European real estate: from headwinds to tailwind

The wind is changing for European real estate. Interest rates have peaked and are likely to head lower in Europe. The pace of cuts may be unclear, but they are likely to be more extensive than in the US. With current rates already at 4 per cent in the euro zone versus 5.5 per cent in US, further cuts will increase the divide between the two.

That means real estate prices should soon start heading higher, making current low valuations very attractive, particularly in a world where other asset classes – such as equities or gold – are already near record levels. And even if inflation does linger for longer than expected, real estate’s status as a real asset should prove supportive.

At the same time, the lack of funding and inflation of construction material prices have crimped development activity, with construction in some key European markets dropping by 50 per cent in the last couple of years. This has resulted in a strong supply/demand imbalance in real estate. In stark contrast, in the US, there is oversupply not only the office sector, but even on multifamily homes as a result of overdevelopment over the last 15 years. This points to contrasting fortunes: the European property market can recover faster than the US one, despite weaker economic fundamentals, due to significantly better supply/demand dynamics.

Even during the recent economic weakness, the right sectors in the right locations in Europe experienced very strong pent-up demand. As a result, in 2023, which was a very weak year economically for Europe, when we signed new leases in our 13 strategies across our portfolio we saw rental growth of between 14 and 45 per cent.

Now that the macroeconomic backdrop looks a bit more stable, we expect demand to increase. With rates having peaked, companies will become more comfortable about committing to new plans – including new buildings. And, while supply will also pick up, this will take longer.

Fig. 1 - Time for a pick-up
European real estate investment volumes, EUR bn

However, not everyone is in a position to benefit. Until now, both buyers and sellers were on the waiting line – in Europe, transaction volumes dropped by 60-70 per cent in 2023 (see Fig. 1). Now time is running out for highly leveraged property owners, who have seen financing costs rise to unsustainable levels. More and more of them can no longer service their debt and are becoming forced sellers. For those who do have money to invest, this creates a buyer’s market.

Current conditions, thus, present a once in two decades entry point opportunity to take advantage of the attractive valuations on offer within real estate – including the potential to do deals with forced sellers – and then to capitalise on the improving fundamentals.

Overall, valuations across Europe dropped by 20-40 per cent over the past 18-24 months. Admittedly, in the best asset classes and best geographies, the rental growth due to the supply/demand imbalance has partially compensated for this drop.

Sustainability and weather

So where do we see the most potential?

The buildings that will benefit the most are ones which best meet the changing needs of occupiers. One key requirement is sustainability– both to attract increasingly emissions-conscious occupiers and to appease toughening regulations on energy efficiency, which will soon make swathes of buildings unlettable by law as minimum energy labels come into force across Europe.

Within our value-add real estate portfolio, we have been transforming three former Victorian warehouses in the centre of Manchester – the UK’s second biggest city – into modern offices, with a strong focus on sustainability. This retrofitting includes solar panels and heat pumps, as well as more innovative features such as sensors which can automatically switch off heating or air conditioning when someone opens a window. The green premium (or "greenium") in this case has led to a 45 per cent increase in rents, in what is otherwise admittedly a weak economic backdrop.

Such projects can reap big rewards. In Sweden, we repositioned a printing facility into a data centre, at the same time reducing its carbon emissions by 60 per cent with features like reverse heat pumps (that take the heat of the data centre which usually goes into the air, and capture it in order to warm up the rest of the building). Through a combination of changing the asset use, improving its green credentials and a few other value-add initiatives, we were able to sell the asset to a core real estate investor, generating strong returns.

In terms of regions, countries where historic real estate deals have been heavily leveraged – such as Germany and Sweden – have been among the hardest hit by market turbulence and thus potentially offer some of the best value today. In Germany, property values dropped 36 per cent peak to trough. Indeed, over the past four years, we looked at over 300 deals in Germany, and said “no” more than 300 times, because the metrics did not make sense to us. Now, that is changing dramatically as the formerly done deals at high valuations and high loan-to-value (LTV) ratios start to come undone, and we believe the current pricing will present some attractive entry points.

And it’s not just about looking for cheap valuations, but also about identifying popular spots. Thanks to relatively low taxes and good weather, the ‘Floridisation’ of Europe is attracting wealthy Northerners to Milan and Madrid.

Among sectors, offices are cheap, but often for a reason: many existing office buildings are no longer needed in a post-pandemic world of more flexible working. That, though, means we can invest in great locations at a good price, and then transform those offices into more desirable use, such as residential.

Europe’s real estate map will be redrawn further over the next two to three years. Some legacy assets will struggle, and, with banks still cautious on lending, some existing participants will not be able to access more capital. This in turn, will present attractive opportunities for investors with fresh money to deploy and with the capacity to reposition assets for changing occupier needs and sustainability regulations.