What’s Shaping the Value-Add Opportunity in European Real Estate?
While there are challenges in real estate, the landscape is presenting attractive value opportunities at a point when we are approaching the bottom of the cycle.
High prolonged inflation and the consequent impact on interest rates have caused a steep decline in European real estate markets. However, while the challenging landscape paints a negative picture, it obscures the long-term attractiveness of the asset class—and the compelling cyclical opportunity it presents today for value-add investors. In particular, we believe there are a number of cyclical and structural forces, which will determine occupier and capital demand, and therefore growth in the short to medium term.
The unwinding of over a decade of low interest rates acted as a harsh reminder of the cyclicality of European real estate, with transaction volumes dropping sharply by 65% from the year prior (Figure 1). Data shows a 20% pricing correction from the peak although valuations don’t fully reflect this yet,1 and, where sellers are under stress, there are opportunities at significant discounts beyond these levels—in some cases, 40–50% off peak pricing2.
Figure 1: European Real Estate Capital Flows
Source: Real Capital Analytics/MSCI. As of June 30, 2023.
The new rate environment and value correction is also putting severe strain on borrowers with impending refinancing events, particularly for assets with cash flow interruption, at a time when debt market liquidity, at least from traditional sources, is constrained. We estimate that there is a €70 billion debt funding gap between 2023–2025.3 In many cases, refinancing will require an insertion of fresh equity, providing an opportunity for investors who can take positions across the capital stack.
Assessing the situation today, 18 months into the downturn, various indicators suggest that we are approaching the trough of the cycle—with inflation still high but moderating which, assuming the trend continues, will see an end of the current hiking cycle in the near term. At the same time, European REITs, a useful barometer to assess the trajectory of lagging direct property valuations, continue to be impacted by macro data but have not meaningfully breached the lows recorded during the peak of the energy crisis.
While these cyclical factors continue to present risk, we believe that it is outweighed by the potential upside of investing into a heavily corrected market. We seek to combine this value play with a focus on those sectors which are likely to have robust growth—shaped by structural megatrends—as we move into the next cycle.
1. Urbanization & Demographics
56% of the world’s population live in urban areas, and the number of urban dwellers is forecast to double by 2050 to over nine billion people.4 There is a lack of housing supply in many western European cities, both free market and affordable, not helped by restrictive planning policy—which provides sustained upward pressure on rents. There is a similar supply/demand dynamic in the purpose-built student accommodation sector: Europe is home to roughly half of the top globally ranked universities,5 but there is a chronic under provision of modern fit-for-purpose student accommodation across many university cities, particularly in less mature markets like Italy and Iberia (Figure 2).
Figure 2: Number of Students to Number of Beds
Source: CBRE. As of May 31, 2023.
The growth of cities is also being felt keenly in the logistics sector. For instance, London’s population has grown by 32% since 2000 while at the same time its industrial land supply has reduced by over 40%.6 At a time when e-commerce is necessitating closer proximity to consumers, the supply/demand friction is vast, which will continue to stimulate strong rental growth. We see particular value in industrial outdoor storage (IOS), which has emerged strongly in the U.K. as a result of its supply constraints, diverse tenant base, low passing rents with upside potential from a maturing sector, and alternative use optionality.
Staying on the topic of logistics, nowhere has the influence of technology been seen more in the last cycle than in the advent of e-commerce, comprehensively disrupting logistics supply chains. Despite the huge resulting growth, we believe that more is still to come both in mature markets such as the U.K. where online accounts for 25% of total sales, as well as less mature ones like Spain, Portugal, and Italy where rates are in the high single digits.7 Fundamentally, the supply of modern functionally appropriate stock remains extremely tight and this is likely to remain low as construction continues to lag demand—a trend likely to be exacerbated as new speculative developments are mothballed, providing an opportunity to develop into the locations which continue to see pent up demand.
E-commerce is but one example of the impact that technology can have on real estate and, as we look to emerging new disruptors, it is difficult not to be excited by the potential opportunities from generative AI during the next cycle.
Sustainability has enjoyed a rapid surge in focus in recent years resulting from a combination of regulatory and social pressure, and today it is a priority issue. Sustainability has long been integrated in our value-add approach as an alpha generator. There is a clear polarization between the best most sustainable buildings and the rest, with the former attracting premiums, both rental and, increasingly, cap rates. Consequently, when we are retrofitting or redeveloping assets, we are targeting net zero carbon because we believe that this will be the standard above all others in the future. We have been successful in doing this at our Open 336 office development in Milan, Italy, which completed last year, and in numerous other assets like the Tide Bankside office and Momentum logistics park, both in London, which we believe will be market leading on completion.
While there are challenges in real estate, in our view the landscape is presenting attractive opportunities at a point when we are approaching the bottom of the cycle—where risks are increasingly skewed to the upside and there is potential to generate outsized risk-adjusted returns. We are focused on the sectors with the strongest structural tailwinds behind them—logistics and living in particular—while also being prepared to capitalize on tactical value opportunities from market dislocation and distress. Overall, we remain convinced that the current vintage will be a compelling one for European value-add.
1. Source: Real Capital Analytics/MSCI. As of June 30, 2023.
2. Source: Barings Real Estate Research. As of June 30, 2023.
3. Source: Barings Real Estate Research. As of June 2023.
4. Source: The World Bank. As of April 2023.
5. Source: Times Higher Education rankings. As of June 2023.
6. Source: The Industrial Land Commission. As of January 2022.
7. Source: ONS. As of July 2023.