Opportunities are emerging across real estate markets in the UK and Europe, but investors will have to be nimble and discerning in their asset selection, say Imogen Ebbs and George Fraser-Harding.
Read this article to understand:
- Why 2023 is presenting buying opportunities for investors with spare capital
- Our outlook across sectors, including living and logistics
- How a new macroeconomic regime could affect the landscape for real estate investors
After a gruelling winter, marked by soaring inflation in the UK and across Europe, investors could have been forgiven for hoping for a benign start to 2023. Any tentative grounds for optimism were supported by economic data earlier in year indicating the UK and European Union may yet avoid a prolonged recession.1,2
However, recent events in the banking sector, which began with the collapse of Silicon Valley Bank in the US before spreading quickly to the Europe and UBS’s acquisition of its ailing Swiss rival Credit Suisse, has highlighted how risks can emerge quickly and from various parts of the economy. This is particularly the case in an environment of continued uncertainty over inflation and interest rates, which has affected the outlook for many asset classes, including real estate.
The tough economic backdrop has weighed on property valuations over the last 12 months and led to a period of price discovery, during which buyers and sellers scrambled to determine fair value. But although sentiment has been impacted, it is important to recognise not all investors are in the same position. For example, while some property funds have been forced into distressed sales, investors with capital to deploy have already been able to acquire strong assets at a discount in 2023.
Continuing liquidity pressures in some markets are likely to open new windows of opportunity over the coming months. Those hoping to take advantage will have to move swiftly and ensure their investments are on the right side of longer-term structural shifts shaping the future of real estate, from demographic changes to hybrid working and the climate transition.
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 key investment themes and risks.
What have been the key developments in real estate markets so far this year?
IE: We came into the year following a period of extraordinary turbulence in 2022. After Russia’s invasion of Ukraine, central banks responded by tightening policy and the post-pandemic recovery abruptly stalled. Higher borrowing, construction and maintenance costs had a negative impact on real estate markets and transaction volumes fell sharply, especially in the second half of the year.
The drop in valuations bore comparison with some of the worst periods of turmoil we have experienced
The pace of the shift was astonishing; the drop in valuations bore comparison with some of the worst periods of turmoil we have experienced. This was particularly pronounced in the UK. According to MSCI, no major market globally saw steeper declines than the UK in the second half of 2022.
As investors responded to uncertainty and sought to withdraw capital, co-mingled fund structures came under pressure with investors unable to redeem in line with daily traded liquidity policies. In response, some UK property funds had to impose gates and sell assets.
With around £16 billion of capital currently gated across UK real estate funds, there is renewed attention on the need to better align fund structures with the liquidity profile of the asset class. It is one of the main reasons we closed our legacy co-mingled daily traded institutional and retail funds and are instead seeking to develop fund structures that better meet investor needs.
Whilst macro uncertainty persists and recent issues in the banking sector have given investors pause for thought, ongoing uncertainty was expected in 2023. We anticipate it will drive varying levels of sentiment and price dislocation throughout the year. Tightening credit conditions heightens refinancing risk and weaker assets are likely to be impacted to a greater extent, underpinning our view on the K-shaped recovery across prime and secondary assets.
Investors in a position to deploy capital were able to take advantage of this environment
In contrast to the issues facing daily traded funds, investors in a position to deploy capital were able to take advantage of this environment. We were quick to move and have committed over £420 million across Europe and the UK since last Autumn.
With a further £500 million of capital to deploy and a pipeline of over £300 million at various stages, we continue to focus on income, asset quality and deploying capital with discipline.
Which sectors look likely to offer opportunities over the coming months?
GFH: The sectors we liked at the beginning of last year still look attractive, as we invest into thematics for the long term rather than jumping in and out of hot sectors.
We went through a period during COVID-19 where construction was limited, so we are coming into this repricing with vacancy rates in key logistics and office markets below their ten-year average. An increase in construction costs alongside higher cap rates [calculated by dividing a property’s net operating income by its asset value] mean this theme is set to continue as less supply comes onboard.
Take European logistics: while the picture varies across regions and countries, we see strong rental growth in that sector. Although valuations have declined along with the wider market, the occupational supply-demand dynamics are strengthening.
IE: In the UK, our focus continues to be on sectors disproportionately affected during the recent period of price dislocation, including prime offices, logistics, living – including single-family housing and student accommodation – and essential retail. We are also interested in life sciences, building on our strong history in the sector.
Our UK focus continues to be on sectors disproportionately affected during the recent period of price dislocation
These sectors stand to benefit from structural tailwinds over the longer term. We have a particular focus on regionally important assets with strong rental growth potential and will access scale through portfolio transactions.
GFH: We expect further market dislocations over the coming months, as debt matures, buyers struggle to refinance at higher rates and funds elsewhere in Europe experience their own liquidity pressures.
The key for investors is to be able to move quickly in these moments. If you look back to previous cycles over recent decades, buying opportunities tended to last for 12-18 months. However, this correction is moving at a speed not seen before. The market is more transparent, sophisticated and has started to attract truly international capital. This means these windows of opportunity are narrower.
Investors with dry powder, a strong counterparty reputation and conviction about long-term thematic trends should be best placed to take advantage when these opportunities present themselves.
What are the attractions for investors in single-family housing?
GFH: There has been a noticeable lack of institutional investment in the residential rental sector, with a significant proportion of stock owned by individuals and small-scale buy-to-let landlords. But given the structural dynamics, we see attractive opportunities in this area.
In the UK in particular, house prices are still expensive and supply insufficient; add in the pressures of the cost-of-living crisis and many people simply cannot afford to buy their own homes. There is a need for much more affordable rental accommodation to meet demand.
We have identified opportunities to buy stock at a significant discount to vacant possession value from housebuilders looking for an exit route. From an investment perspective, the sector can offer higher returns and a fundamentally lower risk profile than a lot of commercial sectors in the UK.
IE: The outlook for the residential rental sector in the UK is also being influenced by the removal of the government’s “Help to Buy” scheme and a general sentiment shock that is likely to cause a fall in housing transactions this year and next. JLL anticipates a 30 per cent drop in transaction volumes in 2024.3 This will only accelerate the shift from home ownership to renting.
Longer term, sector fundamentals should be underpinned by urbanisation and demographic trends
Over the longer term, sector fundamentals should be underpinned by urbanisation and demographic trends.4
As an asset class, single-family housing can contribute to a diversified real estate equity strategy; the large number of underlying tenants tends to result in stability of income and low volatility in performance. And because residential assets have a high correlation with inflation, they can be efficient liability hedges, supporting long-term value appreciation.
The ability to add social value is another important dimension. Providing residents with good-quality rental housing, with the option for longer-lease terms, provides stability and creates better communities. The use of technology is an important part of building communities; for example, creating a “digital town square” through resident apps can build engaged communities.
Office markets are still being reshaped by post-COVID changes in working patterns. How do we expect these dynamics to play out over the medium term and how are they affecting our investment strategies?
IE: We are seeing significant changes to the sector, not least an accelerated “flight-to-quality” among occupiers, who are increasingly looking to lure workers into the office by offering well-designed spaces for collaboration and idea sharing. Offices with strong environmental, social and governance (ESG) credentials are seeing especially strong demand.
Investors must increasingly focus on quality as secondary assets risk obsolescence. As the market becomes ever more bifurcated, we expect secondary offices to be repurposed for other uses. There is likely to be a slow removal of sub-optimal space from the market as and when the economics stack up. Recessionary pressures will exacerbate this divergence.
GFH: Investors must also pay attention to the specific circumstances in each location, as these will affect the pace and extent of the transition to hybrid working.
Investors must pay attention to the specific circumstances in each location
For example, in London, most people live far from the office districts in the City, whereas many citizens in European cities live within a 30-minute walk or bicycle ride to the office. This affords them and their employers more flexibility when it comes to working arrangements.
There are other factors to consider. In Denmark, for instance, home workspaces must comply with the regulations for standard offices, which means they are subject to health-and-safety inspections to ensure the desk is the right size, the office chair is ergonomic, the bathroom is up to code and so on. As a result, there is less working from home in Denmark because it is more expensive for companies to satisfy the rules. Investors must be alive to these regional nuances.
How do we assess the opportunities and risks associated with the accelerating climate transition?
IE: The market still does not have any systematic way to price ESG. Buildings emit significant quantities of carbon and are likely to face physical risks from climate change; new regulation and shifting occupier preferences could quickly render older, inefficient assets obsolete.
We want increased transparency with ESG-related capital expenditure priced in
In an ideal world, we want increased transparency, with ESG-related capital expenditure priced in. We have the expertise to integrate climate risk into our underwriting and capital-pricing models and actively manage our portfolios with climate in mind.
GFH: The climate transition is having a big influence on everything we do. The impact will be stark, from valuations and rents to occupier dynamics and cashflows. The key is to be disciplined in the assessment of buildings and their sustainability credentials to judge whether they are at the required standard and, if they are not, the costs involved in upgrading them.
Some commentators suggest we have entered a new macroeconomic regime. What are the implications for real estate?
GFH: For a long time, it was relatively easy to make money in real estate and people got complacent. Now the market has readjusted, and value is harder to come by. It is going to be crucial for investors to get the big calls right in deciding where to allocate from a top-down thematic perspective, and in selecting the right assets from a bottom-up perspective. The opportunities are there for those with the expertise to navigate a more varied landscape.
Real estate investors will have to think more creatively about how to drive returns
IE: In the era of low interest rates and cheap financing, an allocation approach based on the direction of the market – beta – would often pay off. But as we enter an environment characterised by tighter monetary policy, real estate investors will have to think more creatively about how to drive returns. Partnering with asset owners and aligning strategies through joint ventures is one way we can do this.
Taking a long-term view is important and aligning capital to structural themes that underpin how we use and rely on the built environment is fundamental. Technology, deglobalisation, demographics, climate and social change will become ever more important. Income and asset quality will be the route to success as we move through uncertainty and position for long-term growth.