Commercial real estate investment across Europe fell to its lowest level since 2010 in the second quarter of 2023, the latest data from MSCI Real Assets reveals, as investors, spooked by higher interest rates and an uncertain economic outlook, put acquisition plans on ice. The volume of offices sold — Europe’s largest real estate sector — plunged by 84 percent to €8.3 billion, its lowest level since 2009, and the number of buildings sold was at an all-time low.

The dramatic slowdown in first-half investment volumes was global and there has been little differentiation in terms of sectors following a standoff between buyers and sellers, Tom Leahy, Head of EMEA Real Assets Research, says. “There is still a lot of uncertainty about where interest rates will settle in the medium to long term.”

So far, however, there are very few forced sellers in the market, he adds. “Distress is often a trigger for repricing and there will be some refinancing challenges, but the systemic risk in banking worldwide is not as great as it was in 2007. It could take years before distressed properties filter through the system, based on the experience of the post-GFC cycle.”

Distress is ­often a trigger for repricing and there will be some ­refinancing ­challenges.

Opportunistic property investors move to the fore

Relative newcomers to the property investment landscape are likely to beat a retreat in an environment where debt is no longer free and the risk-free rate has shot up to 4 percent. But that will create a more level playing field for seasoned players, some of whom are already quite active. In Europe, US private equity giant Blackstone topped MSCI’s ranking of leading buyers in H1 2023 following the final close of its latest global real estate fund, Blackstone Real Estate Partners X, with $30.4 billion of total capital commitments — the largest real estate or private equity drawdown fund ever raised. 

The 2015–2019 peak period was an easy time to invest, according to Damian Harrington, Head of Research, Global & EMEA Capital Markets at advisor Colliers. “The world was flat where capital was concerned; now it is anything but. I think we’ll now see more nuances in how markets play out as the macro factors influencing pricing and cycles differ, and in some cases quite markedly.”

Overall, we see the rise of Asia-Pacific investors rather than North American players gradually taking the lead as the main source of capital in Europe and globally.

Advisor Savills expects a slight recovery in investment activity during the second half of 2023 on the back of a gradual improvement in the economy, as both lenders and investors start to adapt to the new high environment in terms of interest rates, debt cost and yields. Should the European economy improve in 2024, as the economist consensus suggests, Savills anticipates a rebound of 35 percent in investment activity next year with some €220 billion worth of transactions across Europe. 

There is no shortage of capital. Around 74 percent of the circa €250 billion in capital raised globally during 2022 is yet to be invested, data from INREV, the association of non-listed real estate investors, shows. While opportunistic players like Blackstone are already jockeying into position, the first movers are, overall, likely to be different to those who ventured back early immediately after the GFC, INREV’s CEO Lonneke Löwik says: “Overall, we see the rise of Asia-Pacific investors rather than North American players gradually taking the lead as the main source of capital in Europe and globally.”

Industrial tipped to lead the recovery

Market watchers are unanimous that industrial and logistics (I&L) assets will be the first to recover in the new cycle, led by income returns rather than capital growth. “Industrial properties were becoming very expensive towards the end of 2021 and early 2022, but rising interest rates have blown away some of the froth,” says MSCI’s Leahy. “Property is having to adapt to higher interest rates, and higher yields are the consequence.” 

The negative capital value impact has, however, been softened by higher rents, which rose by 15 percent on average in the last year, with many markets such as the Netherlands, Germany and CEE exceeding this rate of growth, says Luke Dawson, Head of Global and EMEA Capital Markets at Colliers. “That may slow to 5 percent or 10 percent in some locations, but the I&L sector is closest to rebalancing and will be the leading investment sector in Europe this year.” Average I&L vacancy rates in Europe are 4 percent, he points out. “The picture is similar in North America (4 percent) and in APAC (6 percent).”

Mixed fortunes in the office sector

The sector now facing the strongest combination of cyclical and structural headwinds is offices, particularly in the US, where market watchers expect major challenges and increasing bifurcation as vacancy rates soar to 50 percent in secondary and tertiary locations. Many traditional office employers like banks and law firms but also tech companies are struggling to get their staff back into the office post-Covid, resulting in swathes of redundant, ageing and vacant office buildings. 

Conditions vary considerably across markets and sub-markets in Europe and Asia, but both regions are, by contrast, still holding up relatively well thanks to stable occupancy levels. This is particularly true of prime locations in the leading cities such as Milan, where Union Investment recently acquired a highly sustainable redevelopment project that its Head of Investment Management Europe, Martin Schellein, described as “the perfect first investment for our anticyclical entry into the Milan office market”. 

Following completion of the refurbishment works in the final quarter of 2023, the building will be handed over to its new tenant, Bottega Veneta, a brand of luxury goods company Kering, on a 12-year lease. The property, located in the heart of Milan’s historic business district near the cathedral and La Scala opera house and directly adjacent to the Galleria Vittorio Emanuele II shopping arcade, was acquired from a real estate fund managed by Italian investor and developer Coima in an off-market transaction.

Investors are rediscovering retail

While parts of the office sector face an uncertain future, the retail sector appears to be finally getting out of the doldrums. Selective segments such as retail parks and grocery-anchored assets performed well during the Covid pandemic and continue to do so, ­MSCI’s ­Leahy says: “We’re seeing a decent amount of activity in that sector, particularly in the UK, where yields have already corrected.” A higher-yield play in the current interest rate environment is helping retail investment to bounce back across all global regions, Colliers’ Harrington agrees.

“It is strongest in APAC, where it is not overdeveloped, whereas in Europe and North America it continues to undergo a gradual correction. High streets are selective, but the luxury end also continues to outperform.” Office and retail were traditionally the mainstays of real estate portfolios, but a huge shift in investment volume has taken place over the past decade across various asset classes such as I&L and residential, leading to a more evenly distributed breakdown, Savills’ European Research Director Lydia Brissey says. “This shift reflects the actual needs of society and the increased liquidity within each real estate asset class, as well as the growing inclination towards wider portfolio diversification to mitigate potential risks.” Cash-rich investors like Union Investment are well-placed to take advantage of the changing market, CIO Martin Brühl says. “Our real estate business continued to grow even after the turnaround in interest rates and we have made targeted investments in the systematic diversification and resilience of our portfolio – with a clear focus on the quality and sustainable earnings strength of our assets.” His immediate priority, however, is to leverage the enormous performance potential that lies within the portfolios: “We aim to ­retain our ‘fire power’ in order to ­increase our purchasing volumes again at the right time.”

Sustainable investment in existing holdings is the new normal

MSCI’s Leahy believes there will be, selectively, opportunities for redeveloping “brown” or functionally obsolete office or retail properties, but there are many barriers including planning and technical requirements and high costs, he warns. “Office conversion numbers are very limited; it is not a panacea. The same is true for retail.” Awareness is, however, growing that the greenest building is the one that’s already there. Leahy: “The mood is shifting to demolition and embodied carbon mitigation through the reuse of materials and building something envir- onmentally friendly in its place.”

As investors adjust to a higher interest rate environment, many are coming to grips with the need to manage the carbon footprint of their existing assets as part of the “new normal”. That said, ESG factors have been a key consideration for investors and managers across Europe for several years following the creation of the EU Taxonomy in 2020, which aims to help determine how much carbon dioxide is acceptable for economic and financial activities, INREV’s Löwik concludes. “Criteria such as these, and European regulations such as SFDR (Sustainable Financial Disclosure Regulation), play a crucial role for European managers looking to make green investment decisions. Europe continues to lead the green transition when it comes to real estate, but very likely we will soon see strong initiatives and regulatory developments from the US and Asia as they start to race ahead on the journey to a net zero carbon environment.”

By Robin Pascoe