A Bright Outlook for European Real Estate

Key Takeaways:

• Markets have re-priced substantially and rapidly.
• Unlike previous downturns, market fundamentals remain very strong.
• Secular themes which shape the supply and demand dynamics continue to create conditions for growth, driving supportive fundamentals in our preferred sectors (logistics, residential, student housing, hospitality).
• We are expecting an increase in buying opportunities over the near-term and are already seeing opportunities build in our pipeline.
• While European markets have re-priced at different rates, we are starting to see yields stabilize, indicating that the worst of the re-pricing may be behind us.  We believe now is the time to allocate, before positive sentiment is priced in.  

Material repricing, motivated sellers, strong fundamentals, and dislocated financing markets make the opportunity in European real estate investments among the most exciting we have seen in the last 25 years.

Real estate has repriced dramatically in the region, and a significant number of asset owners are coming under pressure to sell, with the highest quality, most liquid assets typically first on the list. In this environment, high-quality properties are often available at attractive valuations. Unusually, however, and unlike in the Global Financial Crisis, fundamentals have been persistently strong, with low vacancy rates and a positive outlook for rental growth, particularly in sectors with strong thematic tailwinds, such as logistics, multifamily residential, student housing and hospitality. Though access to financing is improving as interest rates begin to moderate, higher costs of capital continue to restrict those with refinancing pressures or open-ended funds with mounting redemptions. This is reducing competition in the market and adding to the buying opportunity.

We often hear concerns from global investors that Europe has a lower economic growth outlook than the United States, but we would point out that this does not necessarily make the region less attractive. "Risk-free” rates are about 150 basis points lower than in the United States at both the short end and long end of the curve, making the yield spread to the risk-free rate more attractive in Europe and putting investors in a position to benefit from a more favorable financing environment when rates fall. Second, not every theme, asset, or city is low-growth. There are segments of the market with very strong rent growth, and investors who can choose the right types of assets in the right cities and neighborhoods can create higher real returns.

We feel some urgency behind this opportunity and have been investing steadily over the past 12 months, having made 12 new acquisitions in European real estate equity and developing an increasingly busy pipeline. However, global real estate markets are transparent, and we believe more positive sentiment might soon start to be somehow reflected in asset pricing. Calling the bottom of any market is notoriously difficult, but a stabilization in transaction yields leads us to believe the worst of the repricing is likely behind us and the time to act is now (Exhibit 1).

EXHIBIT 1: Early Signs Point to Stabilizing Yields

What Is Driving the European Real Estate Opportunity?

Through our debt and equity businesses, we have observed that a combination of rising interest rates and macro uncertainty related to the Russia-Ukraine conflict has pushed prices approximately 20%-40% lower than their peak values in 2021 and 2022. However, fundamentals remain strong in many sectors, as we’ll discuss in more depth in the next section.

Given the backdrop of macro-economic uncertainty and rising rates, European transaction volumes fell nearly 50% in 2023 (Exhibit 2). We attribute the decline to the gap between what sellers were willing to accept and what buyers were willing to pay and a shortage of core capital, which typically accounts for a healthy proportion of market transactions. A retreat from the office sector, formerly one of the largest sources of overall transactions, is also a factor.

EXHIBIT 2: Transaction Volumes Fell Precipitously in 2023

However, we are now seeing transaction volumes start to build. Buyers and sellers are moving closer on pricing expectations as a wide group of property owners come under more pressure to sell assets and financing availability improves. Those who borrowed in 2021 and 2022, face the prospect of refinancing buildings that are now worth less at higher rates. Some sources indicate there may be a €114 billion funding gap between 2024-2027.¹ Those who cannot refinance are selling assets. Helpfully for buyers, financing costs have moderated by 60 basis points (bps) on the continent and 30 bps in the United Kingdom since September 2023, with banks now generally more willing to lend than a year ago.

Likewise, open-ended funds across both continental Europe and the UK are facing significant redemption requests. In a search for liquidity and given the difficulties in challenged sectors or locations, they are often offloading their most liquid assets first.

Where Do We See the Opportunities?

We see a sharp bifurcation across many sectors in Europe between the demand for sustainable, green, and efficient buildings and older, less efficient stock. We are focusing on developments and assets that are best-in-class both in terms of traditional metrics such as location and by sustainability standards. For example, we’re working on a joint venture that will bring a 200,000 square-foot sustainable building to downtown Manchester, along with a significant amount of public space. The first phase of the project aims to achieve net zero emissions in both construction and operation, and the building itself is set to be one of the most eco-friendly and energy-efficient buildings in the United Kingdom. We also plan to offset the remaining carbon emissions using carbon credits. The development is almost entirely pre-let at record rents for Manchester. In our view, these kinds of energy-efficient projects are more future-proofed against increasingly tight energy efficiency standards and volatility in energy prices and in line with changes in what tenants and the public expect and value.

We see attractive fundamentals over the medium term in our four preferred sectors—logistics, multifamily housing, student housing, and hospitality. These “sheds and beds” sectors all have supply constraints, strong demand, and secular tailwinds, making them a favorite among many investors. What we think will set some investors apart is the ability to access and execute deals through extensive relationship networks and deep, varied pools of capital.

We have been active in logistics over the last 12 months. Rental growth has slowed lately, but we expect it to return over the next 12 months. Vacancy rates within the prime logistics segment is extremely low (Exhibit 3) and we expect it to remain that way until at least 2028, due to higher development costs, higher capitalization rates, and regulators taking a stricter view of development for environmental reasons. Meanwhile, the longer term trends of increasing e-commerce penetration and nearshoring should support demand growth. We are focused on high-quality facilities in areas with durable demand and access to both power and labor.

EXHIBIT 3: Prime European Logistics Vacancy Rates

The residential picture also looks promising. European housing markets are chronically undersupplied, partly due to tough planning regulations. In multifamily housing, we look for sustainable rents and a stable regulatory regime that makes it possible to accurately underwrite rents. Increasing demand for higher education is also creating demand for student housing, another sector we are actively playing in. Given the scarcity of high-quality supply across Europe, we are starting to see interesting opportunities through forward funding or forward purchases structures for well-located assets with attractive amenities.

Finally, we are optimistic about hospitality, with occupancy in European hotels almost back to pre-pandemic levels. Travel from Asia has not yet fully recovered, and we think an uptick in visitors from the region, particularly India, could drive a new wave of demand growth in the coming years. Meanwhile, we expect new supply in 2024 and 2025 to average 15,000 fewer rooms a year than the long-term average - a result of land scarcity, moratoriums on new development, and a preference for alternate use of available land.

How We’re Approaching the Market

As we consider a busy pipeline of potential investments, we are focusing on high-quality assets in attractive locations. We see opportunity in assets when they have stressed capital structures, but not when they are in true distress. We focus instead on opportunities with motivated sellers and strong fundamentals.

We also think sustainability is critical to underwriting. Tenants, investors, financiers, and institutions are all more focused on environmental concerns and place a premium on green, efficient buildings that are compliant with incoming legislation and can deliver energy and well-being performance.

We see this moment as unusual and exciting. Investors with on-the-ground expertise in the region’s widely varied markets and deep, flexible pools of capital are faced with an array of motivated sellers and tight financing conditions that reduce competition. Buyers can be selective and enter at attractive price points. Interest rates are moderating, and liquidity is returning to markets in both debt and equity as strong supply-and-demand dynamics and secular tailwinds support strong rental growth in our preferred sectors. Even as we stay disciplined and selective, we recognize this period as one we must not miss. 

^1. Source: CBRE, “The Debt Funding Gap for European Real Estate,” December 2023. 2024-2027 debt funding gap based on forecast values.