Residential stands out as the most attractive property sector on a risk-adjusted basis, according to new research published by AEW.
The report, which forecasts rental growth, yields and total returns across 24 different European residential markets, also identifies residential as the most resilient of all property types, offering bond-like, stable and predictable cash flows.
For these reasons, residential total returns have historically been less volatile than for the other property types, while at the same time generating prime total returns close to 8% pa.
Continued lack of supply and strong demand from new household formations is driving prime rental growth in most European markets. Despite an increasing number of rental regulations to ensure affordability for tenants, prime residential rental growth is projected at 2.6% p.a. over the next five years on average in Europe.
Environmental regulation is becoming more demanding every year in residential as in other property sectors. It will not be possible to let homes with an Energy Performance Certificate (EPC) of G and F in the near future.
However, rental and environmental regulations have not been deterring investors, who have committed more capital than ever to European residential in 2021. Volumes have been boosted by large portfolio sales and M&A, but also by new entrants and increasing allocations from existing investors. In less mature markets, institutional investors look for pre-funding opportunities with developers to build their portfolios.
Yield forecasts in AEW’s base case scenario are based on the outlook for swap-implied government bond yields. In this scenario, the risk premium over government bond yields is expected to remain high at 284 bps on average in 2022-2026, compared to 160 bps over the past 15 years. Over the next five years, prime total returns for the residential sector are forecast to reach 5.1% p.a. on average in the 24 markets covered, ranging from 3.4% p.a. in Munich to 8.1% p.a. in Manchester. A stronger inflation scenario would negatively impact residential total returns as the improved income returns would be offset by higher exit yields.
Hans Vrensen, managing director, head of Research & Strategy at AEW, said: ‘The residential sector continues to offer institutional investors a substitute to bonds, with potential for inflation-linked rental upside and capital growth delivering resilient returns. However, more focus must be placed on decarbonising the existing residential stock, which could be at risk of obsolescence if not properly addressed by the industry at large. Institutional investors are well placed to address this, while also benefitting from the upside.’
