European real estate: Opportunities in a time of change and complexity
Dr. Paul Kennedy
Despite elevated political, economic and occupier market uncertainties, European real estate continues to present compelling investment opportunities.
Recent softness in real estate pricing widened spreads between bond yields and non-core real estate yields. In core real estate, spreads remain historically wide.
Rising inflation has enhanced real estate’s attractiveness as an inflation hedge.
In logistics, limited supply and strong demand are putting upward pressure on rental values. Overweighting this sector should continue to be accretive to returns.
Strong demand for quality office space should support rental growth even where vacancies are high; more than ever, creative and thoughtful stock selection will be crucial.
Current pricing has created opportunities for new funds and those with substantial dry powder; funds dominated by legacy assets face headwinds.
Today’s European real estate market is beset by change and complexity. While the outlook is clouded by uncertainties–amplified and accelerated by COVID-19 and Russia’s invasion of Ukraine–we still see compelling opportunities.
In the occupier market, demand-side shifts associated with the rise of e-commerce, the shift to hybrid working patterns and a growing focus on climate change have contributed to rental mispricing. In the investment market, a confluence of factors have contributed to reduced liquidity and price corrections: elevated inflation, quantitative tightening, equity and bond repricing, concerns about Europe’s economic growth outlook and uncertainties about the changing drivers of occupier demand. This is particularly true for assets offering value-add opportunities.
The pandemic’s impact on the retail, logistics and industrial real estate sectors
The growth of e-commerce was accelerated by COVID-19: from 10% of UK retail transactions in 2013, and 5% of those in Europe, e-commerce had tripled as a fraction of retail activity in both markets by the end of 2021—and there is clearly scope for further growth in e-commerce, particularly in Europe. Our analysis suggests that current market pricing does not reflect the upside these trends imply for logistics assets, nor the downside implied for retail.
At the same time, supply-side restrictions are becoming more evident in the logistics sector, largely due to high and rising construction costs and restrictive planning policies. The shift from physical to online retail has revealed that the retail sector is clearly at risk of obsolescence, while enhancing the opportunities in logistics.
The impact of changing work patterns on European real estate
Low unemployment, employees’ rising preference for hybrid work arrangements and companies’ expectation for onsite presence to improve productivity have led to a flight to new and high-quality offices, which are in short supply. For example, in central London, vacant newly delivered office space as a percentage of aggregate vacancy has shrunk (Exhibit 1). Over the long run, about 40% of all vacancies tend to be new space, but the most recent data (1Q 2022) suggest new space comprises less than 30% of office vacancies.
New, high quality office space in central London is increasingly hard to find
Exhibit 1: Central London aggregate office vacancy (% new; 1Q 1985–1Q 2022)
Traditionally, high levels of aggregate office vacancy signaled declining prime (“Grade A”) rents. This appears to have changed. Current data show strong rental growth for the best quality space, even in markets with elevated aggregate vacancy.
More than ever, a creative and thoughtful approach to stock selection, design and fit-out is likely to be crucial for investment performance.
Construction costs, climate concerns tightening supply in European real estate
High and rising inflation is lifting the cost of refurbishing and redeveloping properties just as the need for redevelopment grows, restricting supply. The transition to net-zero carbon emissions has also made it more challenging for real estate investors to secure consent for ground-up redevelopment. As a result, there is a growing focus on refurbishment and repositioning, further contributing to low aggregate vacancy rates, particularly for the best quality space.
Increasing intra- and inter-sector dispersion in the European real estate market
Returns are diverging by sector—indeed, the differences have never been greater. For example, the shift from physical to online retail has enhanced logistics returns at the expense of retail (Exhibit 2). Concurrently, the shift to hybrid working combined with the strong diversification benefits of the residential sector have enhanced residential returns. Within sectors, property performance dispersion continues to rise between the best and the rest.
Dispersion of returns among real estate sectors has never been greater
Exhibit 2: European core real estate total returns 1Q 2001–1Q 2022 (4Q rolling min, max and range, all sectors)
With Euro-U.S. dollar parity, European assets are on sale for USD-based investors
Euro-U.S. dollar parity has returned for the first time since 2002, supporting a thesis that the USD is overvalued vs. the euro. The current USD valuation suggests an approximately 20% tailwind for GBP and euro investments for USD-based investors that is likely to unwind over the next decade. This means European assets are on sale for USD investors, with a likely additional 2% annual return over local currency returns. An even stronger tailwind is possible if, as we expect, current USD overvaluation unwinds more quickly.
Further reasons for optimism about the European real estate market
Despite the increase in both government and corporate bond yields this year to date, spreads between real estate and fixed income yields remain compelling vs. history. Further, spreads between core and non-core real estate pricing remain wide and, given current uncertainties, are likely to remain so, suggesting enhanced opportunities for non-core investors (Exhibit 3).
Spreads between real estate and bond yields remain wide
Exhibit 3: Spreads between real estate yields and government bond yields, and between core and non-core real estate yields
The European real estate market continues to offer compelling opportunities and an attractive entry point for both core and non-core investors.
Ongoing changes to the macro environment are driving re-pricing, reducing liquidity and elevating uncertainties in both the occupier and investment markets. At the same time, occupier markets are being reshaped by e-commerce, the shift to hybrid working and a growing focus on climate change.
These trends have created the complexities that underlie the investment opportunity. Savvy investors can take advantage of the resulting mispricings by seeking out managers, portfolios and properties positioned for this time of change.