Market Outlook

It may seem like we’ve been living in a constant state of crisis for the past fifteen years. Financial, political, epidemiological crises, buffeting the world from all directions, ending what was to some a golden age of tranquillity. But for real estate investors this was far from the reality. From 2010 onwards allocating capital to real estate seemed almost like a one-way bet. Investment volumes surged, capital values doubled and the market convinced itself that lower for longer was the new normal. Yes, there were times of stress, but overall, life was good. Eighteen months ago, that all changed, as the market entered one of the most severe downturns since the Global Financial Crisis.

Today, as we sit surveying the damage, we must ask ourselves: is that it, or is there more to come? The answer is not that simple. With the correction now well advanced and lower interest rates on the horizon, there is a strong case to made that we are now at a turning point, and that the market will enter a recovery phase in 2024. This is indeed our expectation. Already we see a small number of segments returning to growth, laying the foundations for a broader upturn throughout this year.

But in no way does this suggest that 2024 will be easy. Recession stalks the global economy, with Europe no exception. And while we may not be expecting a deep downturn, businesses are likely to fail and jobs expected to be lost, putting upwards pressure on vacancy and dampening the exceptional rental growth we’ve experienced over recent years.

Financing will also remain challenging. Having so far proven something of a Phoney War, the refinancing battle may have only just begun. And while we may not be seeing systemic risks or a widespread shortage of debt finance, the ending of grace periods, higher debt costs, additional equity requirements and a general unwillingness to lend outside of favoured sectors, all suggest we should see a steady increase in defaults well into the period of recovery.

However, prime European real estate is currently pricing at around 20% below 2022 peak levels and for some investors this will be enough to bring them back into the market, no longer burdened by the denominator effect, seeking out opportunities for higher returns. We strongly believe that parts of the market now look attractively priced, particularly in the face of recession, where a solid income return from good quality real estate could once again pique investor interest.

Challenges also bring opportunities. An overcorrection of good quality assets in unloved sectors, deep discounts on secondary stock ripe for redevelopment, and the provision of whole loans during periods of elevated refinancing all have the potential to provide excess returns over the years to come. Navigating this will not be easy, and therefore it will be important that we enter this period with a deep understanding of our markets, focusing not just on what looks cheap, but on fundamentals, on space that works for occupiers now and into the future.

Above average returns

Peak interest rates, solid fundamentals and a diminished pipeline

The global run up in bond yields through summer and early autumn caught many by surprise, souring the mood across the real estate industry. European REITs sank 10%,^[1] any signs of emerging optimism evaporated and eventually the market capitulated, pushing prices to new lows. With just €140 billion of transactions in 2023 (50% below the ten-year historical average),^[2] the all-property prime yield in Europe ended the year more than 80 basis points higher at 5.2%.^[3]

However, as we enter the new year, we sense a slight shift in the mood. The most notable driver of this has been a sharp improvement in debt costs. Five-year Eurozone swap rates fell from an October peak of 3.5% to around 2.4% by the end of the year,^[4] with debt markets pricing in a series of rate cuts throughout 2024.

With an increased acceptance amongst real estate buyers, sellers and appraisers that values across almost all parts of the market are considerably lower than they were 18 months ago, alongside a recent rally in both debt and equities, this suggests that institutional investors considering real estate are no longer significantly burdened by the denominator effect. And while some may consider cutting back on target allocations to the sector, on balance this suggests a period of improving liquidity.

We may still be a few months away from reaching the low point in valuations, but overall, we believe that at the prime end of the market, the correction is all but complete. This is unlikely to be the case for poorer quality assets in weak locations, where we see a risk of further price correction. Not only are these assets more vulnerable to the economic downturn, but it is also likely to be some time before we see liquidity return, with debt finance both expensive and in short supply for this type of product.

As we move into the second half of the decade, we expect the recovery to accelerate and broaden. The return of economic growth and the current reduction in new starts should both help to reduce vacancy, boosting rental growth. Indeed, we believe some real estate markets could face acute shortages of new space over coming years. Many of Europe’s largest cities already lack sufficient rental housing as well as good quality logistics, while even the unloved office sector across many prime locations is reporting low single digit grade A vacancy. With residential development in places like Germany or Sweden currently running around 25% below required levels,^[5] European logistics starts down 30% on 2022,^[6] and office net additions projected to turn negative in the second half of this decade, we see plenty of reasons to suggest rents could continue to grow well in excess of inflation for the rest of the decade.

We expect 2024 to be an exceptional vintage year for real estate investment. With rental growth and the return of yield compression, prime property-level returns could reach double digits across all major sectors from 2025 onwards.

There will of course be challenges. CBRE estimates the debt funding gap may not peak until 2026^[7] – although price recovery should help to reduce some of the risk – while looking back to the financial crisis, loan defaults in the UK didn’t peak until 2011.^[8] We also shouldn’t forget that structural drivers have certainly not gone away and will continue to shape and disrupt real estate demand for years to come. As such, a wide range in the return performance of sectors and subsectors, markets and submarkets, assets, and strategies, looks like a probable outcome.