1. European returns will improve as the economy recovers
European real estate markets slowed in response to the wider slowdown in the real economy in 2018 and 2019, but rents continue to rise as supply shortage is now acute in a number of major western European cities. Pan-European vacancy rates now average under 5% and in some markets, such as Paris, the supply of new grade A[1] space is below 2%. If European GDP growth picks up into 2021 as expected, real rents should keep increasing given structural and cyclical constraints on credit supply and limits on new construction. As a result, we expect attractive relative returns from real estate in response to rising net income.
2. Global capital flows into real estate look set to continue…but where are they headed?
Since the global financial crisis, flows to private equity real estate have been steadily increasing. We believe that these flows will substantially increase over the next 3 years as the investment community (particularly pensions and insurers) will have to deal with a great wall of fixed income maturities. During 2019, 2020 and 2021, in excess of EUR 1trillion of European sovereign bonds with coupons in excess of 2% will come to maturity. Financial institutions already struggling with solvency will find it hard to reinvest in similar bonds given negative yields. We expect that the majority of this capital will be invested in alternative asset classes with private real estate taking a significant share. These flows will provide a substantive floor for real estate prices, despite relatively low yields for the very best core real estate assets.
3. The rise of risk tolerance
The quid pro quo for high prices and low yields for the best Core[2] buildings is that much of this inbound capital will gravitate to higher risk strategies. We believe this will lift the already significant flows of capital into value-added real estate strategies and fuel demand for strategies such as Core Plus[3]. Equally we expect more risk tolerance and investors reallocating capital away from retail assets, will also add to the appetite for operationally more intensive assets such as multi-family residential, student housing retirement living, self-storage and hotels. Selectively allocating to these sectors ahead of these flows is clearly critical for investors seeking to maximise risk adjusted returns.
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[1] Grade A properties represent the highest quality buildings in their market and area. It is the equivalent of investment grade real estate and refers to offices only
[2] “Core”, “Core Plus”, “Value Add” and “Opportunistic” are terms used to define the risk and return characteristics of a real estate investment. They range from conservative to aggressive and are defined by both the physical attributes of the property and the amount of debt used to capitalize a project.
In average “Core” investors expect to achieve between a 7% and 10% annualized return and use less than 40% debt to capitalize a transaction.
[3] In average, “Core Plus” investors tend to use between 40% and 60% leverage and expect to achieve returns between 8% and 12% annually.
(source Investopedia)