AEW forecasts that the UK will top the list of 20 countries surveyed in its European Annual Outlook 2023 as the best place to invest in property, despite the looming recession and as debt refinancing issues return.

The global real estate investment manager identified the logistics and prime shopping centres as those likely to generate the highest returns in 2023-27, while residential and logistics will be the most resilient for rental growth.

AEW’s new base-case scenario assumes that inflation has peaked across the 20 countries covered and is expected to come back down to below the 2% target adopted by central banks by early 2024 after they hiked rates and initiated monetary tightening, according to Oxford Economics.

Despite low unemployment and a successfully managed rebound from COVID lockdowns, AEW is predicting higher bond yields as well as a short and shallow recession in the fourth quarter of 2022 and most of 2023.

As for deal volumes, AEW expects 2022 full-year volumes in the European real estate market to land at €260bn (£223bn), with €218bn invested in the first three quarters. This follows the 2021 record of €350bn and reflects the effects on leveraged investors from the doubling in borrowing costs over the last 10 months.

The research, led by Hans Vrensen, managing director and head of research and strategy Europe at AEW, estimates that there will be a debt funding gap of €24bn for the next three years in the UK, France and Germany, as refinancings of maturing loans are expected to face issues from the decline in capital values and lenders’ reduced risk appetite pushing for lower loan-to-value ratios. This presents an opportunity for equity and debt investors with capital to deploy, AEW added.

Hans Vrensen

AEW’s Hans Vrensen

In its relative value analysis, only five markets are considered attractive, while 47 are classified as neutral out of the 168 market segments covered, meaning investors can expect to reach the required rate of return from their investments in 30% of markets.

It is the second year in a row that the UK has been ranked most attractive out of the 168 market segments covered by AEW, on a relative value basis over the next five years. Benelux come in second, reflecting an above-average share of attractive and neutral markets.

Projected returns for all property across Europe during 2023-27 remain positive, although yield widening has pushed forecast returns to 4% per annum across all market segments covered, down from 4.7% six months ago. This is mostly caused by higher government bond yields pushing up property yields and limiting capital value growth, according to the report.

Further findings include:

  • Logistics is expected to generate the highest returns of any sector over the next five years at 5.4% per annum as solid rental growth offsets yield widening.
  • Prime shopping centres are in second place with returns of 5.1% per annum on the back of high current yields. Shopping centres are expected to be the top income-producing sector over the next five years, with base case income return projections remaining relatively stable.
  • Negative capital returns are expected for the next three years across all sectors with a cumulative capital value decline of -12% in the base case scenario, less dramatic compared to the GFC which saw a -20% cumulative loss during 2008-9.
  • Residential and logistics are the most resilient sectors for rental growth. The higher cost of debt financing and construction, as well as ESG regulations across all asset classes could further limit supply, protecting most sectors from the recessionary impact bringing the demand for space down.
  • Only 8% more employees are working from home compared with pre-COVID and the impact on office demand has been less significant than previously expected. Adjusted office employment growth for 2022-26 shows the strongest improvements in London, Amsterdam and The Hague compared with AEW’s previous forecasts.
  • Five segments remain in the attractive category on a relative value analysis: Paris light industrial, Berlin and Zurich logistics, and Stockholm and London shopping centres.

Vrensen said: “The first European-cross border war in 80 years has pushed inflation to record levels. Whilst we believe the peak of inflation has now passed in our base-case scenario, the economic backdrop and higher borrowing costs have significantly altered the outlook for real estate investment to the downside.

“However, our research shows that opportunities do remain for investors, who are well positioned with capital to deploy. Also, the last few years have taught us that the macro-environment can change quickly. Our forecasts cover a five-year forward view, but we think investors need to be more prepared in the current volatile environment as the situation may change on the upside or negatively.”

He added that the real estate market continues to experience supply limiting factors, such as rising debt financing and construction costs, across the board, concluding: “We expect these supply limitations to counter the negative impact on demand from wider economic headwinds.”

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