After seven successive quarters of declining investment volumes, there are signs that European deal activity may finally be back on the road to recovery, writes Tom Leahy, head of EMEA Real Estate Research, MSCI.
The bottom of the cycle cannot come soon enough for a market that has experienced a tumultuous comedown from the extended period of low interest rates that pushed huge volumes of capital into European property.
There was some optimism 12 months ago that the second half of 2023 would see a pickup, but that proved misplaced, and acquisitions of European commercial property fell for the seventh successive quarter in the first three months of 2024. While the rate of decline may be slowing, aggregate transaction volumes were at their lowest level since 2012, as the market continues the difficult readjustment from the low interest rates that drove the boom in real estate after the Global Financial Crisis (GFC).
An optimistic view
An optimist would point out there are still high levels of uncertainty where assets should be priced and so little incentive for owners to bring assets to the market now, knowing that buyers will very likely demand discounts to get a deal over the line. This hypothesis is in part supported by the continued fall in the count of sellers, and a Q1 spike in the number of terminated deals and pulled offers to levels not seen since 2010.
The price shifts that have occurred in some segments of the European market since the start of 2022 also help explain some of the illiquidity in the transaction market. By running a mark-to-market exercise using the MSCI hedonic price series we can demonstrate a large proportion of assets in the major markets are likely worth less than they were acquired for. This has clear implications for market liquidity as owners do not want to crystallise losses, and so will delay sales for as long as possible. However, this is not always possible: repeat-sales data show that more European offices were sold at a cash loss versus a cash gain in Q1.
However, it is also clear that many segments of the market have not repriced sufficiently to bring greater interest from buyers. This disparity is enumerated by the MSCI Price Expectations Gap, which is negative for many core parts of the market, indicating that sellers would have to further reduce asking prices to get deals over the line. This is further supported by a fair value exercise, which shows that office yields would have to move out further in many markets given current expectations around interest rates, inflation and rental growth.
Troubles mount for office owners
The size of the office market means it remains the largest investment class by capital deployed, but the headline figures cannot disguise the post-pandemic, post-inflation malaise impacting the sector. Office trades in London, Paris and the major German cities are back at or below GFC levels. The cyclical slowdown is being amplified by structural shifts like hybrid working and accelerated obsolescence.
The RCA CPPI repeat-sales transaction price indexes show that office prices at the end of March in German A Cities were down 29% from their prior peak, while the outturn for Central London is -26% and for Paris -16%. The slightly better outturn for Paris may reflect some of the extreme illiquidity in the transactions market, as fewer Paris offices sold in Q1 of 2024 than in any prior quarter.
It is also true that the data show a bifurcation in the outcome for offices, with the newer, higher-quality assets outperforming the secondary and tertiary properties. A potential solution to this problem is to either redevelop the asset and repurpose for a different use-class, or to refurbish it and bring back up to market standard. The volume of office properties bought for redevelopment or refurbishment in 2024 equates to 24% of total sales. This is higher than in any calendar year on record and demonstrates the market is starting to respond to structural changes in the built environment and the opportunity they present.
Looking beyond real estate private equity
While real estate investors have been waiting on the sidelines for clear signals on when it may be prudent to dive back into the market, some have been paying more attention to potentially more attractive opportunities across the risk spectrum and capital stack during this period of heightened uncertainty. Real estate debt has attracted a lot of attention from investors in recent times due to the higher interest rate environment and the perception of more stable returns in an environment of falling values.
The notion of more stable returns is borne out by the results for senior debt and whole loan funds in MSCI’s recently launched European debt fund index. However, the performance of funds focused on mezzanine debt and subordinated loans has been poorer, suffering negative returns in the final quarter of 2023 but also performing more negatively than both the core, open-end real-estate equity funds in the MSCI Global Core Quarterly Property Fund Index and the closed-end funds (more typically value-add and opportunistic) in the Burgiss Global Real Estate Funds Index.
Looking forward to a recovery?
The Q1 transaction market data might have been particularly gloomy, but some good news has emerged in the most recent updates. April’s numbers suggest that European deal activity may have finally bottomed out 21 months on from the onset of the slowdown in July 2022. Admittedly, this is growth from a low base and one quarter’s data does not a recovery make, but it does support some of the more positive sentiment that has fed through from various surveys and conversations with dealmakers.
The listed market, where forward-looking sentiment is assimilated into asset pricing on a daily basis, also offers another positive signal. MSCI’s Liquid Real Estate Indexes adjust for the impact of company leverage and broader equity market volatility, with the aim of showing what listed market pricing implies for the underlying real estate asset performance. These show UK listed returns turning positive, which has been followed by an improvement in total returns from the MSCI UK Quarterly Property Index.
Moreover, European property returns moved back into positive territory in the first quarter of 2024, after six successive quarters of negative returns. Capital values continued to fall across all sectors but at a more moderate level than in prior quarters and were mostly offset by the income return. Offices were still the main drag on the market and the only sector where quarterly returns remained negative.
Eye on central banks
European central banks have now started to bring interest rates back down, which may help to ease the refinancing pressure on property owners and help to bridge the substantial price expectations gap that exists in most major markets. However, the industry has been a key beneficiary of a 40-year plus interest rate cycle that ended in 2022.
During this period it was highly likely property owners would be selling into a market where the risk-free rate was lower than when they acquired the asset. This has a positive impact on capital values all other factors being equal. Therefore, once property benefits from the short-term boost from falling interest rates and they settle at levels likely higher than the post-GFC period, the industry will have to carve out a new spot for itself in the remodelled investment landscape, with an emphasis on driving returns through active asset management.
