Global demand for stabilized, income-producing real estate has remained strong, with institutions continuing to commit to the asset class and expected to increase allocations further in the coming year.
The Covid-19 pandemic has refocused occupiers’ attention on the types of real estate that are considered to be operationally critical going forward. It has disrupted trends, leaving individual sector picks more polarized than ever and widening the gap between market segments with deep tenant demand, growing rents, and compressing cap rates and those with shallow demand, overvalued rents, and a retrospective valuation basis.
This shift in occupational sentiment has recalibrated the definition of “prime” commercial real estate. While location, design, specifications, and configuration remain important credentials, investors are increasingly seeking to acquire and hold assets deemed “needed” and “future-proofed” by their relevant occupational community. Sustainability is a critical factor as companies seek to align with carbon footprint targets and other green initiatives.
Source: Bloomberg and Savills as of September 2021.
Institutions’ deployment patterns are shifting, with sector allocations moving away from traditional segments such as offices and retail, and toward emerging areas of focus, including rental housing, healthcare, student accommodation, and self-storage, which offer stable income streams. Capital market activity in 2020 across offices and retail were down 31% and 6% year-on-year, respectively, in stark contrast to the pan-European logistics space, which saw investment volumes up 14%.1
Source: CBRE, Investment Volumes, based on CBRE figures as of year-end 2019 and 2020.
Offices remain one of the largest sector choices, representing 32% of total annual European investment volumes as of June 2021, second only to residential.2 The adoption of pandemic-era flexible working practices as well as sustainability considerations are impacting how occupiers use offices as well as which locations and specifications are believed to attract rental premia or necessitate discounts going forward.
The combination of more polarized tenant activity with a systemic shortage of debt funding for speculative development means physical delivery of new office accommodations are believed to remain well below the long-term average; leaving grade A vacancy rates low (below 2%-3%) across the majority of gateway markets. Banks have been reluctant to resume their traditional pre-financial-crisis lending activities because of credit risk concerns and loss histories, but regulation continues to play a role, making the cost of development funding prohibitively expensive. As a result, a shortage of new, modern, grade A supply continues in a market where occupiers are actively seeking betterment (to meet legal requirements or to better attract and retain talent).
Pandemic-related safety and health considerations will also drive occupational decisions as tenants seek offices that satisfy Covid-era needs. For example, offices with poor ventilation systems or congestion issues (such as slow elevators or poor staircase access) are going to struggle to retain tenants.
With real estate accounting for 30% of global annual greenhouse gas emissions,3 the industry is starting to make significant changes to reduce its carbon footprint. The move toward a lower-carbon environment is accelerating the obsolescence of legacy buildings facing higher maintenance and compliance costs, and a failure to address these issues will likely dent asset values.
A recent survey by Knight Frank found that four out of five companies say sustainability considerations will influence their occupational strategies, but respondents say less than a quarter of their real estate portfolios currently have an environmental accreditation.4 In relation to its net-zero commitment, the UK government has mandated a minimum B Energy Performance Certificate (EPC) rating by 2030.5 Only 3% of total building stock in the UK6 and just 20% of the entire City of London office stock7 currently meet that standard. These factors are already impacting investment market liquidity as buyers factor in the quasi-contractual costs required to comply with regulation.
Offices nonetheless remain the largest component of the investable universe in real estate; historically, it has been a highly liquid sector across Europe and has delivered strong results. We expect to see continued opportunities as net demand for best-in-class, grade A space has increased, reflecting tenants’ need for physical betterment to attract talent and align with their corporate sustainability targets.
As the market continues to operate in a low-interest-rate environment and as inflationary pressures grow, investors are focusing on sectors where rental growth will likely remain strong. These include logistics in particular, as well as residential.
The pandemic has accelerated the rapid expansion of online retailing and fueled demand for shorter delivery times, in turn creating greater need for last-mile logistics.8 This has driven demand for industrial premises in or near large urban markets, currently characterized by a significant supply and demand imbalance. In the UK, for example, there was less than one year’s supply of stock in key regional markets as of first-half 2020. The lack of supply and a shrinking grade A vacancy rate has been met with deep institutional demand, as evidenced by record-breaking investment volumes in the UK of £4.7 billion in 2020, up 30% versus 2019.
In addition, take-up totaled 56.6 million square feet (sf) in 2020, the strongest year ever recorded.9 This is in stark contrast to total supply, which fell by 3.8 million sf to just 32 million sf over the 12 months to first-quarter 2021, driving the nationwide industrial vacancy rate to 5.7%.
Furthermore, the supply-demand imbalance precipitated by the e-commerce boom has led to strong rental growth nationwide in the UK, with estimated rental values (ERVs) in London increasing 7%-8% per year between 2014 and 2019.
Investor demand in Europe’s residential sectors has been trending up, with investment volumes reaching an all-time high of €11.4 billion in the first quarter of 2021, up 23% versus the same quarter of 2020 and representing 30% of overall investment.10 This has also been met with a stream of new market players, reflecting a growing appetite for income-producing assets that provide stable cash flows. The strength of the asset class is evidenced by its resilience to the Covid-19 pandemic as a needs-driven sector, with strong occupancy levels and high rental collection rates (averaging 80% across key markets11).
In the UK, a structural undersupply of quality rental housing juxtaposed with rising demand is pushing rents up.12 Affordability constraints in homeownership and mortgage availability have led many would-be homeowners to rent for longer, a trend we believe will persist. Furthermore, the pandemic has heightened requirements from occupiers, many of whom are seeking affordable but well-specified suburban homes, with gardens and work-from-home space, as they move from city center apartments to less densely populated areas.
Germany represents the largest component of Europe’s residential investment market, with its multifamily segment contributing 44% of all capital deployed in the first half of 2021.13 However, as in the UK, the German market is also characterized by a demand/supply imbalance, pushing rents upward.
Selling pressures have not yet become apparent, with lenders being urged not to lean too heavily on borrowers, including by considering forbearance on covenant defaults where appropriate and even permitting banks to grant short-term payment holidays without triggering additional capital requirements.14 However, opportunities are arising through consensual recapitalizations, with borrowers needing to refinance maturing loans or fund ongoing capex needs. A pipeline is also emerging from listed companies seeking to deleverage or raise cash for buybacks and closed-end funds facing liquidity pressures. A disproportionate share of these opportunities will lie in the most occupationally challenged sectors: hospitality and retail.
Despite the clear challenges the hospitality sector has faced since the onset of the pandemic, 2021 has witnessed a nascent recovery for many hotels. In leisure hospitality, the pendulum has swung from a sector on life support to one that’s benefiting from the greatest pent-up demand, as people embrace their newly reacquired freedom of movement.
Global hospitality data provider STR predicts occupancy will reach between 80%-100% of 2019 levels by the fourth quarter of 2022 for most markets, with full revenue per available room (RevPAR) recovery expected by at least 2024. Government relief continues to support the sector, with temporary reductions in hospitality value-added tax (VAT) rates and income support schemes, which have mitigated insolvency risk for many businesses.15
Investment volumes were at historical lows in 2020 (at €8.5 billion16) amid a lack of debt availability, closures, and travel restrictions that curtailed transaction activity. Government support initiatives have been keeping the industry afloat, but as these measures eventually wind down, we expect to see an uptick in buying opportunities.
The Covid-19 pandemic has only intensified the adoption of e-commerce, accelerating the structural decline in the retail sector with the demise of traditional department stores and fashion-anchored shopping centers. But this doesn’t mean all physical shopping formats will become obsolete: The winning formats will adapt and thrive, responding to cultural trends favoring experiences and social interaction while also being incorporated into a contemporary-format logistics chain.
One of the only retail formats to remain open during lockdown, and which has demonstrated enduring resilience to e-commerce, is grocery-anchored retail. These assets have maintained their appeal to retailers, shoppers, and institutional investors who value the stable income from assets that form part of everyday life. The segment attracted €6.7 billion of capital flows in 2020, up 40% from 2019 volumes. Furthermore, grocery-anchored retail’s share of total real estate increased to 22% in 2020, up from 6% in 2016.17
Traditional enclosed retail can also offer attractive repurposing potential. Some of the most valuable redevelopment sites across Europe are currently covered by distressed or dysfunctional retail property. Land is a scarce resource in urban areas, and alternative uses alongside increased densification may offer a recovery route for retail landowners. A sensible strategy in retail today is understanding location and site value, being able to right-size the retail footprint, and having the resources and capabilities to assess – and ultimately deliver – the highest and best use (which may or may not include retail).
In 2022 and beyond, we believe success in Europe’s commercial real estate market will be based on the acquisition or creation of assets with a sustainable, growth-orientated occupational outlook. The need for “future-proofed” properties that will avoid obsolescence amid Covid-related shifts in sentiment and demand has become increasingly urgent.
While we see opportunities spanning all property segments in the coming year, a careful approach to stock selection will be paramount amid the industry’s accelerating evolution.
1 Savills ‘Spotlight: European Investment’ (25 May 2021)
2 Aberdeen Standard Investments ‘European Property Market Outlook Q3 2021’
3 Schroders ‘Does an emissions scandal await the real estate sector?’ (23 April 2021)
4 Knight Frank ‘Your Space – 2021’
5 UK Governments ‘Non-domestic Private Rented Sector minimum energy standards: EPC B implementation’ (17 March 2021)
6 Department for Business, Energy and Industrial strategy, May 2021
7 Property Funds World ‘Ten per cent of London’s office stock may become unusable in 2023 due to low EPC rating, says Colliers’ (9 August 2021)
8 Savills Research ‘National Investment’ (8 January 2021)
9 Savills’ “Big Shed Briefing” (January 2021).
10 Knight Frank, “The Intelligence Lab: Global Property Market Insight” (7 May 2021).
11 Savills Research, “European Multifamily” (February 2021).
12 Savills Residential Research, “UK Housing Market Update” (August 2021).
13 Savills, “Spotlight: European multifamily” (14 September 2021)
14 Bank of England, ‘Our response to coronavirus (Covid)’ (14 September 2021)
15 Savills ‘Spotlight: European Hotel Trends Outlook’ (6 May 2021)
16 Hospitality Insights ‘European real estate investment up 45% in Q2’ (19 July 2021)
17 JLL’s ‘Resilience in consumer grocery spending increases investor appetite in European grocery real estate’ (25 March 2021)
Investing involves risk, including possible loss of principal. The information presented herein is for illustrative purposes only and should not be considered reflective of any particular security, strategy, or investment product. It represents a general assessment of the markets at a specific time and is not a guarantee of future performance results or market movement. This material does not constitute investment, financial, legal, tax, or other advice; investment research or a product of any research department; an offer to sell, or the solicitation of an offer to purchase any security or interest in a fund; or a recommendation for any investment product or strategy. PineBridge Investments is not soliciting or recommending any action based on information in this document. Any opinions, projections, or forward-looking statements expressed herein are solely those of the author, may differ from the views or opinions expressed by other areas of PineBridge Investments, and are only for general informational purposes as of the date indicated. Views may be based on third-party data that has not been independently verified. PineBridge Investments does not approve of or endorse any re-publication or sharing of this material. You are solely responsible for deciding whether any investment product or strategy is appropriate for you based upon your investment goals, financial situation and tolerance for risk.
For additional legal and regulatory information related to PineBridge offices and countries, please refer to our Regulatory Disclosures.
Global
