The sharp divergence between the favoured and unfavoured sectors of European real estate, which has arisen over the past two years out of the Covid-19 pandemic, will begin to reverse in 2022, according to the latest Investment Strategy Annual (ISA) published by LaSalle Investment Management.
After identifying in last year’s ISA a “growing chasm” between logistics and residential real estate, on the one hand, and office and retail assets, on the other, LaSalle projects this gap to gradually narrow from this year onwards, with the Omicron variant likely to create a sharp, though brief, period of disruption. This re-convergence will be driven in part by the steady reduction in pandemic-related headwinds for certain retail and office subsectors – with retail warehouses and top-tier high streets the most favourable of the former, and the recovery in offices depending on asset quality and location.
Meanwhile, the sustained inflow of capital into the comparatively small investable universe of European logistics and residential assets has pushed up pricing and driven down yields – albeit these “sheds and beds” remain a top pick, with the best-positioned office and retail assets only set to start closing the gap.
While intense competition for limited stock and the resulting price appreciation in the European logistics and residential sectors is driving initial yields lower, LaSalle still sees these sectors as attractive, especially for investors who wish to take on manageable incremental risk, including through development and refurbishment. Both sectors’ fundamentals remain robust, with strong income performance set to continue and low downside risks to cashflows, which justifies the use of moderate levels of leverage to sustainably enhance returns. Conversely, improving fundamentals and the significant reserves of capital seeking yield may rightly fuel renewed optimism about the large but unfavoured European office and retail markets, but investors must take care to trace the fractures between winning and losing market segments and locations.
In its detailed analysis of the key dynamics and investment opportunities in each sector across Europe, LaSalle found:
In logistics, yields compressed rapidly in 2021 to unprecedented lows, dropping below those for prime offices in Europe for the first time. However, low vacancy rates augur well for an acceleration in rental growth – which, outside of key UK submarkets is long overdue – towards rates of growth that have been sustained in other parts of the world. The impact of physical retail regaining market share from e-commerce should be mitigated by a rise in just-in-case inventories following this year’s supply-chain disruptions.
In residential, pandemic-specific disruptions are rapidly normalising, restoring the long-standing supply-demand imbalance in key European cities like London, Paris and Berlin. Attractive opportunities include forward funding build-to-rent stock in supply-constrained major cities, for both young professionals and young families, and in supply-constrained regional cities, such as Spanish and German university towns, as well as affordable housing.
While Continental Europe has led the UK in the return to offices, thanks to shorter commute times and wellness-friendly building characteristics, LaSalle projects only a modest long-term impact of remote working on physical occupancy in London and the UK. A focus on best-in-class office space that meets occupiers’ ESG agendas and offers high-quality amenities should bifurcate the market, shrinking the pool of investment-calibre assets and necessitating sustainable development and refurbishment activity.
European retail assets diverge significantly in terms of subsector, quality and location. Weaker tenant demand will likely drive down rents for non-prime pitches in Continental Europe more than the UK, which is closer to bottoming out and should present a mispricing opportunity. Yields, however, for convenience and grocery-anchored stores and higher-quality retail warehouses began falling in 2021, signifying rising investor demand. Yield compression is now also expected in 2022 for the best shopping centres in the UK. Conversely, the recovery of shopping centres across Europe, in particular those anchored by department stores or with high concentrations of fast fashion tenants, is less assured.
Brian Klinksiek, Head of European Research and Global Portfolio Strategies at LaSalle Investment Management, said: “We are seeing the emergence of clear relative value in certain segments of the retail sector and, when restrictions permit, a consistent return of workers to offices in key European cities, especially London. This has increased our conviction that there are attractive risk-adjusted returns in certain parts of these sectors for investors. But this does not diminish our enthusiasm for taking incremental risk and capturing the ongoing momentum of the logistics and residential sectors, where we see income growth taking over from yield compression as the key driver of returns.”
The ISA also explored the growing impact of climate change on real estate and evolving expectations around the asset class in terms of not only financial performance, but also contributions to society and offering to tenants. LaSalle foresees the desire to manage the carbon footprint of a real estate portfolio being capitalised into asset values and land values with investors and occupiers demonstrating greater willingness to pay for locations that offer low-carbon transportation options, renewable energy and better waste and water recycling.
Jacques Gordon, Global Head of Research and Strategy at LaSalle, said: “As COVID-19 recedes, climate change will likely be the next big challenge for real estate. Europe is advanced in the transition to a substantially de-carbonized future, in terms of both regulation and market expectations. Investors in European real estate must also address rising climate risks, which are likely to result in rising insurance costs, stranded assets and costs associated with mitigation strategies. However, the integration of climate risk analysis also represents an opportunity for investors to get ahead of the trend, attract capital and tenants and outperform competitors who aren’t paying attention.”