The investor’s experience is rarely unequivocal. Gains are welcomed with delight, but also trepidation over whether profits should be taken before any reversal. Losses are feared, but the psychology of sunk costs can reinforce determination.
So how should investors interpret markets today? Equities have extended their winning run, but macroeconomic risks still loom. Bonds offer appealing yields compared with the era of quantitative easing, but the spectre of inflation is so far preventing monetary policy from pivoting decisively in the asset class’s favour.
Fortunately, given these competing emotions, investors have alternative options. Real estate is an important one – indeed, 2024 could represent one of the best-ever vintages for European real estate, offering investors a rare opportunity to invest at cyclical lows just as fundamentals start to improve.
We must acknowledge that real estate faced a category 5 hurricane in 2023, with the speed and size of rate hikes battering both leveraged owners and investor sentiment. Some of the effects are still being witnessed, with negative headlines engulfing troubled developers and exposed banks in places as varied as the US, Germany, and China. In addition the pandemic also had a very strong effect on the office sector, reducing demand at a time of lots of new supply in particular in the US market.
So what is the good news? First, interest rates now seem to have plateaued; regardless of the pace at which they decline – the subject of much current debate in markets – they are unlikely to increase further. Global equities have already reacted to this and are at peak prices from the US to Japan. Bonds have retreated a little after their strong rally to end 2023, but may now be rangebound until central banks communicate their intentions more clearly.
Real estate, on the other hand, has yet to stage the same recovery from its lows. There seems to be no reason why asset prices in this market shouldn’t adjust higher over time as investors recognise that the worst of the impact from rising interest rates is now in the past.
At the same time as investors can benefit from this attractive entry point – and there are still many motivated sellers in real estate, so buyers can drive bargains – improvements in macro conditions could provide additional support for rental growth and asset prices. Evidence of economic resilience is thus another tailwind for real estate yet to be reflected in valuations.
In fact, European real estate delivered rental growth in 2023, underpinned by favourable supply and demand dynamics. In some sectors the growth reached double digit percents due to lack of new supply – even in the most challenged of sectors, offices. Vacancy rates in European offices are low, from as little as 1.9% in central Paris to sub-10% in London, Madrid, and Frankfurt and Berlin. This helped average office rents in prime European cities to increase by more than 6.3% last year.[1] With an ongoing dearth of new developments, this trend should continue in 2024; the weak market has left development projects down by over 50%, meaning that as and when there is an economic recovery in Europe, it will be met with no new supply in an already constrained and undersupplied market, which should lead to rental growth. For those willing to express a view on real estate gaining in capital terms from the end of the hiking cycle, like other asset classes already have, such rental boosts – especially in top-tier locations – should prove very attractive.
So while investors must consider a multitude of risks for equities and bonds, real estate has already priced in a lot of bad news and its return profile now seems highly skewed to the upside. Buying around the market lows, which we are facing now due to the interest rate environment, has historically been rewarding for value-add investors in real estate. This timing aspect, plus the rental growth prospects for the right supply-constrained sectors and the longer-term sustainability trend of ‘greener’ buildings attracting a premium, could be a powerful combination. When sentiment is lowest, the opportunity set is often highest.
