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Looking ahead: “Do more in ‘24” or “survive ‘til ‘25”?

Kim Politzer

Kim Politzer - Director of Research, European Real Estate

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The phrase often heard at ExpoReal, the international real estate fair in October 2023, was “survive ‘til ‘25”, suggesting another tough year ahead in 2024 following a difficult 2023. Yet there are reasons to be optimistic about real estate investment in 2024. We highlight why there will be opportunities for those with capital. However, there will also need to be an adjustment in expectations around what will drive performance and the role that real estate will play in a portfolio.

Key takeaways

  • The past 18 months have been difficult for European and global real estate markets, as rapidly rising interest rates have driven valuations and transaction volumes down. In stark contrast to the US, Europe has seen resilient occupier markets driven by steady demand and a shortage of high-quality space.
  • We predict 2024 as the turning point, driven by the expectation that central banks will begin cutting interest rates. However, critical risks remain to prevent central banks’ from easing monetary policy given the potential for inflationary shocks among other risks.
  • We see opportunities in the logistics sector, best-in-class office space in major cities, and value-add strategies engaging in brown-to-green renovations.

Near-term: top-down macro factors drive the timing of the turning point

The global direct real estate investment market has been hit hard by rising interest rates over the past 18 months. Rapid increases in interest rates resulted in the withdrawal of debt from the market, a sharp repricing of assets, and a loss of liquidity, further exacerbating uncertainty. Higher interest rates meant that the relative pricing of real estate no longer looked attractive compared to fixed income. In general, 2023 was characterised by weak investment volumes, with year-on-year transaction levels down by about 50%.1

So, what could trigger the beginning of a recovery in activity in 2024? First and foremost, falling interest rates. At the heart of the likely out-turn for European real estate this year is the speed and scale of interest rate cuts, driven by the expected path of inflation and strength of European economies. In the near term, inflation remains on a downward trajectory, and economic growth across much of Europe remains weak.

Initial estimates suggest that GDP growth for 2023 was 0.5% for the Eurozone, while inflation has come down from 9.2% at the end of 2022 to 2.9% at the end of 2023.2 From a ‘glass half empty’ perspective, 2023 was effectively a year of treading water with close to zero growth, which was in sharp contrast to the robust growth achieved in the US. But, from a ‘glass half full’ perspective, most European economies managed to avoid a recession despite elevated interest rates and inflation.

The ECB kept rates stable at their January meeting, indicating they wanted to see wage inflation soften further, easing pressures on core inflation. There is broad consensus that central banks will likely start cutting interest rates during Q2 2024 (see Figure 1), but the speed and scale of cuts for the rest of the year is much less certain.

Figure 1: Four 25bps cuts in base rate expected by year-end 2024
Forecasts of ECB Refinancing Rate

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Source: Reuters poll, January 2024.

There are clear risks to the outlook for inflation, not only from wages, but also exacerbated by further supply chain disruption in the Red Sea and the Panama Canal, pushing the Shanghai Containerised Freight Index (SCFI), which measures the cost of seaborne freight, to almost double its pre-Christmas level in January 2024.

Figure 2: Geopolitical risks could derail central banks’ plans
Shipping costs spiked sharply after attacks on ships in the Red Sea, which could add 15-30 bps to the European inflation outlook for 2024

Geopolitical risks could derail central banks’ plans

Source: Shanghai Shipping Exchange, February 2024.

Interest rates impact real estate in terms of providing debt to fund acquisitions. Furthermore, the way banks deal with refinancing existing commercial real estate debt will also be important, with 30%-40% of European real estate loans due to be renegotiated by the end of 2025.3 With a widening debt funding gap, some investors cannot provide additional equity and may become stressed or forced sellers.

Another critical consideration is the effect of interest rates on asset allocation and real estate’s expected returns relative to other asset classes. For instance, 10-year government bond yields indicate whether there is an appropriate spread over the ‘risk free rate’, and equity and corporate bond yields help gauge real estate’s relative attractiveness. Many of these yields move ahead of central bank base rates, as the market anticipates the changing interest rate environment.

Over the past three months, as the market has become more convinced that the interest rate hiking cycle is complete, longer-duration sovereign bond yields and corporate bond yields have fallen, while real estate has seen continued increases in yields. This has widened spreads, improving real estate’s relative attractiveness (see Figure 3). Although this may not be enough to trigger increased market activity in the direct real estate market in the short term, it does appear to have been sufficient to result in a rally in listed REITs. Several successful new real estate-linked bond issuances and tightening spreads in fixed income space further evidence of improving conditions.

Figure 3: Yield spreads for prime real estate
Spreads widened in Q4 due to sharp fall in IG bond yields and continued increase in real estate yields

Yield spreads for prime real estate

Source: Fidelity International, CBRE, December 2023; S&P Eurozone Investment Grade Corporate Bond Index, January 2024; S&P UK
Investment Grade Corporate Bond Index, January 2023.

For direct real estate, there are signs that parts of the market are becoming more attractive, particularly where there continue to be strong expectations of rental growth. However, for Eurozone markets, near-term activity is likely to be driven by the return of domestic European investors, with the case for foreign capital being deployed in Europe being much weaker.

For example, the US 10-year Treasury yield is relatively attractive at c.4%. A more robust near-term macroeconomic outlook points to better occupier demand for US real estate, except for the office sector, where significant structural issues of oversupply will take time to work through. Furthermore, Asian investors are also relatively cautious about returning to global markets. They are generally over-allocated to offices, making them cautious about real estate performance. But there are also practical considerations; few Asian investors have representative offices outside Asia, and the slow recovery in global travel from Asian countries post-COVID also limits the capacity for due diligence and asset inspections outside the region.

A further facet of cross-border investing is the likely impact of movements in currency, which can often dwarf the real estate returns. However, some of the weaknesses in European currencies evident in late 2022 has unwound, and currencies look range-bound at present, with near-term macro factors favouring a modest strengthening of the US dollar.

We therefore expect to see the first signs of recovery in market activity in domestic and European investors that are well-capitalised with long-term investment horizons. There has been some activity from family offices and occupiers acquiring assets at attractive prices in market conditions where they face limited competition. Higher up the risk curve, we may see more opportunistic cross-border capital seeking to take advantage of distress.

Given the recent movement in bond yields (both sovereign and corporate) and the expectations for interest rate cuts through H2 2024, we believe that we are at or close to the bottom of the market. Activity should pick up in H2 2024, and 2024 should be a good vintage year for those with capital to invest.

Medium term: bottom-up factors will be key to delivering outperformance

With interest rates not expected to return to the low levels of the pre-COVID period, the prospect of benefitting from significant performance driven by yield compression is limited, in contrast to the experience across direct real estate investment in the decade to mid-2022. This has important consequences for investment strategy as capital growth will become more dependent on achieving rental growth; delivering stable income growth will grow in importance once again.

Understanding income risk and recognising where these risks lie will be important in a proactive approach to limiting their downside impact, especially given the relatively weak near-term economic outlook. This will include actively identifying lease events and working with tenants to extend leases, taking opportunities to realise rental uplifts, particularly in the industrial sector, and minimising the impact of tenant failure. At Fidelity, we have developed quantitative tools to help understand income risk within portfolios, such as specific tenant risks, leveraging the knowledge of specialist sector analysts across equity, fixed income, and private credit.

In the next phase of the cycle, we believe rental growth will play a greater role in capital appreciation. Therefore, it is important to focus on areas where market conditions point to strong rental appreciation. The logistics sector is an area that continues to benefit from multiple tailwinds. Ongoing supply chain reorganisation is creating demand from manufacturers and third-party logistics (3PL) operators, and this has been a key driver of demand over the past 12-18 months (see Figures 4 and 5). In addition, the surplus space that online retailers acquired during the pandemic is being absorbed as online sales now outstrip peak levels achieved during lockdowns.

Figures 4 and 5: Supply chain disruption driving demand from manufacturers
Replacing online retailers as the second largest source of demand

Supply chain disruption driving demand from manufacturers

Source: Savills, January 2024.

Therefore, we expect demand in the industrial & logistics space to remain robust, and potentially accelerate gradually over the next 18 months as the macroeconomic environment improves. At the same time, development activity in the sector has been in decline. Developers are cautious, given recent increases in construction costs due to high inflation, with material costs and labour shortages putting pressure on overall development budgets. At the same time, falling values for finished products further squeeze the profitability of development. We expect continued pressure on industrial rents and expect this sector to offer the best prospects for rental growth in the next two to three years.

What about offices? Investment sentiment towards the sector is notably negative, with Real Capital Analytics recording fewer office deals in Europe than at any time since their analysis began in 2007.4 There are significant concerns regarding future demand because of the move to hybrid working. Yet, there is also demand for sustainable buildings, supported by regulations requiring buildings to become increasingly energy efficient.

Environmental obsolescence is something that European markets will have to grapple with over the next decade as it becomes more difficult to redevelop new buildings. Planners are increasingly considering the embodied carbon in existing buildings when deciding whether to grant planning permission to demolish and redevelop a site, yet refurbishing poorer quality buildings in areas of low rental value will not be economically viable. There is undoubtedly a ‘green premium’ in terms of rental values and rental value growth, given the shortage of office stock that meets occupier requirements. Still, there is also a growing ‘brown discount’ as investors wrestle with the costs and asset management capabilities required to deliver best-in-class space through refurbishment. For those investors with the skill set to deliver ‘brown-to-green’ strategies in well-connected, amenity-rich locations, rental growth and strong investor demand should produce attractive returns.

We also expect to see strong rental growth in the residential sector. Across much of western Europe, changes in household composition have been driving strong demand for houses and apartments for some time, with the amount of new stock delivered falling well behind demand. Rising interest rates have also resulted in fewer people being able to afford mortgages, adding pressure to residential rental markets. As with the industrial sector, there has been a considerable reduction in construction activity in the past year as rising costs, labour shortages, and increased cost of debt have resulted in a significant fall in profitability among residential developers, driving some into insolvency. Again, a mismatch between supply and demand should generate strong rental growth. In Europe there are risks that governments will seek to further regulate residential rental markets, particularly if rents rise steeply. While such regulations may not fully address the underlying issues, they can have the potential advantage of providing longer periods of tenure and lower cost ratios.

Survive and thrive in ‘24

With signs of the real estate market stabilising, particularly in more liquid parts of the market, we expect 2024 to be a good vintage year for deploying capital. However, acquiring assets will not be without its challenges. There may be some opportunities from distressed sellers, but those selling assets are more likely to be ‘motivated,’ for example, by refinancing challenges, end of fund life, or recapitalising requirements. In our view, off-market deals will likely become more common, and having a good on-the-ground network will be invaluable in finding opportunities. Still, there is a considerable gap in the pricing expectations of buyers and sellers, and it will require careful assessment of opportunities and good negotiating skills to complete deals.

Some investors may wish to wait until they have seen values stabilise before considering deploying capital in the sector, but it is notoriously difficult to time the market given the time it takes to execute deals in direct real estate. In previous cycles, the first 12 months following the market bottom saw strong bounce-backs in returns, with investors who sat on the sidelines missing out. 2024 could present similar opportunities for investors to benefit from this early recovery phase of the cycle.

1 MSCI Real Capital Analytics, January 2024.
2 Eurostat, February 2024.
3 Bayes Business School Commercial Real Estate Lending Report, 2023.
4 Real Capital Analytics, European Capital Trends, Q4 2023.

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