European Real Estate in the New Economic Climate

London (HedgeNordic) – Real estate has potential to at least keep pace with inflation. “Outside the British Isles, European commercial real estate rents are indexed either directly to the Retail Prices Index, or else like in France to a proxy that is pretty close, with annual uplifts. This offers medium-term inflation protection. We then aim to select assets where revenue can grow faster than inflation, due to mismatches between supply and demand, as well as price-agnostic demand,” says Mike Bessell, Managing Director and European Investment Strategist at Invesco Real Estate.

Mike Bessell, Managing Director and European Investment Strategist – Invesco Real Estate.

On the supply side, inflation and supply chain bottlenecks could even be a benign influence for investors, insofar as they are leading to some more marginal projects being mothballed, according to Bessell.

Meanwhile, demand for last mile logistics is intensifying as the trend moves from outsourcing and offshoring to near-sourcing and reshoring, and supply chains are repositioned from just in time to just in case, based on optimizing the changing balance of costs. “Rents are only 5% of costs for a typical logistics operator, whereas transport can be 50% and labour costs are a high share too,” says Bessell. On top of general wage inflation pressures, there are specific shortages of drivers who are qualified to drive lorries, trucks and other larger vehicles.

The office market is also seeing shifts in patterns of demand: “some older space is being relinquished but there is a shortage of grade A high quality space in areas such as London’s West End or the Central Business District in Paris,” says Bessell.

“We then aim to select assets where revenue can grow faster than inflation, due to mismatches between supply and demand, as well as price-agnostic demand.”

The real estate investor supply/demand balance is also favourable: “there is a finite pool of stock and capital, and planning permission is needed. Yet there are record levels of dry powder – US$443 billion on pitchbook data – to deploy,” he points out.

An Oasis of Calm Amid Story Fixed Income

The rental revenue growth story could however be tempered if higher interest rates and/or risk premiums lead to lower asset valuations – via debt markets or discount rates or both.

Though government bond yields, swap rates and corporate credit spreads have violently blown out in early 2022, real estate has thus far seen only marginal impacts and seems to be largely disconnected from wider fixed income turbulence: “the swap cost component of borrowing has gone up, largely because rate options price off higher volatility. However, margins over underlying interest costs have generally been static, and sometimes even come down as underling interest rates rise. We do not expect a 50 basis point move in rates will translate into a 50 basis point rise in cap rates for property. As of March 2022, we noted Paris CBD cap rates had widened by 10-15 basis points, but logistics cap rates continue to tighten and in UK offices, London West End cap rates came down from 3.75% to 3.5% in the second half of 2021,” Bessell explains.

“Many property assets anyway have long-term fixed rate debt in Europe, though we do accept that leveraged buyers will be more price sensitive.”

“Many property assets anyway have long-term fixed rate debt in Europe, though we do accept that leveraged buyers will be more price sensitive. Banks may also shy away from riskier developments and require lower loan-to-value ratios,” he adds.

Recession Risk and Covid Stress Tests

Recession risks could be adverse for some property assets. Recession scenarios, especially in Europe, are being discussed by the media, hedge fund managers and Davos WEF delegates, but as far as consensus economic forecasts are concerned, nobody appears to be worried about it as of May 2022: “the lowest forecast for Europe 2023 is 0.8% economic growth, the highest is 3%, and most forecasts for 2024 are between 2-3%. Some individual countries might see one or two quarters of marginally negative growth but we do not see an overall recession,” says Bessell.

“During Covid we carried out a detailed review of our office holdings, covering locations, flexibility, tenant structures and demand, and this gives us confidence in the assets we currently own in this sector.”

Nonetheless, recessions usually come as a surprise, and are recognized in retrospect after economic data is revised. Even before Covid the economic cycle was one of the longest expansions and may need to pause for breath at some stage. If a recession does materialize, Invesco Real Estate has some confidence that its asset allocation and sector selection could be resilient in a recession scenario, partly based on the Covid slump: “During Covid we carried out a detailed review of our office holdings, covering locations, flexibility, tenant structures and demand, and this gives us confidence in the assets we currently own in this sector. We had previously undertaken a similar exercise on our retail assets. As regards residential, Europe has been structurally undersupplied for years or decades, resulting in the current tight vacancies and strong demand. Our core programmes have long weighted average lease terms. Our offices, residential and retail are focused on strong locations in gateway cities. We do not take location risk and have very little development risk,” says Bessell.

Geopolitics and the ECB

An extended war in Ukraine could increase recession risks, particularly for Europe. Invesco Real Estate has mapped out scenarios based on a faster or slower conclusion to the economic impacts of Russia’s invasion of Ukraine, and is prepared for both possibilities: “the strategy is to select assets that would perform well in either scenario. And it is likely that the ECB would be more supportive, in terms of delaying or avoiding rate rises, and maintaining, resuming or increasing bond purchases, if the war does drag on,” says Bessell.

Sub Sector Tilts

Regardless of the macroeconomic backdrop, Invesco Real Estate is an active manager in real estate and has its own views on asset allocation and individual property selection.

It is hard to universally generalize about Invesco Real Estate’s asset allocation as there are multiple mandates focused on specific segments such as residential, or hotels and separate accounts where clients can determine their own requirements. That said, house views versus INREV reveal some asset allocation preferences: “we are overweight hotels where we have a specialist team and programme. We are in line on residential, and on retail where we have supermarkets for inflation targeting and luxury retail in Paris and Milan in a very bespoke product. We are very marginally underweight of logistical and industrial, partly because pricing has moved so significantly that even assets in weaker locations with looser covenants are being lifted, so in this sector we are selectively selling into strength while focusing on strategic locations linked to e-commerce,” says Bessell.

Geographic Bets and Gaps

Geographically, the team comes close to pan-European coverage through a mixture of direct office footprints and affiliates. As well as core European locations such as London and Paris (which also covers Belgium and Luxembourg) there is a presence in Milan, Prague, Warsaw, and Madrid, which also serves Portugal. “We are generally sticking to core locations and gateway cities and are wary of broadening out the core definition to include smaller, less liquid and more volatile markets,” says Bessell. Therefore, the firm has historically avoided Greece due to volatility and the Baltics due to illiquidity. It has also eschewed Norway and Switzerland owing to high valuations arising from abundant local capital. Finland in general and Greater Helsinki in particular – which both offer some yield pickup – are markets that Invesco Real Estate regret omitting and the gap could at some stage be filled.

“We are generally sticking to core locations and gateway cities and are wary of broadening out the core definition to include smaller, less liquid and more volatile markets.”

Bessell, who sits in London, continues to have a liking for his local market: “London is still playing catch-up and there is still limited supply of grade A office space and urban logistics, which benefits from UK leadership in e-commerce. Before 2015, London traded tighter than the rest of Europe and is now 75 basis points wider in absolute terms. UK logistics, the best sector in 2021, has already matched European logistics valuations, but offices have lagged,” he explains. Of course, interest rate differences between the Pound and Euro may explain part of the pickup, but he still sees valuation upside in the UK.

New Buildings Meet ESG Needs

focus on the areas of shortest supply, with transport and urban location connectivity and record low vacancy rates, but also meet higher ESG standards for buildings sustainability, where older buildings may fall short. This illustrates the “brown discount” phenomenon: the capital spending needed to improve some properties to more sustainable standards is starting to get factored into valuations. “What was once a green premium for more sustainable properties is now required to attain grade A status. Invesco Real Estate has detailed and comprehensive improvement plans for its remaining non-ESG rated exposures,” says Bessell.

ESG Improvements

Multiple Invesco Real Estate strategies have been categorised as SFDR Article 8 funds, and some may even go to Article 9. The firm is proceeding cautiously to develop confidence in the new regime and avoid any perception of greenwashing.

Invesco Real Estate’s strategies mainly have 4- or 5-star GRESB ratings, though some vehicles with a higher proportion of development projects cannot currently rise above a 3-star rating, pending completion to ascertain data measurement and building standards.

Asset Selection

ESG overall is one criterion among many desirable features that can make property more valuable: “office values can be enhanced by transport links, exercise facilities, green space, leisure attractions and even children’s creche facilities and other attractions within a ten-minute walk,” says Bessell.

“We do not expect that videoconferencing will eliminate business travel, though it might lead to fewer but longer stays.”

Similarly with hotels very specific locations need to be assessed and they cannot be quickly and easily categorised. For instance, demarcating hotels into leisure versus business can be too binary, since many cities are working seven days a week, with both tourists and businesspeople active throughout the week. “We do not expect that videoconferencing will eliminate business travel, though it might lead to fewer but longer stays. Ultimately hotel locations need to be analysed on a granular basis because revenues per room in Gare du Nord, are very different from those on the Champs Elysees in Paris,” says Bessell. Most of the firm’s hotel assets are mid-level or luxury as budget is a longer lease game with less added value upside from asset management.

Indeed, the way in which properties are managed in terms of ESG, sustainability and other quality and amenity improvements can be important for both rental growth and valuations. The economic outlook now faces greater uncertainty than in late 2021, but Invesco Real Estate are confident that selected properties will be well positioned to weather a variety of economic conditions.

This article features in HedgeNordic’s “Private Markets” publication.