A broad-based recovery in UK and European real estate looks unlikely in 2023, but discerning investors can still find value, say Imogen Ebbs and George Fraser-Harding.
Read this article to understand:
- Which sectors and countries look to be most resilient
- Why the lack of deal activity is creating opportunities for investors with dry powder
- The appeal of single-family housing and life-sciences real estate
On August 3, the Bank of England (BoE) raised interest rates for the 14th consecutive time, to 5.25 per cent – their highest level since February 2008.1 Similarly, the European Central Bank (ECB) raised its benchmark deposit rate to 3.75 per cent on July 27, its highest level since 2001.2 Both central banks are engaged in the tricky task of trying to combat inflation without inflicting pain on their economies.
Up until now, the UK and European economies have proved resilient: UK GDP growth has stayed positive, expanding 0.2 per cent quarter-on-quarter in the period April-June, for example.3 But high inflation and rising rates have hit activity across a range of sectors, including real estate.
According to JLL research, investment in UK commercial real estate decreased 53 per cent year-on-year in the first half of this year to £14.2 billion – 37 per cent below the ten-year average.4 The decline in European volumes in the first half was even steeper – a 61 per cent drop to €65 billion, according to Savills.5
However, when digging deeper into the numbers, clear nuances appear. Certain sectors remain resilient and in demand – notably life sciences, single-family housing and logistics. Investors with capital to deploy and strong convictions about longer-term thematic trends have been able to take advantage.
Figure 1: UK versus Europe investment volumes, 2014 - 2023 (€mn)
Source: JLL, July 2023.6
In this Q&A, Aviva Investors’ Imogen Ebbs (IE), head of UK real estate equity funds, and George Fraser-Harding (GFH), head of pan-European real estate funds, discuss the importance of being selective in this environment.
When we last spoke, there was still uncertainty around capital values and where pricing would settle. Has anything changed?7
GFH: While there is still uncertainty, capital values in the UK have been largely stable over 2023. But there is differentiation across asset classes and geographies.
Logistics, for example, was the first sector to reprice before stabilising, whereas offices have been slower to react. As with all of these troughs, different valuers move at different speeds, which feeds into the indices. There is a sense landlords on the continent have been pushing valuers to hold office yields; however, they have now widened, a trend we expect to continue.
Values in Europe have been slower to react but, again, the situation varies across countries. In the Netherlands, yields have moved quicker, partly because there is more global capital in that market. There has been less movement in France, Germany and Sweden, where the investor bases are largely domestic. Again, this is now moving.
IE: The market did not see a sharp correction in the first half, largely because of a lack of liquidity and transactions. As you would expect, there is greater liquidity and more certainty for prime assets. Beyond that, particularly in sectors reliant on debt financing, there is a lack of evidence for valuers to work with. Outside London, for example, there has only been one prime office deal completed in the UK.
Over the coming months, there is uncertainty around how the occupier market will respond to tighter credit conditions, higher interest rates, lower consumer spending and growth. We are also closely monitoring how supply will affect pricing, with more stock expected to come to market over the next 12 months because of liquidity and refinancing pressures. But, overall, moving through into next year, we expect conditions will start to stabilise in areas of the market with strong fundamentals.
According to most forecasts, we are close to the peak in interest rates and the threat of a “hard landing” for the UK and Europe has subsided. Is that reflected in investor sentiment?
IE: I think it is unlikely we will see a broad-based recovery in real estate this year. Sectors that are dependent on discretionary spending, along with office buildings that do not meet modern occupier requirements, are under pressure. By contrast, higher-quality assets in prime locations that are supported by favourable long-term structural trends will be more resilient.
GFH: Our focus is on identifying assets that will benefit from those structural shifts. The dislocation in the market over the past year has presented a number of such opportunities at attractive valuations, and we have been able to invest significant capital in the UK and, to a lesser extent, Europe.
But discipline around pricing is critical. After the global financial crisis (GFC), you could have bought almost any real estate asset and would have done well. In a higher interest-rate environment like this one, you need to own buildings that will provide good rental growth and an excess return.
Are the well-publicised issues in the real estate debt market presenting opportunities for equity investors?
GFH: Earlier in the year, we saw sellers with liquidity issues coming to market. Now we are starting to see more signs of distress among leveraged landlords, which could present opportunities. These distressed acquisitions allow us to buy at yields higher than the market and, in these cases, debt is becoming accretive.
IE: Opportunities are coming but, again, you must be selective. As George said, the environment today is not comparable to what we saw after the GFC, when supply across the board flooded the market. A lot of assets being sold will not necessarily be of the quality buyers are looking for. Owners of assets with good fundamentals and rental-growth prospects are in a much better position to work with lenders to find solutions rather than being forced to sell.
Buyers need to be nimble. We have been in the fortunate position of having capital to deploy. We have moved quickly when attractive opportunities have arisen and have widely canvassed the market with around £33 billion of opportunities assessed in the first six months of 2023. Where we have seen compelling opportunities, we have moved swiftly. Our acquisition of the Brakes urban distribution unit in Reading, for example, was completed within 15 days of agreeing terms.
The first half saw a sharp decline in transaction volumes. What will it take to inject life back into the market?
IE: The inertia has been driven by a mismatch between seller and buyer expectations. As the market stabilises, you will have greater pricing certainty and more transaction volumes to use as a reference for valuers. That will provide greater confidence.
GFH: Landlords on the continent are coming under real pressure to dispose of assets now. Having motivated sellers at realistic pricing will see transactions pick up.
In our view, where real estate is trading now presents good long-term value. On a selective basis, this is a good time to be actively looking at opportunities. In a less-crowded market, you can be more discerning in terms of acquisitions.
Somewhat surprisingly, given negative sentiment over recent years, retail has held up better than other sectors in 2023. Why is this and what are your views on the sector?
IE: It comes down to three things. First, retailers that are still trading have survived the pandemic and the cost-of-living crisis, so have demonstrated they are efficient and relevant for modern requirements. Discount retailers are in growth mode and dominant occupiers like Next and Pets at Home have posted strong results. Secondly, there has been very little new development in this sector, with many schemes converted for other purposes, including residential, leaving vacancy rates as low as between three and five per cent in certain locations.
Finally, the sector has been repricing since 2018. So, when we started to see a dislocation in the wider real estate market last year, retail yields were already higher than other sectors and therefore more protected.
Now that prices have readjusted, it could be a good entry point for investors. Again, it is about being selective and monitoring fundamentals like local market dynamics, the adaptability of the building and its location.
What are your thoughts on opportunities and risks in single-family housing?
GFH: Alongside Spanish build-to-rent, we see UK single-family housing as one of the best opportunities to find long-term value in the European residential sector. We entered the market a couple of years ago, and it became crowded very quickly. But recent repricing, on the back of rising interest rates, has meant less competition even though the occupational fundamentals have only strengthened. Many home builders are concerned about their exit points, and we are speaking to them directly to acquire assets at compelling values versus vacant possession value.
IE: In the UK, it is the sector where we have the highest conviction; we have deployed around £460 million in single-family housing since the final quarter of 2022.
Discipline is key though. Inflation feeds through to build costs which, combined with falling house prices, puts pressure on contractors and suppliers. We have been careful to structure our deals to protect against that, and we have also been prudent in working with partners, such as Packaged Living, that have specialist capabilities.8
Figure 2: Enquiries per rental property
Source: JLL, July 2023.9
Life-sciences real estate has also proved resilient. What are your views on that sector?
GFH: We are a long-term owner of life sciences real estate – particularly in Cambridge. We have also conducted research into the best life-sciences locations in Europe and are actively looking at opportunities on the continent in Paris, Munich and Stockholm.
IE: Our investment in life sciences in Cambridge illustrates our long-term conviction to the sector. Chesterford is a leading research park in Cambridge within a 260-acre campus and a key part of the world-leading Cambridge bio cluster. We have developed the site over the last 20 years into a balanced ecosystem with a range of occupiers. There is huge opportunity to grow the reach of the park with a further pipeline of up to one million square feet of additional R&D accommodation. As well as expanding and developing existing schemes, we will look to increase our exposure to the sector through new acquisitions.
How do your acquisitions so far in 2023 break down by sector and what are your upcoming priorities?
IE: We have completed around £700 million in UK acquisitions since the third quarter last year and have further capital to deploy as our funds continue to grow.
Figure 3: Aviva Investors UK and European real estate acquisitions by sector since Q3 2022
Note: Retail includes shopping centres, supermarkets.
Source: Aviva Investors, August 2023.
GFH: In Europe, logistics is one of our key areas of focus. The rental growth we have seen in the UK over the past ten years has not come through as strongly in Europe yet, but we expect that to change. There are low vacancy rates in many regions and new supply is constrained due to higher construction costs and exit yields, meaning that development appraisals no longer work. We believe there is a strong opportunity for outperformance through excess rental growth over the short and medium term.
Figure 4: UK logistics vacancy rates (per cent)
Source: CBRE Research, July 2023.10
