A reset for European real estate is underway
2023 could be a golden vintage for property investors
The year 2023 has the potential to be one of the most attractive years for real estate investors since the aftermath of the global financial crisis (GFC) and eurozone crisis. Market stress is building on multiple fronts, which may turn the sellers’ market of the previous seven years into a buyers’ market. Across Europe pricing has already shifted. Yields have increased by 50 to 75 basis points (bps) since end 2021. We expect yields to rise by a further 25 to 75 bps in the course of 2023.
Due to the looming recession, occupier markets will come under pressure in 2023. However, it is unlikely to be anywhere near the scale of the years after the GFC, as markets have shown much better supply discipline. Investors can stay on course with strategies for the most attractive locations and sectors in Europe that are driven by long-term megatrends in demographics and technology and are unlikely to be affected by both the interest rate reset and the recession.
What is causing the market reset?
European investment markets peaked in January 2022. Since then, inflation rates have increased significantly on the back of the pandemic disruption, an overheating U.S. economy and the energy crisis. In response, interest rates rose rapidly and from the record lows that have been in place for close to a decade. As a second-round effect, high inflation, painful increases in fossil fuel costs and interest rate hikes are set to cause recessions in almost all European economies. This new macro environment is driving a profound reset of property markets in Europe:
- Public markets, particularly on the bond side, corrected significantly in 2022. The denominator effect created a mismatch in portfolios with investors now overallocated to private markets, including real estate. This could reduce demand for real estate investments and may lead to unplanned sales and potentially further price corrections. Active investors could face less competition for attractive stock compared to previous years as a consequence of reduced demand.
- Central banks have used quantitative easing (QE) to flood the market with liquidity and manage yield curves, most significantly during the COVID crisis in the eurozone. QE has inflated asset prices, not least for real estate. This practice has now ended with announcements that central banks’ QE holdings are scaling back and removing artificial support for asset pricing. Real estate market froth may disappear quickly as a result.
- Investors have benefitted from attractive financing conditions since the GFC. While that has not lead to overstretched loan-to-values (LTV) , which was the case before the GFC, even moderate LTVs under 60% can nevertheless lead to covenant breaches due to historically high valuations (low yields). Such positions may motivate sales, often encouraged by lenders.
- Re-financings and new acquisitions are facing negative leverage across almost all sectors and jurisdictions. Additionally, financing costs at current levels can eat up a significant portion of rental income. This could drive sellers to market at higher yields than previously available and ultimately lead to further outward yield shift across all sectors.
- The economy is showing signs of heading towards a recession, which will likely reduce demand for space across asset classes, in particular in more exposed business sectors such as offices, retail and industrial. Amid concerns of some unrealistic business plans unravelling, projects could become available on the market at discounts. This could have a knock-on effect to investor sentiment for real estate in the short term.
- High inflation is putting cost pressure on operators in alternative real estate. These additional costs could incentivise them to share their pipeline and expertise with strong capital partners.
- Construction costs have risen more than CPI inflation, making asset management, re-positioning and new developments more difficult to execute without the backing of experienced and patient capital. Opportunities to step into projects at discounted prices should present themselves.
- At this point the global financial reset, coupled with political stress and energy security risks means any outlook comes with more uncertainty and a wider range of outcomes than normal. This sentiment is likely to increase the available risk premiums for short as well as long duration investments.
New market conditions could offer tailwinds in the next 12 to 15 months
The market changes underway since early 2022 amount to a complete reset of the environment investors have been operating in since the eurozone crisis subsided. Euro five-year SWAP rates have been 2 bps on average between 2016 and the start of 2021, before surging to 315 bps in November 2022.
Financial stress is building and listed market data as well as debt metrics suggest that the hand of many asset holders may be forced in the coming 12 to 15 months. Ultra-low interest rates floated all boats, even unseaworthy ones. In the last downturn, low interest rates came to the rescue of real estate investors, which is unlikely to be the case in 2023. In fact the opposite is true, equity-backed investors will be in a stronger position to select attractive assets on their terms.
High yields on the horizon?
From a starting point of historically low yields, value declines can be brutal. While valuations are less volatile, we expect market prices to fall by 20-50%, varying by local market conditions, sector fundamentals and asset quality. Higher up the risk curve, for example developments or buildings with ESG challenges, the correction will be more severe than on the core end of the spectrum, where investors buy into strong income streams.
The window of opportunity could be short-lived
Europe is facing demographic challenges, which anchor these economies at relatively low levels of growth and therefore historically low interest rates. As a result, we believe that the period of high interest rates will be short-lived and start to ease as early as 2024. This implies that higher property yields will also be temporary.
This optimism is supported by a comparatively mild recession as the European economy starts from a strong position with record low unemployment, being in the midst of an energy systems investment boom and close to widespread adoption of various new technologies. This means real market stress is likely to be limited to the coming 12 to 15 months. Real estate bear markets tend to be short and sharp. This means that when the market settles again, from 2024 onwards, pricing cannot be expected to return to 2021 highs immediately, but should recover well after a market reset in 2022/2023.
Like all asset classes real estate has a challenging period ahead, but markets are not headed for a permanent collapse and property is unlikely to fall out of favour.