Structural damage? Assessing the prospects for European and Swiss real estate

Key takeaways

• Rising rates and recession risks are hitting commercial property markets; non-centrally located offices and retail face additional headwinds
• Rent indexation can offset some of the pain of higher operating and borrowing costs for real estate companies. Supply shortages in warehouses, affordable residential developments, and energy efficient, centrally located offices will also support prices
• Depressed European property firm valuations probably price in too much bad news, albeit some highly leveraged firms could face rights issues and/or dividend cuts
• We retain a cautious view and neutral weighting for now and see opportunities to increase allocations once rates peak in 2023

Property markets face difficult times, and listed real estate investments have suffered in 2022. Yet they could see a sharp recovery as interest rates reach their peak. We discuss the market trends and opportunities ahead.

Property markets bear visible scars from rising interest rates. House prices are falling in the US and UK, and more sharply in Canada, New Zealand and in some Nordic countries. Declining housing affordability represents a key risk for the global economy in 2023, but what does it mean for property investors?

Risk and return dynamics can look very different for direct investments in commercial property – where both rental growth and capital appreciation must be considered – and indirect investments in the shares of a fund or company that manages a property portfolio. Direct investing is usually a longer-term strategy. Indirect investments are more liquid, but incur greater volatility. Both are seen as a hedge against inflation, with rents indexed to rising prices, yet both have suffered this year. In direct markets, October saw the worst-ever monthly fall in UK commercial property values; deals fell in most countries worldwide in the third quarter, according to MSCI data. Indirect investments have fared worse than beleaguered equities and bonds: listed European property is down around 35% year-to-date. Higher yields on ‘safe’ and liquid European sovereign debt and corporate credit have also eroded the relative appeal of real estate investments. After the UK’s ‘mini-Budget’ in September, 10-year government bond yields spiked to 4.5%; around the same as the yields investors could earn on UK industrial property¹.

Hitting home – rates and recession risks

Rising interest rates and growing recession risks are the cause of much of the gloom across European property markets. Demand for retail space and offices falls in a downturn. Concerns rise over the ability of tenants to pay rents, or to absorb increases in the face of rampant inflation, especially when heating and lighting costs have also gone up sharply. A slowdown in consumer spending is hitting a retail sector already struggling from a structural shift to online shopping that was hastened by the pandemic.

Offices face additional headwinds. The working from home trend is proving enduring. Cities with many centrally-located apartments (Madrid) or a strong workplace culture (Cologne) have seen a greater return to the office, but on average, office occupancy rates across Europe are now only around 43%, estimates estate agents Savills, versus 70-75% pre-pandemic. Firms are cutting space when multi-year leases come up for renewal. Traditional supply and demand dynamics are also at play: London saw new office building slow after Brexit, constraining supply and supporting prices; conversely, Warsaw is still recovering from a construction boom in the early-2010s. Meanwhile, office buildings often require huge investments to make them energy efficient, sparking fears that some older, out-of-town workspaces could become ‘stranded assets’ on property investors’ balance sheets.

Real estate companies are also grappling with the rising costs of operating and maintenance, borrowing and debt servicing, while falling valuations are increasing their loan-to-value ratios. The latter are currently around 40% across Europe, far lower than the 60% seen during the Global Financial Crisis (GFC), but a level that has already seen share prices fall and asset disposal plans launched. Big German residential landlord Vonovia announced its intention to sell EUR 13 bn of properties in August, but buyers are proving hard to find. UK property funds have seen a wave of investor redemption requests. In the US, Blackstone said it would limit withdrawals from two multi-billion dollar property funds after a surge in such requests. With portfolios of long-term assets, problems at big property-owning companies can take time to materialise, but for some highly-indebted European firms, investors fear the need for dilutive rights issues or dividend cuts further down the line. 

It’s not all gloom – nor is it 2008

Still, property firms today are less reliant on short-dated bank loans than pre-GFC, and more reliant on bonds with longer maturities (5-10 years), making them better prepared for rising interest rates. They can also raise rents to help cover rising borrowing costs. Of course, affordability is an issue, and many may choose not to do so, particularly for struggling retailers, or for lower quality office buildings where they want to keep current tenants. But legally, they can pass on all, or a substantial part of rises in the consumer price index for commercial property (100% can be passed on to office tenants in France and Switzerland, for example). Residential landlords can pass on lower increases, and these risk being more controversial. In August, Denmark introduced a temporary cap on residential rent increases, permitting adjustments of 4% over the next two years. But in Switzerland, we expect residential rental growth of 3-5% in 2023 alone and a minimum of 2.5% for indexed commercial leases.

Another support for both rental growth and capital appreciation is a shortage of supply. Within European property markets, supply shortages are concentrated in three areas. The first – despite a bumper construction year in 2021 – is in warehouses, particularly in big logistics hubs such as Rotterdam. The second is in affordable residential developments. Many developers stopped construction after the GFC, while population growth continued. In Switzerland, the vacancy rate for apartments in Geneva and Zurich is less than 1%. The third is in centrally located offices with high sustainability credentials. These are in hot demand as firms struggle to meet net zero targets; companies are also trying to tempt employees back with offices in more attractive locations, perhaps nearer restaurants or shops, preferring to spend their budgets on smaller but better sites.

Under construction: a more positive view

Perhaps the biggest draw for would-be investors in listed real estate is the amount of bad news already factored in to current prices. Despite a rebound from mid-October, European property firms are still trading at discounts of around 45% to their net asset value (NAV), implying an expected 30% write-down on their portfolio valuations, raising property yields by 1.6% on average.

To us, this looks excessive. Timing the entry point could be key, however. History suggests that real estate often underperforms equities as rates rise, but once they peak, it outperforms for anything from 3-12 months. We therefore see significant catch-up potential for valuations once rates stabilise in 2023.