High inflation and rising rates hit activity in real estate markets over the past year. But cautious optimism is now returning to the investment landscape in the UK and Europe, say Imogen Ebbs and George Fraser-Harding.
Read this article to understand:
- Why the UK and European real estate markets look to be entering a new phase
- How rate cuts could affect the residential market
- How the Long-Term Asset Fund regime could influence UK real estate investment
High inflation and rising interest rates significantly altered the landscape for a range of investments over the past 12 months, real estate included. The challenging macroeconomic and financial environment depressed property values and led to a period of market recalibration.
But the impact on market participants varied widely. While certain real estate funds have been compelled to sell assets under duress, those investors with ready access to capital have found opportunities to secure high-quality assets at favourable prices.
With the macroeconomic outlook more certain and public debt and equity real estate markets starting to stabilise, we believe conditions are such that a new chapter of the cycle is emerging. At this inflexion point, it is clearly important to assess the influence of both cyclical shifts and longer-term structural megatrends on sectors and individual assets. Deploying capital at the optimal moment is also critical.
In this Q&A, Aviva Investors’ George Fraser-Harding (GFH), head of pan-European real estate funds, and Imogen Ebbs (IE), head of UK real estate equity funds, discuss the current state of the market cycle, how the anticipation of rate cuts is influencing investment behaviour and how the sustainability profile of assets is affecting pricing.
How have the UK and European real estate markets performed over the last year and what is your outlook for the remainder of this year?
GFH: The impact of market downturns has not been uniform across regions (see Figure 1). The UK saw the sharpest pricing adjustment globally. Repricing then followed in continental European markets.
Figure 1: Capital value decline across regions (per cent)
Note: Benchmarks used: MSCI UK Qtly Index, Q1 2023; MSCI Monthly UK Index, June 2023; MSCI Pan European Qtly Index, Q1 2023.
Source: Aviva Investors. Data as of May 2024.
The correction process in the UK has been rapid and is now showing signs of stabilisation, a trend we anticipate will extend to Europe in the latter half of the year. This variation in the timing of the market recovery suggests the UK may experience positive capital performance sooner than Europe.
A distinguishing factor in this market correction is the strength of the occupier market, particularly in prime sectors such as strategic logistics locations, Grade A offices in major cities, and the broader residential market.1,2 Investing wisely in these areas not only gives investors the opportunity to benefit from capital value stabilisation or recovery but also the potential to capture significant rental growth.
IE: This year, the three watchwords are cyclical, structural and vintage.
On a cyclical level, the UK is at a pivotal juncture, embarking on a new and exciting real estate cycle characterised by significant market adjustments. With inflation starting to ease, there is a sense of cautious optimism as we advance into the second half of the year. Although we may not return to the historically low interest rates that followed in the wake of the Global Financial Crisis (GFC), some rate cuts are expected and the outlook for prime real estate assets in the UK is increasingly appealing, particularly over a five-year horizon.
A longer-term structural perspective is crucial. Megatrends such as the energy transition, the changing nature of work, demographics and global supply chains are transforming the macroeconomic order, and these shifts are playing out at a local level. Ensuring we identify the potential winners and losers within the built environment and align our capital to where we see long-term structural demand is critical to driving long-term value.
As for vintage, the current phase looks to be optimal for deploying capital and the first couple of years of the new cycle are poised to offer a particularly compelling investment window as valuations stabilise and we start to get greater clarity on the macroeconomic outlook. Last year, we took advantage of capital repricing and acquired best-in-class assets at deep discounts. Our total investment of £1.5 billion into high-conviction sectors across the UK and Europe puts our strategies in a strong position moving into recovery.3
How have high interest rates impacted real estate markets, and what effect might the anticipated shift towards more relaxed monetary policies have on investment?
IE: In the UK, the market has been adopting a cautious stance, anticipating the onset of a rate-cutting cycle. This has contributed to a lack of activity. Prospective sellers, in particular, have been hesitating to move forward with deals. Bid-price spreads are narrowing, and we expect to see the market dynamic and investor profile change when the expected rate cuts begin.
One sector to watch closely is residential real estate, especially single-family housing. Market conditions were supportive in 2023 as debt-backed buyers retrenched from the market, mortgages became unaffordable, taxation changes interrupted supply and housebuilders sought more partnership deals. We took advantage of this market, deploying £500m into 1,300 homes across a number of transactions in the UK. The market dynamic is expected to change as debt becomes accretive (i.e., adds value) again but our sustained engagement with programmatic partners and builders over three years places us in a strong position to navigate any impact on pipeline and a more competitive marketplace.4
GFH: In pockets of the continental European market, the cost of finance is becoming accretive already. A decline in interest rates would lower borrowing costs further. However, it is important to note that while liquid markets typically react swiftly to rate cuts, in real estate and other private markets the response may lag. Thus, there may be a delay between the decline in interest rates and a new phase of activity.
As for the effects of higher rates, liquidity is scarce in the pan-European markets, leading to signs of distress of late. We have capitalised on this by securing deals from motivated sellers. Another surge in forced sales may occur if liquidity does not improve before the distress intensifies, which could create further opportunities for investors with capital ready to deploy. Our primary expectation, however, is for a gradual reduction in interest rates in Europe, accompanied by an increase in market liquidity. While there is a risk of price volatility due to these dynamics, we believe markets will stay resilient and gradually stabilise.
On the subject of distress, we have seen sales of office buildings in London at large discounts to prior valuations in recent months. Are distressed sales being observed in other locations?
IE: The market is experiencing localised pressures, with certain sectors and assets facing more significant challenges. Unlike the GFC, the current pressures are not uniform across the market but concentrated in certain sectors and more acute where assets have significant capital expenditure needs or weak investor appetite. Prime UK office spaces in London continue to show resilience, with a positive outlook for capital value recovery and strong rental growth. There are greater concerns in other office markets, however, such as Germany.
GFH: Right across Europe, deals are being done at valuations significantly below the ones we saw in 2022. Different countries are seeing different levels of distress depending on the approach to debt, which is creating opportunities. During the GFC, you could have bought almost any real estate asset during the turmoil and expected the price to go up in the years afterwards. This market is different; you have to be specific and focused in terms of the sectors, locations and quality of assets you are investing in.5 Opportunities may abound, but many hinge on being precise in the investment process and decision making.
What are your plans for 2024, and where do you see the biggest opportunities?
GFH: Last year, we invested predominantly in the UK, owing to limited opportunities in Europe. However, as pricing expectations adjust, we have started investing in Europe and anticipate a more balanced investment spread between the UK and Europe in the coming year, reflecting the evolving market dynamics.
In 2024, our focus is on Pan-European and UK logistics due to the exceptional value we’ve identified in this sector for our clients, which should also benefit from favourable longer-term megatrends, such as continued strong appetite for e-commerce and rising demand for on-shoring warehouse facilities.6 Additionally, we will continue investing in the living sector, including single-family housing and student accommodation, through our operating platforms in the UK and Spain.
Another priority for us this year is to deepen our involvement with the operational companies that manage our living assets. The management of real estate has evolved to become more operational in nature, and we are adapting by enhancing our relationships with these companies to ensure our living assets are managed effectively.
How will the advent of the Long-Term Asset Fund (LTAF) regime influence investment in UK real estate?
IE: The LTAF regime is a new category of investment funds designed to provide a broader range of investors with access to private market assets. They have been designed through extensive industry collaboration, and with the Financial Conduct Authority, to have stronger oversight mechanisms and liquidity controls that protect and enhance investor outcomes.
The expectation is that LTAFs will create shifts in the market landscape. The regime provides a new route for different types of capital, with investors such as the defined contribution (DC) pension market in mind. This should mean the sector’s investor base could grow and diversify, with new opportunities for patient capital to access real estate. For DC pension funds that need liquidity, real estate becomes a strong option. This capital will support further investment in real estate and new infrastructure across the country, helping drive economic growth.
Secondly, managers will have to focus closely on the ability to grow their existing fund structures, given older, limited structures are expected to gradually be wound down as the advantages of LTAFs become clear. As the fund structure landscape changes, volatility in selling, high cash levels and forced selling, especially from retail funds, could become much less common. With the Aviva Investors Real Estate Active LTAF (REALTAF) our ability to deliver its research-led thematic strategy will not be undermined by the ongoing uncertainty created by liquidity as seen in traditional open-ended structures.
In all, the belief is that LTAFs can transform the UK’s institutional real estate landscape and contribute to greater investment across a wider array of private markets in the UK.
What are the implications of “green premia” and broader ESG factors on real estate investment strategies?
IE: The concept of a green premium in real estate is simple: it refers to achieving better pricing dynamics as a result of better energy efficiency standards within a building. Calculating it however is not as straightforward: it encompasses a multifaceted set of adjustments related to rents, yields and capital expenditure expectations. These adjustments are influenced by the type of asset, sector, occupier, and the investor market dynamics in which its sits. Such factors are continuously evolving, and evidence is emerging that the impacts are heterogenous.
Given such considerations are becoming increasingly important across real estate markets, an opportunity is created to drive value as part of our capital pricing and underwriting approach. Conversely, risks associated with stranded assets, particularly in markets where there is less appetite for best-in-class energy efficient buildings, warrant careful consideration. The issue here is the opposite of the green premium, sometimes known as a brown discount on energy-inefficient assets.
There are growing concerns about real estate assets where expenditure on efficiency improvements may not be financially justified, and that is something all real estate investors should analyse carefully. The complexity and rapid evolution of ESG is leading to opportunities for mispricing, offering a potential to drive alpha, but also ensuring it is becoming a critical part of managing of capital at risk.
