In brief:

• Rising interest rates are triggering a downward adjustment in European real estate pricing and a collapse in liquidity, particularly for higher risk, leveraged strategies.

• Growing evidence suggests, however, that price declines may be more pessimistic than they need to be, given robust occupier demand for high quality, amenity-rich assets, as well as the likely decline in both inflation and interest rates during 2023.

• Many of the long-term market trends that we identified in 2022—such as the rise in e-commerce transactions and focus on sustainable “green” development—remain just as relevant in 2023 and will continue to drive transformation.

• Although recession in Europe may be inevitable this year, real estate investors willing to provide liquidity and navigate greater market complexity and uncertainty are likely to find ample opportunities in both core and noncore assets.

Strong occupier demand implies opportunities in select sectors

Monetary policy is casting a shadow of uncertainty over Europe’s real estate markets. Inflation may have just passed its peak, but central banks have not finished raising interest rates. Inevitably, those rate hikes are triggering a downward adjustment in real estate pricing and a collapse in liquidity, particularly for higher risk, leveraged strategies.

Coming into 2023, price discovery for all European private assets, including real estate, continues to lag the more liquid public markets, but growing evidence suggests that prices in some sectors are more pessimistic than fundamental economics indicate they should be. Investment markets are undeniably weak in Europe, but occupier demand remains strong, particularly for higher quality real estate assets: those with superlative amenities in key locations.

This misalignment has, in our view, opened a window on selective opportunities for investors willing to explore evolving market trends—especially those associated with environmental considerations, hybrid working and e-commerce. Although lower transaction volumes, reduced pricing transparency and ongoing changes to the drivers of occupier demand will make navigation of Europe’s real estate markets more difficult this year, investors may enhance investment performance through careful asset selection and active management.

And since liquidity is scarce, there will be great demand to provide much-needed equity capital over the next 12–18 months. While private real estate prices are often opaque, we think now is the time for investors to think about how to potentially add outperformance, or alpha, to assets.

Economic headwinds present ongoing challenges

Across the European bloc, economic growth is grinding to a halt. Although a recession now appears inevitable, we expect it to be relatively short and shallow. In contrast to the recession sparked by the global financial crisis (GFC), current labor markets remain tight and household savings balances have not eroded significantly, even as inflation has worsened. The UK, which is currently experiencing sharper inflationary pressures and lower economic productivity, presents a slightly different dynamic, but we do not expect to see a significantly deeper recession there, only a more protracted one (Exhibit 1).

Real GDP growth may turn negative in the eurozone and UK during 2023, but those declines will not rival the severity of the GFC

Exhibit 1: Real GDP growth projections for the UK and eurozone, 4Q 2022–3Q 2024 (vs. GFC)

Source: Oxford Economics, J.P. Morgan Asset Management; data as of January 2023.

The economic slowdown in Europe informs our real estate outlook for 2023, but despite this temporary setback, long-term social trends continue to support ongoing structural transformation. The rise in e-commerce transactions, for example, is still powering demand for industrial and logistics assets, such as warehouses, and the rents they can command are robust and rising, even if those rents are not increasing as quickly as they did in 2022.

In the office sector, hybrid working patterns are actively reshaping what tenants require from an office as they gravitate toward higher quality, amenity-rich assets. And a growing focus on climate risk across all real estate subsectors underscores the importance of environmental, social and governance (ESG) considerations to asset owners and corporate tenants alike.

These multiyear shifts are altering the types of spaces that tenants require—and increasing the complexity of real estate investors’ decision-making. In all likelihood, taking a strategic approach to refurbishing and repositioning in-demand assets to add value will pay the greatest dividends in 2023.

The return of the 60/40 portfolio heralds change

In an environment of elevated inflation, real estate’s importance as part of an institutional portfolio strategy is shifting. Only a year ago, with interest rates sitting at (or below) zero in most developed markets, real estate was considered an important source of income—and even a proxy for fixed income. Now, with global bond markets normalizing, real estate is reverting to its more customary role as a source of portfolio diversification and dynamic inflation hedging.¹

While we expect bond yields to fall, they are unlikely to reach pre-pandemic levels. The combination of high and falling yields suggests return tailwinds for fixed income investors in 2023 and beyond. The correction in equity prices that investors experienced during 2022, when viewed alongside the likelihood of a relatively modest recession and waning inflationary pressures in 2023, indicates a relatively positive outlook for both elements of the traditional 60/40 allocation model (60% equities, 40% bonds).

Although the more optimistic outlook for listed assets will impact both relative returns and investor appetite for real estate, ongoing uncertainty about inflation and enhanced demand for diversification—combined with the scale of opportunities presented by assets repricing in a market with constrained liquidity—suggest a stronger outlook. Currently, prime yields across all sectors in key European markets are at the top of their five-year ranges (Exhibit 2). Furthermore, the industry should benefit from clear improvements made over the past decade: Investments are now more accessible and diverse, and investors are more familiar with the asset class than ever before.

Post-pandemic, high quality European real estate assets are now delivering yields at the top of their five-year ranges

Exhibit 2: Prime yields across European office, logistics and residential assets (December 2022 vs. 5-year range)

Source: CBRE ERIX, J.P. Morgan Asset Management; data as of December 31, 2022.
*Central business district (CBD).

Discovering opportunities in market dislocation

As challenging as current economic conditions may be, they provide investors with an unmistakable opportunity to enter the real estate market this year at a competitive advantage. If a more substantial recession than we expect does materialize, some investors will inevitably face greater difficulty securing debt financing, which has also become much more expensive. This will enhance opportunities available to investors who are willing and able to act as liquidity providers.

Elevated market risks are certainly present, however, and we believe it would be prudent for most investors to take a conservative, analytical approach to any emerging opportunities. Differentiating within and across real estate sectors, for example, will be increasingly important in 2023. Investors would be particularly wise to consider applying a narrower definition of “core” to the office market, where blue-chip tenants are gravitating toward the highest quality assets. As we have argued before, we expect occupier demand to remain robust for assets offering strong locational, asset-level and environmental attributes.

We also recommend that investors carefully identify the best industrial, logistics and residential assets, which continue to benefit from strong occupier demand. (Unfortunately, in most markets retail still warrants extreme caution, although we are starting to see some positive signals in parts of the UK.)

While pricing for all assets has weakened alongside rising bond yields and declining economic fundamentals, bifurcation by asset quality remains a defining characteristic. The appetite for higher quality assets is likely to remain elevated, given the flight to quality that we’ve observed in European real estate markets over the past year, and these in-demand assets are also the most likely to provide ongoing inflation protection in the months ahead because they can still command premium rental pricing.

Finally, it’s worth noting that undersupply remains an important consideration for all investors in European real estate, especially in light of rising interest rates. Elevated construction costs—along with a growing focus on climate change, the scarcity of debt financing and concerns about the region’s economic outlook—have led to a moderation in development activity, which has in turn limited the overall supply of investible assets.

Conclusion: Long-term structural trends remain relevant in 2023

Although a period of difficult economic adjustment is perhaps inevitable in Europe this year, last year’s market shocks have created an environment rich with opportunity, particularly for higher risk real estate assets.

Many, if not all, of the long-term structural trends that we identified last year remain relevant in 2023. We continue to see a powerful shift, for example, from physical to online retail transactions—a known trend that is providing tailwinds for the industrial and logistics sector, and headwinds for the retail sector. Across Europe and the UK, the office sector is experiencing a narrowing definition of what constitutes a core asset. Investors willing to navigate the resulting occupier market complexity ought to be able to avoid investing in aging assets, or “obsolescence traps,” that no longer provide sufficient amenities to attract the highest caliber tenants.

Risks will abound in 2023, but investors should remember that the potential to generate alpha tends to be a function of gaining deeper insight into market complexity and uncertainty. This year, European real estate, as an asset class, will undoubtedly offer a surfeit of both.

¹While all real estate arguably provides long-term hedging against inflation, European real estate provides more immediate hedging advantages because corporate leases are indexed to inflation on a real-time basis.

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