Outlook 2022: European real estate
Outlook 2022: European real estate
This year has seen a recovery in European real estate, as Covid vaccines restored confidence among occupiers and investors. While the Omicron variant is a concern, businesses have become skilled at adapting to government restrictions.
Looking ahead to 2022, the positive outlook for the economy bodes well for real estate demand and rental growth at the market level.
Schroders forecasts that eurozone and UK GDP will grow by around 4-5% in 2022 and by around 2-3% in 2023. The main downside risk - besides Covid-19 - is that the recent jump in inflation triggers a wage-price spiral. This could force the European Central Bank (ECB) and Bank of England (BoE) into a steep increase in interest rates, rather than a gradual tightening.
While possible, we think a more likely scenario is that inflation slows rapidly through the second half of 2022, as supply chains normalise and the spike in energy prices falls out of comparisons.
At a more detailed level, the demand for different types of real estate in 2022 will be determined by the interplay of two main factors.
The impact of the pandemic on occupier behaviour
Why real estate is essential for sustainable investors
Globally, over 5,000 companies and non-governmental organisations (NGOs) have now signed the United Nations’ “Race to Zero”. The goal of the Race to Zero is to halve carbon emissions by 2030. One of the main ways to achieve it will be by improving the energy efficiency of buildings. In addition, buildings need to reduce waste and be able to cope with more extreme weather events including droughts, flash floods and heatwaves.
One option is to construct new buildings, but the manufacture of cement, steel and other materials is carbon intensive and thus this can only ever be a partial solution, given the low rate of development in Europe. 90% of the buildings which will be in use in 2030 are already here.
The real challenge, therefore, is to adapt existing buildings. Upgrading heating and ventilating equipment, using apps and sensors to optimise heating and lighting, installing better insulation, are all ways to achieve efficiencies.
Research shows that occupiers are willing to pay higher rents for buildings which are highly energy efficient. Conversely, “polluting” buildings will increasingly become vacant, as governments raise “carbon taxes” on heating fuel and ban landlords from letting units with poor energy ratings. If and when introduced, this will have an immediate impact on relative valuations.
Another aspect of sustainability is delivering a positive social impact. In real estate, this can be achieved by investing in social housing, affordable workspaces, health facilities and in the public realm in less affluent areas. It also involves making sure that building projects provide employment and training for local people. The key is to work with local government and communities.
Behaviour shifts: Which “pandemic behaviours” will stick?
We expect the second major influence on demand in 2022 will relate to the ways in which the pandemic has permanently changed occupier behaviour. Lockdowns led to even faster adoption of on-line shopping and remote working.
Supply chains were strengthened by holding more stock and substituting with local supply. There has been a huge increase in healthcare investment. All of this has been good news for data centres, laboratories, logistics, self storage and vertical farms. Conversely, it has been negative for business hotels, traditional offices and in-store retail.
However, it is important to look under the bonnet. We have seen a complete bifurcation of “haves and have-nots” in the various sub markets. We expect, for example, shop and shopping centre rents in Europe to continue to fall through 2022-2023 as retailers move more of their business on-line. On the other hand, rents on food stores and out-of-town big box units selling bulky goods should track inflation.
Similarly, we estimate that remote working will cut office take-up in Europe by around 15% in the short-term. However demand should remain for offices which are energy efficient, provide flexibility and are attractive to skilled staff. This means that prime office rents in several cities - including Amsterdam, Frankfurt, London and Stockholm - are likely to increase over the next two years.
The main casualty will be secondary offices in cheaper locations, where rents are too low to make refurbishment viable. The jump in the price of building materials over the last 12 months (22% in the UK, for example) has undermined the viability of many refurbishment schemes.
The polarisation in demand by type and quality within the retail and office markets demonstrates that investors need to treat each building as a business in itself. This means offering the right services and support to each tenant. Minimising energy, maximising recycling and finding the best contract model for both landlord and tenant is mutually beneficial.
We believe that investors who adopt a “hospitality” mindset will achieve superior performance, both in financial returns and ESG objectives.
Resilience in the market
One surprise this year has been the lack of distressed sales. To some extent this can be explained by the financial assistance which governments gave businesses during lockdowns and by the long time it takes for banks to work through problem loans.
However, it also reflects the large amount of capital - approximately $15 billion - which was raised in 2020 to buy distressed assets. It has meant that prices have not corrected as much as opportunistic investors had hoped.
We believe that the prospect of a gradual increase in interest rates, first in the UK and then later in the eurozone, means that the decline in European real estate yields which began 2013 is now over. The exception could be logistics given the large amount of capital targeting the sector. In our opinion though, all the good news on future rental growth is now priced in, with prime logistics yields at 3.25%-3.75%. If yields are broadly stable next year and logistics and prime office rents grow, then ungeared total returns on European core real estate in 2022 are likely to be between 5-7%.
That outlook assumes that bond yields remain low by historical standards, but there is a risk that higher inflation becomes permanent and that central banks are forced to hike rates. A lot will depend on people’s expectations for future inflation and wage demands.
While faster inflation would feed through to index linked rents, the impact on capital values and returns would probably be negative in the short run, because a sharp increase in bond yields would be echoed by real estate yields, at least in part. The experience of the 1970s suggests that real estate is only a partial hedge for inflation.