A new chapter

Read this article to understand:

• Data indicating the real estate cycle is turning
• The sectors where pricing is already ticking upwards
• Why we are likely to see a “K”-shaped recovery

The Aviva Investors real assets research team deals in data. Collecting, comparing and interpreting data from a vast range of sources – from vacancy rates to risk premia, rental yields to transaction volumes – can be challenging. But it can provide valuable insights into the state of markets and the direction of travel.

As we look through the latest data on UK and European real estate, we see a clear pattern emerging. These markets are entering a new phase.

Think back two years to the start of the monetary tightening cycle. As central banks hiked rates to tackle inflation in mid-2022, they wrought havoc on real estate markets in many regions. Valuations plummeted. Lending was restricted and the viability of development projects was called into question. And while some real estate equity investors were able to seize opportunities, the higher cost of capital kept many debt-backed investors on the sidelines.

But our research suggests we may soon be able to draw a line under this tumultuous period. The macroeconomic backdrop is becoming clearer, with inflation moderating and rate cuts expected before the end of the year. At the same time, real estate valuations are starting to stabilise, with risk appetite and liquidity starting to return in debt markets too. Real estate investment trust (REIT) pricing is showing positive signalling and our assessment of real estate’s attractiveness, compared with other investment classes, has improved. We believe these signals herald a new chapter in the real estate cycle.

Unprecedented volatility

To grasp the implications of this shift, it helps to take a step back and examine the consequences of the 2022-2024 hiking cycle in more detail. It was truly an extraordinary time for real estate investors.

Just look at the numbers. The second half of 2022 saw UK property valuations fall close to 22 per cent, according to the MSCI UK monthly index, with smaller but still significant declines across Europe (see Figure 1).

A continued erosion of valuations through 2023 and into 2024 meant that, as of the first quarter 2024, there had been a peak-to-trough decline of 25 per cent in the UK (although four-fifths of that fall occurred in the latter half of 2022). October 2022 saw almost seven per cent wiped off values in a single month – the most on record – followed by a further six per cent decline in November.

Figure 2 compares major market corrections over the past four decades – the width of the bars illustrates the duration of the correction, and the height represents the peak-to-trough capital loss. The volatility that occurred during the tightening cycle was like nothing investors in private real estate had experienced in recent history, in terms of the speed of the correction.

However, it’s important to remember this has been a cyclical adjustment, not a structural one. In contrast to previous downturns, demand did not collapse, balance sheets remained broadly healthy and – a key difference from the Global Financial Crisis – leverage in the system was manageable.

Supply also remained in check, with speculative development largely curtailed. After all, extreme market volatility, combined with rising build and debt costs, is not conducive to putting spades in the ground.

A new chapter

What we saw during the hiking cycle, then, was a reasoned – albeit hugely disruptive – reaction to the rapid rise in the risk-free rate. While valuations fell steeply, pre-existing supply-and-demand dynamics remained in place.

The logical question is: what happens next? Absent any further shocks to the financial markets, we would expect valuations to continue stabilising over the coming quarters. As was the case in previous cycles, repricing has occurred more quickly in the UK than in Europe, but the data shows valuations flatlining across the continent too. Pricing has started ticking upwards in some sectors, such as industrials and residential (see Figure 3).

Debt dynamics provide a further indication that we are seeing a shift in market conditions. Real estate debt tends to reprice quickly when rate expectations change, more so than real estate equity. As such, the cost of finance has been higher than property yields for an extended period. But now that debt costs have stabilised and headline property yields have adjusted, this inversion is no longer in place. Real estate debt financing is thus becoming accretive, in the UK (see Figure 4) and in rental housing and living sub-sectors in Europe.

Another signal of the change is the narrowing gap between transaction pricing and valuations. We closely monitor transaction indices, and while these moved quickly during the downturn, reflecting deal activity across the market, we are now seeing valuation indices catch-up. Valuations often lag the market during periods of rapid repricing, but if the gap between transaction and valuation signals is now closing, it means that – all else being equal – the bid-ask spread should also be narrowing.¹ Our scale and level of activity in real estate – we have invested £1.5 billion into high-conviction sectors across the UK and Europe since the hiking cycle began – means we are able to obtain real-time data in this area.

We have also seen a re-rating of listed real estate, where steep discounts have unwound and are now moving back in line (c. 15 per cent at the end of May) with the UK's long-term average discount of 16 per cent to net asset value (NAV), according to Morgan Stanley research. In addition, implied yields on listed real estate have also stabilised, albeit at a higher rate than pre-2022 (which is to be expected given the higher-rate environment).

Be selective

While the outlook for both the UK and European markets is shifting, we do not anticipate an immediate broad-based rebound. Rather, we are looking at a “K-shaped” recovery, with lower-risk, high-quality real estate performing well and other assets experiencing challenges due to significant occupier risks or a pressing need for capital expenditure (capex).

We favour assets in sectors like urban warehousing, rental housing and life sciences which are supported by long-term global structural themes, or megatrends.² Unlike in previous cycles we expect pricing of some secondary assets to remain challenged, driven by structural headwinds. Therefore, returns at the headline index level will mask a disparity in returns across assets.

The K-shaped trend is clearly playing out in the real estate debt market, where pricing remains tight for in-favour sectors and higher-quality assets, and borrowing costs on weaker assets remain punitive.³ This dynamic will drive a further wedge between high- and low-quality assets, exacerbating the divide between winners and losers.

Structurally, we feel the office sector is most vulnerable. We continue to favour high-quality and well-located prime offices in supply constrained major cities, like central London, Amsterdam and the Nordic capitals, but beyond these assets lie vulnerabilities; weaker, secondary offices will remain under pressure.⁴ Investors were already examining the potential effects of remote and hybrid working, and the additional capex spend required to adapt and reposition offices in response, both from an occupier and a sustainability perspective. These considerations will continue to influence valuations in this part of the market.

Other structural megatrends – from the energy transition to shifting demographics and evolving global supply chains – will influence both the macroeconomic picture and the prospects for assets at a local level. Investors will need to monitor these trends and the consequences for demand patterns and long-term value.

In summary, with the macroeconomic fog beginning to lift, rate cuts expected in the second half of the year and valuations stabilising, we feel real estate investors can start looking forward with more confidence. But discerning asset selection and a long-term perspective will remain crucial as the market starts a new chapter.