Capitalise on real estate’s tailwinds?

Why now?

These are among the best-known aphorisms for investors. Where should anyone wishing to apply their wisdom in practice look today?

We believe European real estate may be a compelling answer, for two complementary reasons.

• First, major headwinds over the past few years have left valuations heavily discounted from historic levels – a rarity across asset classes today.
• Second, these headwinds are turning into tailwinds, creating a welcome catalyst for a rerating.

Starting with valuations, we see in figure 1 the scarcity of cheap assets in public markets, in stark contrast to private assets – where real estate, in particular, seems to offer an interesting entry point relative to the historical average.

Assets with low prices but no reason to re-rate may, however, be value traps. So what persuades us that real estate now has the potential to rebound?

The rationale begins with what drove the asset class lower over the past two years: the series of interest rate hikes around the world. As central banks began fighting inflation, they unleashed the most significant rate shock since the 1970s. In Europe, rates increased from 0.9% to 4.3% in only three years – a 4.8x jump. This led to the first negative returns from real estate outside a recession in our dataset going back to 1979, as sentiment soured given the concern over the higher cost of financing and the greater relative appeal of assets like cash that began to yield more.

Those headwinds are now reversing: the eurozone, Swiss, UK, and Swedish central banks are among those to have already started cutting rates in Europe. Moreover, we do not have to wait to see if the theory that this will boost real estate is accurate. Public markets are typically more forward-looking and faster to react than private markets, so we can take confidence from the rally in listed real estate since dovish policy began to be priced in after Treasury bond yields peaked above 5% in October 2023 (Figure 2).

Valuations in private real estate don't reflect paradigm shifts so immediately, not least given that conservative accounting rules prevent some gains from being officially marked until assets are sold, but we expect to see them follow slowly but surely.

Why value add?

The next logical question for investors is how best to gain access to these positive trends. We believe it is value-add strategies, rather than more passive 'whole of market' approaches. To make this case, we switch from a top-down macro view to a bottom-up analysis.

From such a perspective, it is clear that the recovery in real estate will not be universal. Instead, we foresee a K-shaped recovery: the right assets in the right locations will strengthen, but assets facing obsolescence risk will never be cheap enough to be good value investments. In the latter category, for example, we can put many shopping centres, suburban offices, or buildings that score poorly on sustainability criteria (Figure 3).

Active management and prudent asset selection is the only way to construct a portfolio on the right side of the K.

Yet knowing which categories have attractive long-term performance profiles is only half the story; the other is identifying and buying the underlying assets in those categories. As any homeowner knows, nominally identical houses several streets apart can be worth very different amounts.

Investors have two broad options here: buy ready-made future-proof assets, or create them. This is where we believe value-add managers have an advantage.

The market conditions and trends described above have produced many motivated sellers. Some are simply capitulating; some recognise the long-term outlook facing their assets and lack the inclination or capacity to modernise them.¹

In either case, value-add investors with the vision, experience, and resources to reposition their assets can reap the rewards. Redundant buildings can be transformed into objects of desire.

Desire speaks to the demand we expect to see for these assets. If we can pair such secular demand with structural undersupply, the return prospects are tantalising. To take real examples of this in practice, we have acquired an obsolete and vacant telephone exchange in an exclusive area of central Madrid to develop it into ultra-luxury residential apartments, and we have upgraded 125-year-old office buildings in Manchester to boast modern amenities and impeccable environmental credentials.

Of course, such work to improve assets cannot be completed overnight, although investors may be surprised to discover that value-add initiatives can actually compress holding periods relative to other private assets. In our experience, the average turnaround time for an asset is 2.5 years. Because we are not buy-and-hold investors for such strategies, we thus look to sell relatively quickly to longer-term 'core' owners who prioritise income streams over capital gains.

Naturally, it would be wise not to rely entirely on a swift exit after repositioning an asset. We, therefore, think it still makes sense to seek strong rental performance even in value-add strategies. It is pleasing, then, that in 2023 – a year of near-zero economic expansion for Europe – we were able to strike new leases across our portfolio with rental increases ranging from a minimum of 14% up to 45%. Respecting the economic law of real estate, this is only possible where demand exceeds supply – especially where we find innovative ways to repurpose assets to create the supply to meet demand.

The bold and the beautiful buildings

Throughout all this, expertise and experience are crucial – locally in particular. Identifying markets with robust supply/demand dynamics is vital, but it is on the ground that these insights are translated into assets thanks to differentiated sourcing networks and region-specific knowledge to navigate planning and development regimes.

To illustrate this in practice, we were able to assemble a platform of 16 last-mile logistics assets in Denmark by buying light-industrial estates from family owners before converting and unifying them as a portfolio. Having seen the possibility, we were further aided by the resonance of the Pictet brand among family owners and by our ability to acquire relatively small individual properties rather than needing larger lot sizes to deploy capital. That newly combined asset has now been sold at a premium to just such an investor only able to operate at larger scale and keen to diversify legacy portfolios of retail and office real estate.

The number of opportunities we uncover also allows us to make patience a virtue. Over the past several years in Germany, for example, we reviewed more than 300 potential transactions where we saw ways to add value amid favourable supply/demand mismatches. None offered sufficiently attractive entry prices, however, so we declined them all. Since the market has corrected, we are now able to revisit many of them where the fundamental investment case remains intact – but now 25-30% cheaper. This gives us great excitement for the future of the strategy.

This is how fortune favours the bold – those bold enough to be disciplined until the time is right, bold enough to act when that moment arrives, and bold enough to transform assets to realise their full potential.

In European real estate today, we believe bold investors have the chance to seize an extremely rare chance to buy at cyclical lows just as the recovery becomes tangible – and to enhance that performance while managing risks by focusing on value-add strategies.