Global real estate investment manager AEW has released its European Annual Outlook for 2022, which examines how investors can re-align their portfolios in a post-Covid-19 world.
As bond markets price in an expected change to monetary policy in response to rising inflation, the report explores the new environment for real estate.
Key findings of the report include:
- Prime shopping centres are forecast to become the most attractive asset class due to its yield widening over the last two years, showing the best returns compared to other sectors. Significant re-pricing leaves shopping centres in a position where yield tightening of 30 bps is projected for the next five years in AEW’s base case.
- AEW’s rising inflation scenario assumes higher bond and property yields restrict capital value growth across all four main sectors: retail, logistics, residential and offices.
- Prime shopping centres are projected to have the highest returns (7.4% pa) of any sector, due to their attractive current yields and projected tightening. Shopping centre and high street retail yields have widened by over 120 and 50 bps respectively since 2018 and due to this past re-pricing, their yields are forecast to tighten by 2026 by 30 and 15 bps, respectively.
- Since prime logistics yields have continued to tighten to new historic lows, 27 of the 37 logistics markets covered are now classified as attractive for new investors. This compares to all 23 logistics markets classified as attractive in last year’s analysis. Logistics returns come in second place at 6.5% pa over the next five years.
- Despite the debate surrounding working from home as a result of the pandemic, AEW predicts that office space needs will only reduce by 5% over the next six years – less than 1% p.a. As office stock is also expected to grow by an average of only 1.1% over the next five years this pushes vacancy down in AEW forecasts.
- AEW’s inflation scenario shows consistently lower returns across all sectors compared to the base case, due to its implied yield widening over the next five years limiting capital appreciation. Residential is forecast to be the worst effected sector from an increase in interest rates, with the lowest yields of any sector to begin with, as should be expected given the very stable cash flows and a low risk profile.
- Despite adding a new climate-related transition risk premium, our risk-adjusted return approach shows an average positive excess spread of 220 bps for the 168 markets covered. By comparing the expected rate of return (ERR) with the required rate of return (RRR), AEW classifies markets as attractive, neutral or less attractive.
Hans Vrensen, Managing Director, Head of Research & Strategy at AEW, added: “The post-Covid macroeconomic rebound has surprised on the upside. However, this stronger than expected growth combined with supply chain disruptions and associated shortages have triggered higher inflation in both the UK and Eurozone. Until recently, the consensus was for inflation to settle down, but investors have already priced in a hike in interest rates and a tapering of quantitative easing by central banks. In other words, we need to consider what the impact will be from higher inflation even if lower for longer interest rates remain our base case.
“If it endures, a new higher inflationary environment has consequences for real estate investors. In that case, we would expect rising interest rates and bond yields to restrict capital value growth across the board. With over 200 bps in excess spread (between expected and required returns) in our base case there is sufficient cushion to deal with an increase in inflation-driven bond yield widening. However, our base case analysis indicates that we could see a strong recovery in retail, specifically prime shopping centres. In fact, shopping centres emerge as the most attractive asset class across our European property markets on a risk-adjusted returns basis. Logistics continues to benefit from increasing e-commerce activity. Office vacancy is expected to come down from its recent highs, as the acceleration in flexible working and working from home will partly reverse as the immediate impact of the pandemic’s lockdowns wears off. Whilst residential may suffer from rising inflation, the counter-cyclical nature of the asset class and sustainable income characteristics will continue to underpin its defensive appeal for investors.”