DWS Group, the global asset manager with €860 bn of AUM, is starting to think the European real estate market is turning the corner with double digit returns on the horizon for prime assets in its favoured sectors.
On Wednesday, Simon Wallace, global head of real estate research and strategy, and colleague Ruben Bos, head of real estate strategy Europe, gave a sneak preview of the company’s European Real Estate Strategic Outlook ahead of the paper’s launch on Thursday.
Much of the language was upbeat after a difficult 18 months of price corrections in many parts of the market, but there is a sense that things are changing.
Wallace said: ‘Last year was an exceptionally tough year and the uptick in the second half of 2023 failed to materialise not just in Europe, but globally.’
‘But DWS strongly believes that the price correction for prime real estate assets in Europe is done.’
‘We have a really strong conviction. Most importantly, this has been a capital markets-led downturn, and we are now expecting to see more money targeting the real estate sector. We expect to see more liquidity this year. We’ve had repricing in the market, we've had recovery in the equities market, and the dreaded denominator effect for most investors is no longer an issue. Also, the occupier market remains very strong.’
‘As a result, we think 2024 is going to be an exceptional vintage year for the prime real estate market. We are expecting to see over the next five years double digit returns across quality prime real estate in most European markets and that’s on average. There will be markets we expect to outperform as well.’
He acknowledged there ‘absolutely are’ some short-term risks in some markets that perhaps are in recession, but construction levels mean there will be supply shortages in parts of the European real estate market over the middle of the decade.
DWS has strong conviction around markets such as Germany which has endured a torrid 18 months, but the asset manager believes it is poised to come back strongly in the medium term. It is also a believer in cities such as London, Paris, Amsterdam, Warsaw as well as across Germany.
Its two top sector picks are logistics and residential, plus private debt, for which it thinks there will be more opportunities over the coming 24 months.
In addition, it thinks a value add strategy is increasingly attractive in terms of opportunities to refurbish and deliver best-in-class space into major cities as supply shortages hit in the middle of the decade.
Bos said: ‘We think the repricing is largely done, after corrections of just over 20% for prime assets across Europe. We are still a few months away from reaching the low point as there is always a lag with market prices, but we think real estate is at the bottom.’
He said real estate today looked very fairly priced on an IRR basis compared to corporate bonds.
While offices have been hit hardest, logistics is down about 175 basis points in the UK which is about a 20 to 25% value decline, but stronger rental growth is coming through. Residential especially in the UK has been really resilient.
‘We’re at a turning point - the worst is behind us. We are expecting yield compression to come in from next year. The most notable driver of that yield movement is cost of debt with consensus that interest rates have peaked and we expect them to fall this year and ultimately stabilise over the next few years.’
He added real estate fundamentals were good given robust demand alongside falling supply.
There is no lack of lending, but it is just expensive, believes Bos, and borrowing costs should become less expensive. Investors are not being burdened anymore by the denominator effect. While there is still very little liquidity – and DWS does not think transactions will recover this year to the long-term average - he does expect an ‘uptick’ in volume also factoring in motivated sellers.
Double digit growth
‘We feel 2024 will be an exceptional vintage year. We will see rental growth, we will begin to see yield compression for prime assets and returns likely to reach double digits.’
‘When we look at the past, the last two price corrections were followed by exceptional vintages typically 18 months into a price correction and that is where we are at. All this bodes well for strong returns going forward.’
DWS’ report out on Thursday states: ‘We believe that the correction is all but complete at the prime end of the market, with values around 20% below 2022 peak levels.’
‘Poised for recovery’
'With rental growth and the return of yield compression, prime property-level returns could reach double digits across all major sectors from 2025 onwards. European logistics and residential – including student housing and co-living – remain our key core investment strategies. We also see attractive, higher return opportunities in development, including office-to-best-use conversions.’
‘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.’
Not easy though
But in no way does this suggest that 2024 will be easy. The report states: ‘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.
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.’
‘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%.’
2024 an exceptional vintage
‘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.’
‘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.’
