European Real Estate: A new real estate value cycle

A stabilising market

Looking forward, our house view guidance is underpinned by the expectation of a period of real estate yield stability after the recent market correction. European real estate capital markets have been through a significant shock in the period between the summers of 2022 and 2024, but the occupier fundamentals have been robust in most markets and sectors. This is the result of ongoing robust demand and meeting limited supply in most sectors. There is increasing confidence in the market, as evidenced by e.g. the OECD Composite Lead Indicator, which will further support demand for quality space, and hence support rent levels and rental growth. Furthermore, we would note that over the past two years, rental value growth at the market level across Europe has been less than headline inflation, though we have seen pockets of strong outperformance in prime rents in certain locations.

The combination of the COVID-19 pandemic and then the surge in global inflation have resulted in an undersupply of high-quality real estate in key locations, with development activity being curtailed in particular by rising construction costs, including funding costs, and economic uncertainty. As such, while European economic growth is expected to remain below the levels of the US and Asia Pac, we see significant opportunities to deliver strong investment returns by delivering modern real estate assets into undersupplied markets.

Four key tenets for 2025:

1. Yields have adjusted to financing costs, but capital demand remains an area to watch. Our base case is for yield stability after the recent correction, though we note that the adjustment to date reflects the movement in debt costs rather than any longer-term imbalances in capital availability. Further price correction may result if we see a mismatch between the profile of capital looking to invest in real estate versus the type of assets being brought to market.
2. Flat yields require income growth as the driver of returns. A period of low economic growth means not all sectors will see the same demand, so we will lean into the structural tailwinds noted above to drive income. While consumer confidence remains weak, we will lean away from industries / sectors exposed to mass-market discretionary spend.
3. Opportunity arises out of volatility. Historically, forward investment returns have been strongest for vintage years coming out of a market correction. We expect to see continuing opportunities for those able to execute on their conviction strategies in current market conditions.
4. Growing regulatory pressure around sustainability presents both threats and opportunities. Demand for energy-efficient, sustainable spaces is growing while supply is weak, and we will seek to deliver into shortages. Risk of stranding will drive distressed priced opportunities over the medium term, particularly with asset owners that are also impacted by increased debt costs, creating opportunities to acquire assets for repositioning.

ESG

Across the European real estate market, Environmental, Social, Governance (ESG) credentials are an increasingly important consideration for both real estate investors and occupiers. ESG+R (ESG and Resilience) investing is a fundamental commitment at Invesco Real Estate. Increasingly stringent

regulations on the Energy Performance Certification are required when leasing assets, and result in opportunities for institutional investors to reposition less efficient assets to the highest sustainability standards.

Our strategic response to the ESG challenges is to ensure the sustainability of our assets and, in doing so, we seek to maximise investment returns. More sustainable buildings can be proven to drive higher rents and lower vacancies, and price at tighter cap rates. As a result, our focus on sustainability is fundamentally aligned with seeking to maximise investment performance.

We continually monitor all of our existing assets for sustainability, and our business plans ensure that all assets meet all relevant standards in advance of the regulation timeline. The resulting capex requirements are assessed against expected future value impacts, accepting that some capex will be defensive (i.e. to maintain values) and some will be accretive. And we also look to accelerate disposition plans for assets which may struggle to adhere to relevant regulations.

We are also looking to acquire assets for repositioning to Grade A standards. Opportunities are arising from existing owners unable to invest to meet increasing efficiency requirements, particularly when combined with financing / refinancing pressures. We will continue to target core assets in gateway cities where investor and occupier demand remains most robust through cycles, utilising our on-the-ground expertise in our key markets, also securing access to attractive returns on super-core assets that do not normally transact.