AEW, one of the world’s leading real estate investment and asset managers, today releases its European Annual Outlook for 2023. The report examines how investors can position themselves for the significant political, economic and financial disruptions that are changing the landscape for real estate investment, as the long post-Global Financial Crisis (GFC) cycle comes to an end. 

Key findings of the report include:

The UK is ranked most attractive out of 168 covered market segments for the second year in a row on a relative value basis over the next five years, with Benelux second, reflecting an above average share of attractive and neutral markets.

AEW’s new base case scenario assumes that we are past the peak of inflation across the 20 countries covered, which 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’s base case scenario assumes higher bond yields as well as a short and shallow recession in Q4 2022 and most of 2023. Reflecting the heightened uncertainty, AEW’s downside scenario assumes a longer recession and higher for longer bond yields.

AEW expects 2022 full-year volumes in the European real estate market to land at €260 billion (£220billion), with €218 billion (£188 billion) invested in the first three quarters. This follows the 2021 record of €350 billion (£301.7 billion) and reflects the effects on leveraged investors from the doubling in borrowing costs over the last 10 months.

A debt funding gap of €24 billion (£20.6 billion) is estimated for the next three years in the UK, France and Germany, as re-financings of maturing loans are expected to face issues from the decline in capital values and lenders’ reduced risk appetites pushing for lower LTVs. As in the post GFC era, this presents an opportunity for equity and debt investors with capital to deploy.

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 that investors can expect to reach the required rate of return from their investments in 30% of markets.

Projected returns for all property across Europe during 2023-27 remain positive, although yield widening has pushed forecast returns to 4.0% per annum across all 196 segments , down from 4.7% half a year ago. This is mostly caused by higher government bond yields pushing up property yields and limiting capital value growth.

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 (WFH) than pre-Covid, with the impact of WFH on office demand 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.

Hans Vrensen, Managing Director, Head of Research & Strategy Europe at AEW, commented: “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. Real estate investors face a more challenging market environment. 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.”

“Unsurprisingly logistics, despite the largest expected yield expansion, continues to be the most attractive sector given the anticipated rental growth. We also project positive prospects for income growth in residential. Prime shopping sectors remain attractive on a total returns basis, whilst the impact from working from home on offices is less severe than previously anticipated. What’s significant, however, is that the real estate market continues to experience supply limiting factors, such as rising debt financing and construction costs, across the board. We expect these supply limitations to counter the negative impact on demand from wider economic headwinds.”