When introducing our 2018 market report this spring, we did so asking if this is “as good as it gets?”. In other words: Danish economy is expanding, with growth in production and consumption, employment levels are higher than ever, consumer confidence is strong, and interest rates remain incredibly low. In such a “Goldilocks Scenario”, you may sometimes wonder if the framework conditions for property investments are in fact so favourable that things in general can only get worse. Sustained economic growth should prompt rate hikes – if interest rates remain low, it is because of a slowdown in the economy, job growth and consumer spending.
Transaction activity is slowing
Recent years have seen surging transaction activity in the Danish market for commercial and investment property.
Colliers believes that the 2018 transaction volume will not exceed the 2017 level.
This is however not due to a shortfall in demand. Overall, domestic institutional investors remain extremely underweight in property, and many international investors continue to be very keen to invest in Denmark.
Instead, what is putting a dampener on activity seems to be a mismatch between price expectations on the selling and buying sides. For years on end, we have grown accustomed to annual increases in commercial and investment property prices in the 5-10% range – which of course may tempt a prospective seller to factor in continued strong price hikes in pricing expectations.
In particular the market for new residential rental properties and developments is prone to a marked discrepancy in price expectations.
Sellers and property developers have witnessed a sharp increase in land and construction prices. For them to make the same profit, they reason that the selling price must increase, too.
As a matter of fact, though, both Copenhagen and major cities outside Copenhagen have seen quite brisk residential newbuilding activity in recent years, with an additional pipeline under construction. The added supply has put downward pressure on rental prices. Not because the new dwellings are not in demand, but rather because rental prices are climbing to a level where a substantial part of the population does not have sufficient income to pay the required rent.
Professional investors – whether domestic or international – are fully aware of this. As a result, they are becoming increasingly reluctant to base investments in the residential segment on the high rental prices witnessed in 2016 and 2017.
In the residential segment, this has served to slow transaction activity. Investors are keen to buy, but not at excessive prices. They are not prepared to base investments on rent expectations that they deem unrealistic.
The exception from this residential market scenario is the investment market for old-stock residential properties subject to the rules on cost-regulated rent (rent control). This segment continues to attract exceptionally strong investor demand, and income returns are very low.
This, on the other hand, is well-justified. Copenhagen properties subject to the rules on cost-regulated rent typically harbour very substantial rent reserves, which may be activated by comprehensively modernising units as they become vacant. In this scenario, there is no risk of vacancy or downtrending rental prices. Such properties are typically located in fully developed urban districts characterised by sustained strong housing demand.
Nevertheless, it should not be overlooked that properties subject to the rules on cost-regulated rent probably are the most interest-sensitive assets in the investment property market.
You buy at exceptionally low income return levels, which may only increase if you make further investments. As long as interest rates are low, it is not too painful to buy at such very low income return levels, and there is ample availability of inexpensive capital for ongoing modernisation schemes. However, when the price of money at some point starts climbing, precisely this segment is likely to be hit fairly hard in terms of investment calculations.
Offices – and logistics – are the new black
Recent years have seen the completion of many new dwellings. By comparison, office new construction has been quite moderate. In the aftermath of the financial crisis, office vacancy rates were high and demand weak. Most businesses focused on cost-savings as opposed to growth.
Now top-line focus is back in vogue. This means that businesses are expanding and hiring. And it means that they are searching for new office premises.
Although space-efficiency continues to be an important issue, today’s businesses often make arrangements based on anticipated further growth in staff numbers and area requirements.
This has fundamentally changed the situation in the office letting market. Up-to-date and well-located office properties see very low vacancy rates and uptrending rental prices.
This has prompted many investors to shift reallocations from residentials to offices, where framework conditions – the supply/demand balance – seem more favourable in the years ahead. Against the backdrop of an exceptionally limited supply of new offices scheduled for completion in 2019-2010, there is reason to anticipate a continued uptrend in rent levels.
Similarly, we see a sharp increase in investor demand for logistics facilities.
The bright economic outlook and expanding e-commerce have combined to cause a boom in occupational demand for up-to-date logistics facilities, rendering vacancy rates in this segment virtually non-existent. Whereas most institutional investors discarded this segment only a few years ago, investor appetite has grown to be exceptionally strong today. In addition, whereas it was possible to sell only properties let on very long leases a few years ago – at income return levels of 6+%, mind you – today’s investors rely on up-to-date and well-located logistics facilities to attract natural and broad occupational demand in future, too.
What to expect from the rest of 2018?
We expect the final quarter of this year to be just as busy as usual, with quite a large number of transactions falling into place.
In addition, we expect a substantial share of transactions to involve international buyers as they continue to consider Denmark an attractive destination for property investments. This applies not least to the core segment, where income returns are favourable in Denmark relative to our neighbouring countries. Moreover, margins on mortgage credit financing of property, which by international standards are fairly low, make it possible to achieve a direct return on equity substantially exceeding the level obtainable in our neighbouring countries.
In terms of properties with a higher risk profile – belonging to the so-called value-add and opportunistic segments – we foresee a predominance of transactions in the office segment, where fundamentals are unequivocally favourable, that is, vacancy rates are low and rental prices climbing.
We believe that this segment will be dominated by domestic investors, in particular pension funds and property companies, which typically have slightly lower yield requirements than foreign value-add investors.
This notion is supported by the fact that domestic investors in these segments typically invest for the purpose of redeveloping such properties to core standards with a view to long-term holding. International value-add investors, on the other hand, typically operate with a holding period of 5-7 years, as the investment is made for the purpose of resale once the property is fully redeveloped.