Coming to Europe: Where Global Real Estate Investors Should Consider Deploying Capital Now

For years there were essentially two reasons why a global commercial real estate (CRE) investor who maintained heavy exposure to the US market (as many do) would invest in Europe: for diversification or for outperformance. And neither was a sure thing.

For diversification it came down to simple math. Assume the typical institution has 10% of its portfolio allocated to real estate, and much of that allocation is invested in the US – whether because of familiarity, ease of access, positive prior experience, or simple habit. What would a reasonable level of diversification be? Let’s say it’s 10%. That’s 10% of 10%, or 1% of the portfolio, earmarked for reallocation to Europe. Whether that 1% triples in value or goes to zero, is it going to have a significant impact on the overall performance of the portfolio? Probably not.

Outperformance might have been an even higher hill to climb. While some European sectors or strategies may have performed against type, for the better part of two decades, low interest rates in the US, a strong dollar, and faster GDP growth created phenomenal tailwinds for the US market that proved difficult for the market across the ocean to match, let alone beat.

However, even going back before the pandemic, discerning investors detected an element of unreality to US outperformance, says Marc Mogull, chairman and chief investment officer of PineBridge Benson Elliot. This was especially true, he says, for offices, the largest US subsector. “At my annual meeting, I used to put up a chart that had just one comparative number: the office vacancy rate. And in recent years the number was Europe 7%, US 19%. It was really a confidence game in the US, as everyone continued to raise their official rents but with massive rent abatements and other concessions because of all the vacant space in the market. And as long as interest rates were low and there were plenty of funds to keep passing the assets around, nobody was the wiser.”

Now interest rates are high and the post-pandemic hybrid/work-from-home trend has become more entrenched, revealing a too-big-to-hide supply-demand imbalance and talk in news outlets of a “reckoning” in the US office market.1 Europe, meanwhile, has repriced more quickly and shows signs of stabilizing and even reconstituting itself for the next upcycle. That creates a window for investors to act, and perhaps for US-centric global investors to rethink their world view.

One shoe on the other foot, and one about to drop

None of this is to say that the European CRE market has had an easy time of it over the past 12 months. Compared to the start of 2022, prime properties have seen valuations slashed by a market that has re-rated the relative risk/return of core 10- or 15-year property leases yielding 3%-4% when investment grade corporate bonds of shorter maturity are yielding two to three points more. In one rough indication of how widely and deeply the pain has been felt, the benchmark FTSE EPRA Nareit Developed Europe Index fell 36.5% during 2022, virtually wiping out all its gains since 2016.

But while the pain has been severe, it has at least been fast. Europe’s institutional investor base, whose regulations around managing pension liabilities make it inherently more fixed-income-oriented than its US counterpart, responded quickly to the reversal of a decade-long decline in real (i.e., inflation-adjusted) interest rates: As real rates leapt 200 bps between Easter and Halloween, investors retreated from real estate and piled back into bonds. Flows into the property sector dried up, with transaction volumes cratering. Importantly, though, what deals did get done provided the evidence valuers needed to quickly re-price the sector.

The US, on the other hand, has been harder to read – a big change for a market that usually leads rather than lags Europe. While interest rates rose in the US last year too, the prevailing view that the Fed’s proactive inflation-fighting actions would result in a “soft landing” for the economy sustained investor sentiment deeper into the year. As a result, even as the European CRE market has begun to stabilize and its newly mostly prime parts tighten, the US remains in a kind dissociative state. Consider the disconnect between the leading index for REITs (i.e., publicly listed funds) and the one for private funds, where mark-to-market reporting is left more to the discretion of the managers. The MSCI US REIT Index fell 27% during 2022, while the benchmark Open-End Diversified Core Equity (ODCE) Index rose 7.5%, despite the fact that the two are largely indistinguishable in terms of asset composition. Little wonder that a Bloomberg article3 (Investors Seek to Pull US $20B From Core Funds”) from January of this year highlighted “the biggest redemption queue since the Great Recession.” As Mogull remarks, “Who’s fooling who?”

But Mogull is among those who believe there may well be another shoe to drop in the US – this one on the debt side. The first sign of disruption occurred early this year in the commercial mortgage-backed securities (CMBS) markets, when the large money-centre banks that package and securitize loans from lending institutions essentially froze all new issuance after they were left holding debt they’d intended to move off their books before rates rose. Still, CMBS accounts for only 20% of the outstanding US$1.62 trillion in US office and retail loans.2 Much of the rest is held by lending institutions themselves. And unlike in Europe, where commercial property funding is primarily the purview of large systemically important banks, regional banks are by far the biggest CRE players in the US: the same institutions, in other words, that came under tremendous stress this spring after the failures of Silicon Valley, Signature, and First Republican banks and which have signalled their own broad-based retrenchment from the market.

With a refinancing wall of close US$1 trillion in US CRE loans maturing by the end of 2024, that could make for a lot of property owners parading severely devalued properties before an ever-shrinking pool of lenders next year. One possible saving grace is that loan underwriting has been more conservative than it was in the lead-up to the 2008 financial crisis. The average loan to value ratio for office loans was recently running at only 57%, according to a JP Morgan Research report4.

In search of ‘relevancy’

Markets, of course, move in cycles, and market participants by and large have long horizons. For many it will take more than a few rough quarters or even years of poor performance to break from the generations-long tradition of investing their relatively modest real estate allocations in the world’s largest and best-known market. But Mogull would argue that the most compelling reasons to re-evaluate the relative merits of the US and European CRE markets aren’t cyclical; they’re structural.

The CRE market today is thought by Mogull to be divided into two categories of product: “relevant” and “irrelevant.”

By irrelevant, he is referring to a building that is not green and not designed to work the way tenants want to use it today, nor easily capable of being modified to do so. Mogull likens such a property to a damaged tomato for sale at a farmer’s market. Whatever the price on the sign may read, “How much is that tomato really worth?” he asks.

Unlike cracked and weeping produce, irrelevant real estate product does at least come attached to land, which may have considerable recovery value given the right supply constraints. Europe has its share of irrelevant properties today: “brown” buildings beyond salvation, or bland workplaces conceived long before the era of hybrid work and “destination” spaces that can induce employees into the office for at least a couple days a week. But, compared to the US, the inventory of such properties is smaller because the buildings and floor plates were never as large, the construction codes were tighter, and land, especially in or near city centres, was always much scarcer. So, many more of them are likely to get redeveloped into something new.

As for product that is relevant, which does have value today, says Mogull, the European CRE market may not often have the luxury of economic growth as strong as the US to power overall market demand. But it does offer segments where economic growth is less of a factor in absorption rates and where the intrinsic supply constraints can still create highly favourable supply-demand dynamics. This includes rental housing for the growing numbers of people who now find themselves priced out of home ownership by higher interest rates; truly “prime” (in its now narrower definition – i.e., greener, more flexible, and more inviting) centre-city offices; and “last-mile” logistics centres shoehorned into high-scarcity industrial zones close to high-density commercial and residential areas. “Right now, we don't really care if there's economic growth, because that’s not where we’re playing,” Mogull says. “What we’re doing is focusing on sectors that are fundamentally driven by basic needs, knowing we have the supply constraints on our side.”

A final word about currency

Of course, no matter how well the European CRE market or parts of it do relative to the US, it won’t amount to much for an overseas investor in currency-adjusted terms if the same general pattern of euro weakness and dollar appreciation of the last 15 years persists for the next 15. There is an alternative scenario, though: With a rally through the early months of 2023 that left the euro nearly 15% above its September 2022 20-year low versus the greenback, but still 30% off its historic high, currency could be another reason, notes Mogull, to act now. “You could have taken the view that the euro was going the way of the ruble, or you could assume these things move in cycles—it goes up for five, eight, 10 years, and then trends down five, eight, 10 years—and that at some point it was going to reverse itself. I do like to buy things when they're cheap, and the euro right now is still pretty cheap.”

Taken together, why would a US-centric market participant invest in European CRE today? It could be to avoid some of the anticipated further fallout still to come from the end of the era of easy money, or to access the perceived long-term structural advantages of a market with stronger pockets of relevant properties (as well as irrelevant ones with a more realistic chance at an afterlife), or to avoid missing out on a possible currency inflection point. Is it time to view Europe’s CRE market as a source of true potential outperformance, rather than a minor diversifier? Says Mogull, “It’s certainly something to think about.”

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