The case for value-add in European real estate
July 5, 2023 60 Minute watch
IntroductionA value-add opportunity has opened in European real estate. Europe has repriced more quickly than other parts of the world because of short-term cyclical distress, macroeconomic uncertainty driving negative sentiment, a looming wall of refinancing, and some distressed selling by open-ended funds to meet redemptions, most notably in the U.K.
Value is on offer but the window of opportunity won’t last forever. Investors wanting to capitalize on this moment need to act swiftly. An active value-add strategy will be important to success. Structural drivers at play are generating opportunities to add further value on top of that served up by repricing. The conditions are ripe for value-add investing 2.0, a strategy where value-add activities, such as building, transforming and curating assets, are key to unlocking value.
The case for an active strategy: value-add investing 2.0Value-add investing can be passive—buy low and wait for prices to recover to realize the asset’s underlying value. It can be active too, particularly when it comes to real estate, which is where value-add investing 2.0 comes in—buying assets with value-add potential at a discount, taking advantage of repricing, and then building, transforming and curating to maximize the asset’s underlying value.
Whether passive or active, all value-add investing strategies first require the conditions to be in place for opportunities to be generated. Repricing in real estate markets, strong underlying occupancy fundamentals, long-term structural drivers, motivated sellers—all are typically high on a value-add investor’s watch list. All can be found in European real estate markets today, creating a target-rich environment for value-add investors. As sentiment improves, more investors return and pricing recovers. Today’s European value-add opportunities will be no different. Investors need to act now to capture the returns on offer.
An active value-add strategy is needed in the current environment, which differs from prior downturns. Rewind to the Global Financial Crisis (GFC), when a passive strategy centered around taking advantage of the easy monetary conditions unleashed by central banks would have been enough to generate a positive return. As stimulus boosted asset prices, buyers just had to gain exposure and then let markets do most of the work. Fast forward to today and the split between market and manager-generated returns has flipped. This time, investors must do more of the work. An investor must understand the drivers behind occupier demand, identify value-add potential, work with local partners to source and actively asset manage opportunities, be able to access competitive financing and have the capability to execute build, transform and curate strategies. Today’s European value-add opportunity calls for an active, not a passive strategy.
A European opportunity
Value-add strategies work best when more opportunities exist and especially when the number of opportunities is greater than the capital and liquidity available. Typically, such an environment occurs when markets undergo a repricing, when key metrics such as rental growth and vacancy rates remain strong and when assets with value-add potential can be acquired at rebased prices. Europe is ahead of other regions on repricing. As Figure 1 below shows, prime capital values in EMEA fell as much as 12% year-over-year in H2 2022 compared to slightly over 6% in the Americas and 2% in Asia Pacific.
Figure 1: Prime capital value growth, H2 2022, %
CBRE IM believes much of the expected repricing has now taken place across Europe, particularly in the U.K. Figure 2 compares the expected peak-to-trough decline with actual movements seen thus far.
Figure 2: Cumulative peak-to-trough value decline, Q1 2020-Q1 2033
Higher interest rates, together with debt market volatility, have caused the cost of debt to rise in Europe, which has led to liquidity tightening and markets repricing as shown in Figures 3, 4 and 5.
Figure 3: Cost of debt for core logistics
Figure 4: Real Capital Analytics Liquidity Index
Figure 5: Private capital growth, quarter-over-quarter % change
Opportunities amid market challengesReal estate transactions in Europe could improve further still. Lower valuations, higher financing costs and debt market volatility are creating the conditions for an “equity gap” to emerge, whereby loans cannot be refinanced at similar LTV or ICR levels. When loans can’t be refinanced, owners often have little choice but to sell. Elevated financing costs can also create a funding gap for potential investors. High numbers of sellers and low numbers of investors lead to an ideal environment for value-add investing. The changing needs of occupiers present another challenge to owners. Long-term factors such as e-commerce growth, sustainability, employee well-being, working from home, technology and flexibility are impacting occupiers to varying degrees. Occupiers are becoming more discerning. Owners are under pressure to ensure properties deliver what occupiers are looking for. Assets need to be future-proofed to minimize vacancies and avoid obsolescence to ensure continuing rental income, rental growth and liquidity. Often upgrades are required and investment is needed at a time when it is harder to acquire competitive financing. The correction in Europe, spurred by short-term cyclical market distress, long-term structural trends and asset valuation methodology, has created an ideal environment for deploying value-add capital.
An unusual correction
While values have decreased, market fundamentals have remained robust. Prime rents in European office, logistics and retail all grew in H2 2022 even as capital values fell. As Figure 6 demonstrates, this is not typical. Previous downturns have seen a correlation between capital values and rents. This time, however, as capital values fall, rents continue to grow.
Figure 6: EMEA prime rent and capital value growth, quarter-over-quarter % change
It is a similar story with margins. Across the major subsectors—logistics, office, retail and residential—margins are currently higher than in 2019 (Figure 7).
Figure 7: Sector margins (core asset quality), Europe including the U.K.
High-quality, well-located real estate with significant value-add potential can be acquired at attractive prices in this current market.
The opportunity at the subsector level
Subsector opportunities and activities required to add value differ significantly by product type.
Theme: Work-from-home is a critical factor driving structural changes in the office market. CBRE’s Q2 2022 U.S. Office Occupier Sentiment Survey highlighted that 52% of respondents anticipate a contraction in their portfolios and, of these, 84% cited underutilized office space due to hybrid-working arrangements as the reason behind the expected contraction. Hybrid-working arrangements are prompting office occupiers to rethink and potentially downsize office portfolios, but this may present opportunities for an investor.
Opportunity: In the CBRE Survey, 85% of occupiers wanted employees in the office at least half the time. According to McKinsey’s Spring 2022 American Opportunity Survey, “…when people have the chance to work flexibly, 87 percent of them take it.” The challenge for employers is to ensure they have flexible office portfolios that can accommodate hybrid working models that accommodate times when the majority of employees could be working in the office. At the same time, employers are having to offer attractive amenities to entice employees to spend time in the office. Workspaces that can satisfy both employers and employees stand to benefit.”
Value-add: Transforming existing office assets is an opportunity for investors who understand occupiers’ need for offices that entice employees to come into the office and at the same time provide flexibility. Our investor-operator model gives us an operator perspective while delivering strong risk-adjusted returns for our clients. Offices can be transformed into in-demand modern assets that command higher rents and have lower vacancy risk. With an increase in sustainability-related regulations in Europe, many occupiers are focused on this issue, which is driving demand for sustainable office space.
Case study: 280 Bishopsgate, London: Transforming an obsolete asset in a prime location into Grade A real estate
Theme: Lack of housing has been a long-running issue for residential markets across Europe. This has been particularly evident in the U.K. Figure 8, taken from the House of Lords Library, shows how annual net additional dwellings between 2000-2001 and 2020-2021 struggled to reach 250,000, a level lower than the estimated 340,000 homes needed annually until 2031, according to Crisis organization and the National Housing Federation.
Figure 8: Annual net additional U.K. dwellings, 2000-2021
Opportunity: The shortage in housing is not new, but the growing demand for housing that meets higher sustainability and well-being standards is a recent trend. Buildings that are energy efficient, have a lower carbon footprint and are constructed using sustainable materials have an important role to play in the push to decarbonize. As the National Housing Federation writes: “Decarbonizing Britain’s homes is not only an essential part of tackling the climate emergency but it also combats fuel poverty, supercharges the economy, creates jobs and creates warmer homes and cleaner air.”
Value-add: To build sustainable homes and maximize value effectively in Europe, an investor must thoroughly understand the theme, local regulations and activity required to add value. CBRE Investment Management’s regional and local platform enables us to create fit-for-purpose accommodation that has been designed with the environment and quality of life in mind. Turnover is reduced and home maintenance is increased when resident needs are considered, which can lead to lower default rates, vacancy rates and lower maintenance costs.
Case study: Estea, Sweden: Creating residential units in supply-constrained markets
Theme: E-commerce, reverse logistics and supply chain reconfiguration are three themes that continue to drive demand for modern logistics assets across Europe. Record-low logistics vacancy rates and high rents have been seen in the European industrial sector in recent years. These strong market fundamentals are expected to continue for the foreseeable future.
Opportunity: Modern logistics facilities in Europe are in short supply. Europe lags the U.S. in terms of logistics space per capita as shown in Figure 9.
Figure 9: Logistics space per capita, sq. m.
CBRE estimates that 27.7 million sq. m. (298 million sq. ft.) of new cutting-edge logistics space is needed across Europe by 2025 based on e-commerce growth alone or the supply-demand imbalance is likely to get worse. High debt costs and the uncertain macroeconomic environment pose challenges. Development finance will be difficult to secure and will delay new development. European industrial fundamentals are, therefore, expected to remain strong. Opportunities may emerge to acquire development projects that can’t be completed due to the lack or high cost of financing.
Value add: Building modern logistics facilities in prime locations requires a broad network of sellers and developers to source and secure opportunities, especially off-market transactions. Strong relationships with banks can also be a source of attractive projects. Given that occupiers often have international operations, our global platform and network of logistics occupiers provide additional sources for securing deals.
Case study: Montepino, Spain: Creating Grade A logistics facilities in prime locations
Theme: Online shopping prior to the pandemic transformed consumer buying habits, resulting in lower footfall at stores and shopping malls. Lower footfall made attracting tenants harder. Units remained vacant for longer. Rents came under pressure and valuations fell. COVID-19 and associated lockdowns magnified the challenges faced by retail. But the sector responded by adapting and reworking business models to accommodate consumers’ changing habits. Owners reconfigured assets to provide retailers with the space they needed and, where appropriate, incorporated mixed uses such as office and residential.
Opportunity: For the last few years, retail has not been a favored asset type. However, this is now changing. Because of lower valuations, retail is back on investors’ radar. According to CBRE’s analysis of European real estate investment volumes in Q4 2022, “the retail sector is the only sector that is showing a positive trend and is expected to continue to attract more capital in 2023 ... volumes in 2022 were up 20% compared to 2021.” Retail is also the only sector where rents have fallen in recent years, so the sector is now poised for rental growth if actively managed.
Value-add: A savvy investor will seek to curate existing assets. As with the other product types, knowing the market and occupier needs are essential to identifying suitable properties for a value-add strategy that optimizes the space in alignment with retailers’ requirements and customer desires. An appropriate strategy will make the difference in whether rent growth can be achieved. Acquiring assets at today’s attractive yields can further boost the value that can be captured.
Case study: Preciados 9, Madrid, Spain: Repositioning an undermanaged asset acquired at an attractive market discount
The opportunity at the country level
European markets are not homogenous. Each country and region has its own set of drivers, is at different stages in the cycle and has its own supply-demand dynamics. The U.K., for example, repriced sooner across all real estate sectors. In Germany, industrial and residential repriced more rapidly. In Sweden, the residential sector repriced first. Offices in general are anticipated to face further adjustments across most EU markets.
By contrast, repricing in Southern European countries has been more gradual. Interest in the region has remained strong despite the challenging macroeconomic environment. CBRE’s analysis of European investment volumes in 2022 showed a 38% increase in investment activity in Spain in 2022, while Portugal experienced 13% growth, closely followed by Italy, at 12%.
As has been discussed throughout this paper, a deep knowledge of individual markets and established relationships with local partners are required to capitalize on the European value-add opportunity.
The window of opportunity
The window of opportunity currently exists to access prime properties with value-add potential at attractive prices. Once sentiment improves, investors will return, capital inflows will increase and prices will recover. Although there will continue to be opportunities, the deep discounts will be more difficult to uncover.
Value-add opportunities tend to follow the same four-phase cycle. In Figure 10, we map out the various phases of the current opportunity to show how we expect it to progress in the coming months.
Figure 10: Opportunities through the cycle
According to CBRE IM’s timeframe, Europe is nearing the end of phase two—sentiment bottoms—and entering phase three—recapitalization opportunities. This tallies with the view that much of the anticipated decreases in pricing have already taken place across Europe. Prices may have further to fall, but the cycle is maturing. The window is narrowing.
Trying to call the bottom is an impossible task. We, however, analyzed returns over five- to eight-year hold periods at 24 monthly entry points between June 2007 to June 2009 when values were falling across all property types as a result of the GFC. Every cycle is different, but our analysis shows that returns above 8% per annum were achieved even for investments made prior to values bottoming-out—an entry point that had a 23% future decline still generated an 8.1% per annum return on a seven-year basis.
Investing before valuations bottom-out still pays. The message for those wanting to capitalize on today’s European value-add opportunity is to take advantage of the window of opportunity currently open—investing through the bottom if needed—and deploy an active, value-add investing 2.0 strategy.
Disclosures – Case for Value-Add in European Real Estate
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