PGIM Real Estate: Yield shift set to drag on European real estate returns through 2024

15 december 2023

European property total average investment returns are likely to remain weak through next year as the rise in yields remain a drag on the market, but returns should recover into 2025, making core properties competitive for capital again versus other asset classes, PGIM Real Estate’s European Outlook 2024 forecasts.

Elevated interest rates have pushed up debt costs, which stand at levels above prime real estate yields across most European markets and property sectors, and this high spread continues to put pressure on pricing. As asset values have fallen, transaction volumes have pulled back sharply and are close to lows recorded during the Global Financial Crisis. The plunge in transactions threatens to further exacerbate the market downturn, potentially causing an overshoot in the value adjustment process, the Research team at PGIM Real Estate noted.

'The good news is we estimate we are just over 80% of the way through the yield correction process required to restore an estimated long-term stabilized yield level. The bad news is it is likely to overshoot as capital shortages persist', Greg Kane, Head of Europe Investment Research at PGIM Real Estate, said.

Logistics closest to fair value

The market yield correction has so far been relatively even across property sectors and markets, but logistics repricing looks closest to a fair value target, offering an attractive long-term entry point.

Take-up of logistics assets has been sluggish this year due to slowing economic growth, but e-commerce related demand, in particular, is set to increase over time as online spending gains a stronger foothold in less densely serviced continental European markets. PGIM Real Estate’s Research team expects an ongoing, broad-based rental growth across all logistics sub-sectors and geographies, with opportunities expected to start emerging in 2024 given the ongoing rise in demand.

Data centre demand rising and yields stabilizing

Demand for more physical data centre space is rising on the back of the digital transformation trend, while building supply has not kept pace with growing needs, the report said. Pricing has already corrected significantly and is set to look attractive again in 2024/25 as yields stabilize. Given the challenges of transacting in this sector, investors need to start building partnership networks now if they want to deploy capital successfully and capitalize on the opportunities.

Hotels benefit from post-pandemic travel rebound

A strong recovery in travel demand post-Covid is feeding through into rapid growth in revenue per available room (RevPAR) in the hospitality business, with hotel supply growth subdued. Pricing is also attractive for hotels as the sectors’ downturn started in 2020, with the cumulative yield correction much steeper than other major property sectors. Consumer discretionary spending pressures could be a headwind, but the sector may offer tactical investment opportunities in the next phase of the cycle.

Legacy of residential supply shortfall, low availability point to solid rental growth

Residential construction completions have been picking up in European markets, but the supply shortfall remains substantial at around 500,000 units across 13 major cities. Allied with low vacancy rates and rising demand for rental properties compared to ownership, due to current high mortgage rates, these factors point towards a solid outlook for income generation, although an uptick in transactions will depend on markets reaching perceived fair value.

Within the living sector, certain niche segments stand out, in particular student living. Demand is rising across many key university cities in Europe, set against a supply drought backdrop that is quite consistent across sectors and markets. Evidence from the UK in the last cycle suggests operators with a good business model can drive strong rental growth, particularly by offering quality, amenity-driven products to students.

ESG occupier preference and capital requirements to drive office performance

European office stock is largely old and – without significantly more capital injections – is unlikely to be compliant with modern ESG standards even by 2050.

'Real estate investment returns across property sectors are set to remain weak for the remainder of 2023 and into 2024. In the near term, investment opportunities are emerging in markets with the strongest structural growth components and where repricing has taken place. As the value correction gives way to a recovery and growth phase, the opportunity set is expected to grow significantly', Kane concluded.