Rapid repricing in real estate markets and retreating recession fears are set to trigger a rebound in European real estate returns, according to new research from AEW.
The firm's 2023 mid-year European outlook includes an update on base case assumptions to reflect an avoided European-wide recession in 2023, and explores how much further the current market re-adjustment has to go.
The paper also explores the outlook for rental growth and the debt funding gap as inflation and bond yields normalise.
Hans Vrensen, managing director, head of research & strategy Europe at AEW, commented: 'Since our last update in November, the outlook for European real estate has benefited from an improved macro-economic backdrop.
'In our latest base case, a European-wide recession is avoided in 2023. Also, our latest forecasts confirm that there is still some remaining downside in capital values for most markets during 2023. However, post 2024, we project a rebound in capital values and total returns across the majority of European markets.'
Key findings of the report include the conclusion that financial markets have absorbed recent central bank rate hikes and inflation, while bond yields have started to come down. The UK is expected to have one of the lowest economic growth rates amongst the 20 countries covered.
However, levels of uncertainty remain high and AEW’s scenarios help map out the possible impacts. The new base case scenario assumes that inflation normalises in 2023 with a slow and steady economic recovery.
This means that the downside scenario is deemed less likely since it assumes a recession and lingering high inflation.
Across all sectors 2023-27 returns are now expected at 6.8% p.a., significantly up from 4.0% half a year ago. All sectors benefit from improved rental growth and post-2024 yield tightening.
Logistics is expected to generate the highest returns of any sector over the next five years at 8.5% p.a., while prime shopping centres come second with returns of 7.9% p.a. on the back of current high yields and improved rental growth projections.
Rental growth
Logistics and residential are the most attractive sectors for rental growth with 3.1% and 2.9% p.a. respectively, benefitting from the improved macro-outlook. Reduced developers’ profitability is expected to limit new supply and contain vacancy rates.
Prime European offices are expected to be more resilient than non-prime. This is despite the overall negative sentiment on offices on the back of challenging news on US markets.
The report also finds that 2022 investment volumes were down 19% vs the record year of 2021 as leveraged investors were priced out by higher cost of debt. Q1 2023 transaction volumes are expected at around €37 bn, less than half the Q1 2022 level of €83bn but still well ahead of the lowest post-GFC Q1 in 2009 at €13 bn.
The latest total return forecasts factor in some remaining downside in capital values for 2023 – albeit less than the actual 2022 adjustment - with a rebound in capital values post-2024. For Germany and Benelux, the 2022-23 capital value correction is expected to be of a higher magnitude than during the GFC.
Refinancing matters
The report concedes that weakness remains in some firms' finance. Borrowing costs may have stabilised, but re-financing problems remain for maturing loans as values are down and lenders refinance at lower LTVs.
The resulting 2023-25 debt funding gap (DFG) remains unchanged at an estimated €51 bn, which would represent 22% of the total 2018-20 originations. AEW's estimated current DFG stands at 60% of the equivalent post-GFC DFG.
Concluded Vrensen: “As a result of faster-than-expected re-pricing in 2022-23, over 70% or 122 out of our 168 covered European markets are now classified as attractive or neutral - where investors can expect to meet their required rate of return.
'Logistics remains our top pick across sectors with the highest anticipated returns over the next five years. This is followed in second place by prime retail shopping centres.
'Despite the overall negative sentiment, we expect pockets of opportunity in prime European offices which will prove more resilient than their non-prime counterparts.'
