Investing Beyond Borders: The Case for European Core Real Estate

November 1, 2023 35 Minute Read Time

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Flying under the radar

European core real estate strategies are well-established, have a large investable universe and deliver attractive risk-adjusted returns like their U.S. counterparts, yet many investors have not considered such investments. Regional real estate markets exhibit different characteristics and, therefore, can provide diversification in core offerings.

Key advantages to investing in European Core Real Estate include:

  • Index-linked leases providing greater inflation protection compared to the U.S.
  • Larger universe of modern sustainable assets that have low-carbon footprints, have a high level of built-in flexibility and offer a broad range of amenities. With regulations, standards and occupier expectations regarding sustainability on the rise, ensuring properties are modern and sustainable is a requirement to meet the ‘core’ definition.
  • Higher levels of inflation protection, market-leading sustainability credentials—European core has a lot to offer investors having to deal with today’s macroeconomic environment as well as the growing need for real estate to play its part in tackling climate change and improving employee wellbeing.
  • Real estate markets across Europe have experienced a steeper repricing than other parts of the world, so much so that much of the anticipated falls in capital values have already taken place. European core assets can, therefore, be acquired relatively inexpensively for now.

Transcending borders

Core investments transcend borders providing attractive risk-adjusted returns, high and stable income and diversification. Class A properties located in prime areas, occupied by creditworthy tenants on long-term leases can be found in cities across the world. And where there are core properties, typically there will be core strategies generating the same risk/reward profile for investors regardless of location.

No surprise then that the below graph, showing NCREIF ODCE Returns for U.S. Core Strategies…

NCREIF Fund Index – Open End Diversified Core Equity (ODCE), Net

Figure1

Source: NCREIF, as of 3Q 2022. Data for 2022 shows average income return and YTD value appreciation. For illustrative purposes only. Current market conditions differ from prior market conditions, including during prior periods of stress and dislocation. There can be no assurance any prior trends will continue.
…looks like the following graph showing the stable returns generated by European core:

INREV Core Funds Index, Net

Figure8

INREV Core Funds Index as of June 2023. For illustrative purposes only. Current market conditions differ from prior market conditions, including during prior periods of stress and dislocation. There can be no assurance any prior trends will continue.
The same is true for the below graphic showing how U.S. core’s equity-like returns come with bond-like risk…

Trailing 25 Year Annual Returns by Asset Class

Figure9

Source: S&P 500, Bloomberg Barclays U.S. Aggregate Government Treasuries Index, Bloomberg Barclays U.S. Corporate Investment Grade Index, Bloomberg Barclays U.S. High Yield Index, NCREIF Fund Index – Open End Diversified Core Equity (NFI-DOCE), net, FTSE Nareit All Equity REITs. Figures represent annualized quarterly total returns, as of June 2023. For illustrative purpose only. Current market conditions differ from prior market conditions, including during prior periods of stress and dislocation. There can be no assurance any prior trends will continue.
…and the equivalent graph for Europe, showing Core occupies the same spot in the top left quadrant:

Trailing 23 Years (entire history), annualized total returns

Figure2

Source: FTSE All-World Developed Europe, Bloomberg Euro Aggregate Government, Bloomberg Euro Aggregate Corporate, ICE BofA Euro High Yield, INREV Core Fund Index, net, FTSE EPRA Nareit Developed Europe. Figures represent annualized quarterly total returns, as of June 2023. For illustrative purpose only. Current market conditions differ from prior market conditions, including during prior periods of stress and dislocation. There can be no assurance any prior trends will continue.
Then there are the diversification benefits core strategies provide at the portfolio level. Once again, the U.S. core graphic that follows…

Annual total return by asset class (correlation to NFI-ODCE returns in parentheses)

Figure3

Source: S&P 500, Bloomberg Barclays U.S. Aggregate Government Treasuries Index, Bloomberg Barclays U.S. Corporate Investment Grade Index, Bloomberg Barclays U.S. High Yield Index, NCREIF Fund Index. For illustrative purpose only. Current market conditions differ from prior market conditions, including during prior periods of stress and dislocation. There can be no assurance any prior trends will continue.
  • Open End Diversified Core Equity (NFI-ODCE). For illustrative purposes only. Current market conditions differ from prior market conditions, including during prior periods of stress and dislocation. There can be no assurance any prior trends will continue.
…tells the same story as the European equivalent below:

Rolling 1-year total returns and correlation to INREV Core Fund Index

Figure10

Source: FTSE All-World Developed Europe, Bloomberg Euro Aggregate Government, Bloomberg Euro Aggregate Corporate, ICE BofA Euro High Yield, INREV Core Fund Index, net, FTSE EPRA Nareit Developed Europe. Figures represent annualized quarterly total returns, as of June 2023. For illustrative purpose only. Current market conditions differ from prior market conditions, including during prior periods of stress and dislocation. There can be no assurance any prior trends will continue.

The Differences

Core strategies in the U.S. and Europe have a lot in common then, but there are profound differences. The two regions have developed differently, not just in terms of pace but also in terms of what they have to offer. A comparison of the breakdown of the regions’ respective indices is revealing:

U.S. vs Europe private market sector breakdown

Figure4

Source: MSCI Europe Annual index, NCREIF NPI, as of December 2022. For illustrative purpose only. Current market conditions differ from prior market conditions, including during prior periods of stress and dislocation. There can be no assurance any prior trends will continue.
The U.S. is home to niche sectors—life sciences, medical office, self-storage and senior housing. Inclusion in the U.S. index, a clear nod that these sectors are of sufficient size to be investible. The reverse is true for Europe. While these niche sectors exist across Europe, for now at least they lack the scale required to be considered a major core sector.

Differences can also be seen in the respective weightings of the four main property types—office, residential, logistics/industrial and retail. Office, a clear standout. Europe’s near 40% share almost twice that of the U.S.’s 20% weighting. Logistics too warrants a mention—30% in the U.S., barely 15% in Europe.

Explaining the divergence in the two logistics’ weightings is a relatively straightforward exercise: e-commerce penetration rates. According to Euromonitor, which analyzed e-commerce adoption rates in 43 markets, online sales accounted for 21% of total retail sales in the U.S. in 2020. By contrast, the equivalent figures for Spain, Italy and France were approximately half the U.S. level. Logistics assets are an enabler of e-commerce.

Office is less straightforward, but one explanation is that Europe is arguably further advanced along the sustainability path than the U.S. For example, in 2015, the U.K. introduced Minimum Energy Efficiency Standards (MEES) which require landlords of non-exempt commercial properties to achieve a minimum E rating by April 2023. This was followed by the U.K. Government’s 2020 Energy White Paper confirming that by 2030 non-domestic MEES will be raised to EPC B. The implication is that by holding office assets that meet today’s regulatory standards and are on course to hit those of tomorrow, funds can be confident that the risk of obsolescence in terms of failure to meet rising sustainability requirements can be mitigated. Lack of similar standards in the U.S. may go some way to explaining offices’ low share in the overall U.S. core mix. The risk of obsolescence is just too high for some.

Europe’s near double weighting in office could also be caused by the mechanics behind the leases themselves. As the table below shows, in Europe commercial leases are index-linked, while in the U.S. leases are primarily set periodically with reference to the open market.

Standard Commercial lease terms across global markets

Figure5

For illustrative purpose only. Current market conditions differ from prior market conditions, including during prior periods of stress and dislocation. There can be no assurance any prior trends will continue.
The prevalence of index-linked leases in Europe provides landlords with greater protection against inflation compared to the U.S.

A further difference between the two regions is that core Strategies in the U.S. tend to deploy more leverage than their European counterparts. A case of once bitten twice shy holds for Europe, and in particular, the U.K. where the GFC dealt out some harsh lessons for those funds holding significant debt. The effects are still being felt today. As of March 2023, average leverage for those funds in the AREF/MSCI U.K. All Balanced Property Fund Index stood at 1.8%. Compare that with 23% for the average fund in the NCREIF-ODCE Index. Higher leverage can turbo boost returns in rising markets.  The opposite can be true in challenged markets.

A strategy for the times then?

Higher levels of inflation protection, further advanced down the sustainability route, lower levels of leverage—European core has a lot to offer investors, especially when today’s uncertain and high inflationary macroeconomic environment is considered. Throw in the growing need for real estate to play its part in tackling climate change and improving wellbeing and a case can be made for European core being a strategy for the times.

Because of the macro challenges faced, however, core strategies need to be active rather than passive to ensure the risk of obsolescence is kept at bay. Core is about managing risk. For example, in the U.K. the MEES provide a readymade checklist to see where core funds stand in terms of sustainability. Those funds with EPC risk-mitigation programs underway, are fully compliant with 2023 regulations, and have plans to meet the EPC B target by 2030 would appear best placed to mitigate the risk of obsolescence in terms of sustainability.

More generally, as well as building well-diversified and structured portfolios that generate stable and sustainable income, those funds that actively manage asset bases are more likely to grow rents, reduce vacancy rates and add value even during challenging economic times such as today’s. 

A window of opportunity

Real estate in Europe has already experienced a steep repricing. And within Europe, the U.K. has re-priced to a greater degree than other markets (see graphic below). European core is, therefore, further along the correction curve than other regions, including the U.S. Much of the forecast write-down has already taken place in European core. Unsurprisingly, Europe is expected to reach the cyclical trough before the U.S.

Cumulative Peak to Through value decline, 2020Q1-2023Q4

Figure6

Capital Growth figures reflect unlevered property returns of a passive fully invested portfolio before fees and taxes..  Assumptions are generalized to provide a consistent market outlook and asset specific strategies have not been taken into account. *Actual Value Decline for U.S., UK, Europe ex UK, Australia are to end Q2 2023. Japan is to end Q1 2023. For illustrative purposes only. Forecasts are inherently uncertain and subject to change.
As for why Europe is ahead of the curve, once again it boils down to the region’s individual market characteristics. In the U.K., open-ended funds have been hit by a wave of redemption requests, as unitholders responded to the higher cost of debt and the need to rebalance portfolios because of the denominator effect following 2022’s decreases in bond and equity prices. In need of generating liquidity to meet redemptions, funds typically had little option but to sell assets. These forced sales have in turn driven prices down further and, at the same time, provided real-time valuation markers.

And the way properties are valued across Europe as a whole has also played a role. In continental Europe, valuers take into account sentiment indicators. Because of this, the European valuation method is not dependent on transactions taking place, as is the case in the U.S. When transaction volumes fall, valuations in Europe can at least still be reset using sentiment-based indicators.

Elevated levels of redemption requests, valuation methodologies that incorporate sentiment, along with the challenge of having to refinance when interest rates are at levels not seen for decades—all have conspired to propel Europe to the position of frontrunner in terms of repricing.

Unlike previous corrections, however, rental levels have not fallen in tandem with capital values.  Market fundamentals have remained strong—prime rents in European office, industrial and retail all grew in H2 2022, a period during which capital values fell. As the graphic below illustrates, this is unusual—capital values and rents tend to move in the same direction:

EMEA prime rent and capital value growth, % q/q

Figure7

Source: CBRE. Latest = Q2 2023. For illustrative purpose only. Current market conditions differ from prior market conditions, including during prior periods of stress and dislocation. There can be no assurance any prior trends will continue.
The resulting disconnect enables core assets that continue to perform well to be acquired relatively cheaply. For example, an investor participating in a U.K. fund’s primary subscription process will generally be required to pay the offer price. This varies by fund but NAV+5% can be used as a benchmark. Compare that to today’s prices. Investors can currently enter a fund via the secondary market at NAV -1% to -25%. In a world where every basis point (bp) counts, a 6-30bps price reduction represents a significant window of opportunity. Like all windows of opportunity, however, this one won’t last forever. Markets are forward-looking mechanisms. They often bottom out before the data sounds the ‘all clear.’

Advanced repricing and the window of opportunity that it has opened up can be added to the list of reasons why European core ought to be on more investors’ radars.