getting tenants will improve, but all the time people are moving out to the shiny new office blocks elsewhere.’

The only solution, believes Wundrak, is refurbishment or redevelopment. Landlords seem unwilling to do either. ’There is a clear two-tier market being created in Frankfurt right now,’ he says. ’If the secondary offices are going to survive, they will have no option but to refurbish.’

Faced with this fractured market, Henderson will instead look for opportunities that sit between the divide. ’We would not be interested in the secondary market but we think there are opportunities just beyond that,’ says Wundrak.

’There are offices which are close enough to where the occupiers are gravitating, but not so expensively priced as the prime sector. That is where we would be looking.’

Many of London’s competitors in the European office market have yet to feel the levels of pain experienced in the Square Mile. Of Paris, Madrid and Frankfurt, it is the City of Light that has become the most attractive destination for office investors who are seeking safety from the volatility and uncertainty across the channel. But they are also not forgetting Frankfurt, where banks find it harder to cut staff in the same fashion as their London counterparts. Most investors, such as Henderson, however are waiting to see how far the ripples from London spread.

‘We are happy to wait for the right kind of deal,’ adds Henderson’s Wundrak. ‘People have to be much more patient now.’

Brussels flexes its muscles

It is not culturally acceptable to make swathes of people redundant in Germany

Stefan Wundrak, Henderson Global Investors

Could a slew of European directives being exported to the UK from Europe cause further upset in our office markets?

Directive: Soil framework

Status: Bogged down

A row is brewing across the European Union over plans to make developers compile reports about the status of the soil on sites where construction is proposed. The UK has found unlikely allies in France and Germany in opposing the directive, claiming that it could hit housing development and make the regeneration of brownfield sites too expensive.

Having got the seal of approval from the European parliament, member states are still trying to agree on a final draft. It is unlikely to emerge from the Brussels grinder before the end of the year.

Directive: Energy performance of buildings

Status: In effect, but proposed revision

The Energy Performance of ºÚ¶´ÉçÇøs Directive comes into effect throughout 2008. But do not expect Brussels to stop there. Discussion is under way within the European Commission to revise the directive to abolish the 1,000 sq m threshold for the minimum performance requirements when buildings are renovated. A certificate scheme and the introduction of inspection reports are also under consideration.

Directive: Waste framework

Status: Proposed

First floated in December 2005, the Waste Framework directive would set environmental standards for developers and occupiers on how recycled waste should be reused as raw material. It would also set long-term recycling targets for each member state and introduce mandatory national waste prevention programmes.

Directive: Open-ended real estate funds

Status: Early consultations

In March 2008 the European Commission published an industry report looking at the possibility of introducing an EU-recognised open-ended real estate fund that would be available to retail investors across all member states. If successful, the Commission believes it would harmonise a wide array of investment legislation and make cross-border investment less bureaucratic. The initial consultation period closes on 18 May and a further report is scheduled for the autumn.

Directive: Reduced rates of VAT

Status: Under review

The European Commission is reviewing existing legislation on reduced VAT rates and intends to present legislative proposals late this year or in early 2009. Under the existing regime, member sates can apply for reduced rates of VAT on services such as renovation, alternation and repairing of property. It is proposed that the system offers three levels of VAT rate: very low for services of necessity; a second rate for environmental services; and a third standard rate.

Directive: Water performance of buildings

Status: Discussions pending

The prospect of a directive to regulate how much water property uses has been raised by a communication issued by the European Commission. It suggested that, following on from the introduction of the Energy Performance of ºÚ¶´ÉçÇøs Directive, special consideration should be given towards a specific regime for water to combat drought and water scarcity.

Discussions have not yet started.