Turning Tides: Catching the Wave of European Value Add Real Estate

Adding Value

Today’s market differs from previous cycles. We believe we are entering a new regime. Interest rates are unlikely to return to the historically low levels of the pre pandemic era. As such there is a window of opportunity opening driven by asset value repricing combined with the impact of long-term structural trends, or ‘mega forces’. Successful real estate strategies today need to go beyond relying on unwinding monetary conditions alone to generate strong positive future performance. Off-market sourcing, astute market selection, access to competitive financing, and granularity in terms of asset management are key to generating outsized returns.

Value add enables investors to be agile in the face of a changing real estate market. Exit strategies are implemented once a business plan has been achieved (typically 3-4 years from acquisition). However, there is always potential for exits to be accelerated. This optionality enables investors to capture value appreciation in a quickly recovering market, and to capitalize on demand for income producing investments to provide diversification and inflation protection.

The risk that is taken in value add investment is compensated by multiple drivers of return. Investors can diversify the risk taken within their portfolio e.g. development risk, leasing risk. Binary risks (e.g. planning) can be avoided altogether. Value add is a compelling strategy at this stage in the cycle given its ability to deliver both income and capital gains, and the level of risk taken is compensated by the additional gains that can be achieved. Conviction around capital appreciation is the result of astute market timing, and the repricing of the past 18 months has mitigated the downside risk.

Vintage advantage 

2024 marks a once in a cycle entry point to the European real estate market. To date, the UK and Europe have seen valuation declines of 24% and 15% respectively¹. Market dislocations in pricing are expected to persist, creating opportunity to taking advantage of rebased prices on assets with value add potential.

Historically, we have observed outsized market returns following a cyclical downturn. Timing the bottom of the cycle is an impossible task. However, European interest rates appear near peaks and inflation has stabilized. Investing in value add real estate is not without risk, however, these are compensated by the potential upside of investing to a heavily corrected market. Such value play can be paired with alignment with structural forces to promote a resilience of income. This creates a vintage advantage whereby the upside potential outweighs the downside risk.

Catching the wave

Europe is ahead of the curve in terms of repricing. The denominator effect has resulted in several funds requiring liquidity and looking to sell down some of their real estate to balance portfolio weightings. Such activity has driven down pricing and provided valuers with some transactional evidence. Moreover, in Europe, more than other markets, valuations are determined by sentiment in the absence of comparable transactions. This means repricing, like that we have seen in 2023, can occur swiftly and more dramatically than other regions.

Across Europe we are seeing structural forces, or ‘mega forces’ play out, impacting the way we interact with the built environment. Dispersion will persist between and within sectors. By aligning with the mega forces in Europe, investors can put themselves on the right side of this polarization.

Keeping pace with the transition 

Europe is considered the front runner in terms of investor appetite for well performing sustainable stock. This is due to the high levels of regulation that are changing and evolving in the UK and the EU. Governments, investors, and occupiers alike recognise the scale of the challenge faced by the real estate industry, and as such alignment is rewarded. There is not just a strong investment case for incorporating ESG into an investment strategy, it is an imperative to preserve long term value. Many buildings that adhere to transition standards have delivered a clear green premium. These assets often carry lower operating costs, qualify for better finance terms and occupancy rates are boosted as corporates with increasingly tight ESG commitments have a smaller pool of assets they can occupy. There continues to be a distinctive shortfall of stock that meets regulatory standard.

Value add strategies will play a pivotal role in the transition of European real estate. There is a huge opportunity to unlock value through building upgrades, active asset management and refurbishments. To achieve this requires expertise and sufficient capex, partnered with a risk appetite that is often greater than that associated with core investment strategies.