Real estate investment and asset manager AEW has released its European Annual Outlook for 2024, examining the impact of the rapid and significant downward valuation movements during 2022 and 2023, and the prospect of a revival in 2024.
AEW’s outlook is based on its current macroeconomic base case scenario which assumes that inflation comes down and a recession is avoided. However, the recent conflict in the Middle East has heightened geopolitical uncertainty and increases the need to consider a possible downside scenario, which assumes that higher inflation will return causing a prolonged economic slowdown.
Hans Vrensen, Head of Research & Strategy Europe at AEW, comments: “While it may feel a bit surprising and premature to most investors, as many continue to grapple with valuation declines and refinancing challenges, we expect almost all prime European real estate markets to offer an attractive revival and broad-based cyclical recovery opportunity from 2024. For the next five years, we project unlevered prime returns of over 9% p.a. on average across our near 200 European market segments in our base case. Our latest relative value analysis shows a clear positive signal for a cyclical rebound across nearly all European markets. We therefore expect investors to now position themselves as best they can to take advantage of solid returns over the next five years.”
Key findings of the report include:
Real estate debt becomes accretive again from 2025 in the Eurozone and 2026 in the UK
With restrictive central bank policies pushing borrowing costs up and inflation down, economic growth has slowed, 5-year swap rates are projected to come down sooner in the Eurozone than in the UK. As a result, real estate debt is expected to become accretive again from 2025 in the Eurozone and 2026 in the UK.
Prime rental growth upgraded as occupier markets remain supportive
Drivers of real estate demand, such as employment and consumer spending expected to remain supportive, regardless of base case or downside scenarios, driven by the continued limited and, in many markets, reducing supply of new space, with demand and supply remaining broadly balanced. As a result, and coupled with positive GDP growth, AEW’s base case prime rental growth has been upgraded to 2.2% p.a. for 2024-28 across all sectors in Europe (from 2.0% in Mar-23), with prime logistics and residential retaining the joint top rental growth ranking at 2.5% p.a.
Strong returns on offer with total returns revised up to 9.2% p.a., as prime yields tighten in 2024-28
AEW expects a 50% year-on-year drop in European investment volumes to €140bn for 2023, as higher interest rates locked out traditionally leveraged investors and pushed prime yields out. AEW’s base case now predicts a tightening of prime yields with a 20 bps for retail and 60 bps for offices over the next five years, given recent re-pricing and lower bond yields. As a result, prime total returns have been revised up to 9.2% p.a. on average, across all sectors and 196 markets for 2024-28, underpinned by projected yield tightening combined with solid rental growth. Logistics and offices are expected to outperform, generating total returns of 10.4% p.a. each over the next five years, the highest of all sectors, with retail third at 7.4%. The UK offers the best predicted total returns at 10.7% p.a. for 2024-28, with Benelux coming second at 9.5% p.a. Furthermore, average prime capital value growth across Europe is forecasted to turn positive at 2% in 2024, after a cumulative value decline of 17% to end of 2023 since peaking mid-2022, despite a few individual markets still showing some downside.
European offices expected to rebound despite negative investor sentiment
Following on from the points above, AEW believes that the prevailing negative investor sentiment towards European offices might limit investors’ ability to take advantage of AEW’s forecasted rebound for the sector in line with current and projected occupier take-up versus actual supply of desirable space. Despite AEW’s positive outlook for prime European offices, a further bifurcation in pricing between prime and secondary offices is expected to continue.
Reversal of denominator effect to unlock dry powder capital for real estate investment
Liquidity in 2024 might benefit from the unlocking of more dry powder capital for real estate investment as the denominator effect reverses, based on year-to-date total returns across asset classes. This denominator effect had restricted many investors from expanding real estate investments in 2023, as 2022 declines in stocks and bonds pushed real estate above its typical target allocation of 10%. The downward adjustment for property, combined with the rebound in stocks and bonds in 2023, should be bringing the real estate allocation of many multi-asset investors back in line with their targets, freeing up some restrictions for multi-asset investors.
Clear positive signals for nearly all European markets with Germany ranked top on a relative value basis
AEW’s 2024-28 forecast shows a significant improvement in its relative value assessment with an over 200 bps positive excess spread when comparing the 9.1% p.a. Expected Rates Return (ERR) and the 6.9% p.a. Required Rates of Return (RRR), which is partly due to excluding 2023 in the analysis. It is a clear positive signal for investors to return to European markets with 97% of the 168 covered European markets now classified as neutral (54) or attractive (109). Across countries, Germany ranks top in terms of relative value, with the most markets classified as attractive, while from an individual market perspective, logistics in Benelux, France and Spain come out on top. Dutch and Spanish residential, Belgian high street retail and German and UK shopping centres also make it to the top 10 most attractive relative value markets.
€90bn Debt Funding Gap (DFG) for 2024-26, although challenge of refinancing legacy loans reducing
The continued challenge in refinancing maturing real estate debt is quantified by AEW’s updated DFG analysis showing a €90bn DFG for 2024-26 and now including all 20 European countries. LTVs remain the dominant restrictive factor, despite the inclusion of ICR and debt yields as refinancing criteria. Refinancing of legacy loans has been a challenge as interest rates are settling at higher levels and capital values have come down. On a relative basis (i.e. as a share of the original origination amounts), 16% of all 2018-21 loans are now expected to face a DFG, down from 22% in AEW’s Aug-23 estimate. Despite this decline, refinancing challenges could delay the revival across the European markets.
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