Europe’s value-add momentum

A distinctive opportunity has emerged for value-add real estate investors in Europe as capital values witness a correction while occupier markets stay robust. This juxtaposition presents a unique landscape for savvy investors to capitalize on.

“We are excited about this time in the market because you rarely see valuation declines and rent growth at the same time,” says Christina Forrest, head of EMEA value-add funds at CBRE Investment Management.

As capital values ebb, creating an enticing entry point, occupational demand for undersupplied, high-quality assets in core locations promises stability and rental growth for value-add investors. Meanwhile, more transactions are happening in the market, so the window of opportunity to buy European assets at a discount has not closed yet.

Forrest explains: “If you have the right product in the right location you are probably going to be oversubscribed by occupiers wanting to come in and hence can drive that rent up through the competition that you’re getting on the building.

“We are right in the opportunity, and it certainly hasn’t gone yet. It will last for a while. Last year there was a difference between buyers’ and sellers’ expectations that didn’t lead to many transactions. But we’ve seen [those expectations] come closer now. Since the beginning of this year, we’ve seen many more opportunities that fit in terms of pricing and risk-return profile to where we would expect it.”

Spencer Corkin, head of value-add strategies at manager AEW, notes that the window of opportunity for value-add investors to buy at discount “is only just properly opening.”

“While pricing adjusted significantly in 2023 in Europe, the effect of this is only now starting to be felt,” Corkin says. “Banks and borrowers are now facing up to the challenges of refinancing loans, and while some of these are being managed through extensions or recapitalizations, we expect to see much greater levels of motivated sales in 2024.”

Repricing has not been evenly spread across the continent, though. Cristina Garcia-Peri, head of corporate development and strategy at Spanish real estate asset manager Azora, notes three distinct repricing scenarios across Europe: technical repricings, caused by increasing interest rates; fundamental repricings, essentially a technical repricing amplified by the fact that real estate prices reached levels that were not properly priced in the underlying risk; and distressed repricings, which occur when assets have both a technical and a fundamental repricing and are highly leveraged.

“While pricing adjusted significantly in 2023 in Europe, the effect of this is only now starting to be felt”

Spencer Corkin
AEW

“Countries like France or the UK have suffered from fundamental repricings, while Germany and Sweden are going through massive distressed repricings,” Garcia-Peri says. “Southern Europe never reached the pricing levels of Germany or France, and leverage has been kept to very reasonable levels. Nevertheless, because Southern Europe is repricing from a much lower absolute level, the adjusted valuations that we are starting to see now do offer entry points that are still more attractive than more mature markets in Europe.”

Germany, the eurozone’s largest economy, is currently dealing with the deepest real estate crisis in several years, as a sharp rise in borrowing costs – following soaring interest rates – and a higher proportion of riskier lending has tipped the property sector into one of Europe’s biggest downturns.

Prices have come down in Germany for both commercial and residential real estate, says Steffen Kroner, managing director, private equity performance improvement, at turnaround specialist Alvarez & Marsal in Germany.

“A number of large real estate companies and developers have gone bankrupt, and we see opportunity for private equity to create value by buying up distressed real estate assets and turn them into a money-making opportunity,” he adds.

Tristram Larder, head of European capital markets at brokerage Savills, notes the surge in value-add investment is not solely about pricing but predominantly driven by the uncertainty surrounding interest rate trajectories. Investors are gravitating toward investments offering a value-creation narrative, as opposed to long-income buildings that are especially susceptible to interest rate fluctuations.

“A long lease, low-yielding building in a prime location is very sensitive to changes in the risk-free rate. With these assets, investors are basically speculating on the direction of interest rates,” Larder says.

Tricky office sector

The alternative is to acquire properties with potential for value creation via active asset management, which gives the investor more levers to pull rather than just betting on the direction of interest rates. Offices have traditionally been the biggest section of the real estate market, so attracted the bulk of the capital.

Larder notes: “The old regime of buying an average office building in a secondary location because you can’t afford to buy one in a prime location and then do a bit of asset management, finish the leasing and then sell – that’s gone. That’s not happening.”
Uncertainty surrounding secondary office markets in a post-covid, work-from-home world is dissuading some investors from pressing the buy button. There still needs to be a market consensus before this large part of the market becomes investible, he argues.

Similarly, Forrest explains CBRE IM is currently struggling to find right-priced opportunities in the office sector. “Office is the one sector where occupationally there are some headwinds and structural changes coming through – it’s a bit like where retail was a few years ago. So, it’s critical to understand the occupational market, the micro-location,” she says. “Is this the location that will still attract office occupants in the future or not? Underwriting is much harder in a sector that’s undergoing change.”

Despite headwinds, value-add managers are still finding opportunities in tactical repositioning of offices that are well-located but need some capex for upgrades demanded by occupiers today, such as energy efficiency and ESG improvements or amenities.

Spain’s Azora, for instance, acquired last year an old building complex near the Four Towers – a prime business area in Madrid.

“Since acquisition, we discovered additional square foot capacity and have worked with one of the best architects in Spain to fully redesign the building, maximizing leasing capacity and creating a campus effect which is unique in such a business district location,” Garcia-Peri says. “Although [work is] just starting, we are already being approached with potential tenants who will be interested in leasing 100 percent of the building, as well as by some interested buyers.”

Crowding into alternatives

In the current environment, successful office transactions for value-add investors are closing where the underlying occupational market fundamentals support strong business plans, says Laura Houghton, director of EMEA office capital markets at broker JLL.

“Leasing sentiment in Europe has been positive for the start of 2024 as occupiers make final decisions on how the new hybrid work environment impacts their office needs,” she notes. “For instance, in London, there is currently a 20-year high in demand for spaces larger than 100,000 square feet; while in Paris, transactions for spaces over 5,000 square meters (53,819 square feet) have experienced a year-on-year increase of approximately 50 percent.”

Houghton adds that occupier commitment to ESG considerations further boosts the demand for best-in-class, low-carbon buildings, creating opportunities for ‘brown-to-green’ strategies.

Given that value-add opportunities for offices are restricted to core locations in major markets, more and more investors are finding opportunities in alternative asset classes with a large operating component and the requirement for active management to create value.

“Some of them are looking into real alternative sectors – very niche asset classes,” Larder says. His concern is that equity is crowding into smaller parts of the market and could lead to rolling bubbles in some of the smaller alternative spaces as investors use increasingly aggressive assumptions to outbid competitors, deploy capital and hit returns.

Whether it is for alternative asset classes – including data centers, self-storage, truck parks or even garden centers – or more ‘mainstream’ asset classes, investors continue to see value-creation opportunities in the traditional refurbishment of assets, repurposings and even ground-up development.

Forrest says: “We’re seeing quite a lot of logistics developers come to us with a pipeline that needs capitalizing and building out. These are developers who had a pipeline, have been sitting on it and couldn’t capitalize it like they could three years ago through cheaper capital. So, they’ve concluded that if they want to build it out, they need to get a capital partner in. And for that, they might have to reprice their land positions.”

The risks of traditional value-add strategies have not changed much – delays in permits, wider project delays and increase in construction and labor costs alongside the time taken to reach full occupancy and the rent level at which this is achieved.

However, as Garcia-Peri points out: “Being able to take on development, refurbishment, leasing and operating risk will be the winning strategies for real estate and will allow investors to position themselves in nascent sectors with superior rental growth, with assets that are fit for the future.”