Investment in Europe’s commercial real estate market in 2015 is set to reach levels close to its 2007 peak.
But this dramatic recovery could be overshadowed by the storm clouds gathering over the Chinese economy. A combination of slackening production figures, a dramatic fall in the stock market and the Chinese government devaluing the yuan point to slowing economic growth. With one of the largest players in the interconnected global economy faltering, how worried should we be about the knock-on effect on European markets?
Chinese investors have, for some years, been snapping up European real estate, particularly in London, where landmark properties such as the Lloyd’s building in the City and the Thomson Reuters HQ in Canary Wharf are owned by Chinese firms. The residential market has also benefited, with 9.4% of sales in prime London markets in the first six months of 2015 made to Chinese homebuyers, according to Knight Frank.
This level of investment is reminiscent of other booms: during the 1980s, Japanese investors snapped up international property; for example, Mitsui & Company paid more than $610m (£395m) for the Exxon Building on the Avenue of the Americas, which at the time was the highest price ever for a single-office tower in New York City.
University of Chicago professor Robert Z Aliber notes that Japan’s transition from the 1980s to the 1990s is similar to what is happening now in China. He suggests countries can grow rapidly for 30-40 years before losing the low-wage advantage that initially enabled them to capture market share from other territories. China has had 30 years of rapid growth, as increases in its exports pulled tens of millions of underemployed from the countryside to the cities, which in turn led to frenetic activity - and price increases - in the property market.
But the rates of growth China has seen are unsustainable. In many cases, property price-to-income ratios have risen to above 20 times, while rents sit at little more than 1%. This has led to a huge number of properties sitting empty: last year, a national survey by China’s Southwestern University of Finance and Economics estimated that around 49 million residences in urban areas are unoccupied, based on a vacancy rate of 22.4%. In addition, a recent IMF report suggests developers in smaller cities have unsold supply of around three years of sales, assuming demand stays as it is currently and there is no major new supply. The result of this is likely to be a severe decline in prices, an erosion of household wealth, and decreased activity and potential financial difficulty for developers of, and investors in, residential property. Aliber notes that property prices in Japan declined by 75% in the 1990s, and a similar adjustment is likely in China.
Countries tend to invest abroad when the supply of domestic investment opportunities has diminished, usually because domestic demand growth has slowed and production costs have increased. Effectively, overseas investment is a resort turned to when the economy at home is starting to falter.
The effects of problems in China have already started to manifest themselves here: Chinese investors are aborting planned commercial property transactions, such as the £455m purchase of Broadgate Quarter in the City of London.
There may still be a bright side. Anecdotal reports from Knight Frank have suggested that the situation in China has led the wealthy to look more urgently for routes to export capital, intensifying their interest in safe-haven global property markets, including London. But if the situation in China becomes as crippling as some imagine, these gains are unlikely to last long. With China having accumulated debts of 200% of GDP, a severe wobble could potentially lead to a global recession.
Nevertheless, Europe remains an attractive destination for investment. Eurozone GDP growth forecasts have been cut, but we are still talking about growth rather than contraction. The extension of quantitative easing across Europe, which has been hinted at by Mario Draghi, could result in the euro remaining weak against other international currencies, low interest rates continuing and further funds being available for commercial real estate investment. In a low-interest-rate environment, commercial real estate yields, when combined with capital gains, still make investment attractive.
By comparison, in the US, while the economy is also showing moderate growth, investment is hampered by the added costs of the Foreign Investment in Real Property Tax Act. There is talk about repealing the act but investors are not holding their breath.
Average yields for class-A office spaces also remain competitive across Europe, at an average of 4.9%.
Anything that affects liquidity in European markets is a potential risk. Certainly, the situation in China is a consideration but so too are ongoing conflicts in Ukraine and Syria, as well as the increased risk of terrorism globally.
Europe remains a land of opportunity but it is also a complex area with diverse markets. The delicate economic situation means investments in Europe need to be made at the right price and with the benefit of detailed local market knowledge.
Keith Breslauer is managing director of Patron Capital, the specialist pan-European opportunistic property investor