European Real Estate: Fortune Favors the Brave

Over the last two years, European real estate markets experienced one of the largest repricings in modern history, on par with the Global Financial Crisis (GFC). From our perch on the ground in key European markets, we believe the recovery has started, creating exciting investment opportunities.

Financing activity is one of the key leading indicators of a recovery in equity valuations, and we are observing a material pick-up in debt capital market activity through our European real estate credit business as financial conditions ease. Ten-year bond yields are trending downward across all major European jurisdictions and are expected to continue to moderate. In Sweden and Germany, they were already in the 2% range as of Nov. 11. We are also seeing lending margins compress, reflecting more competition across real estate lenders.

One reason the current recovery is unusual is that fundamentals have remained strong throughout the significant repricing, leaving investors in a position to invest in high-quality properties at re-based valuations. Players with dry powder are encountering motivated sellers and a lack of competition among buyers. The bottom line: We think it is possible to deliver value-add returns at a lower risk profile.

However, we also believe this window of opportunity will dissipate over the coming 12-18 months. Global real estate markets are sophisticated and transparent in terms of pricing. We believe we are now past the trough of this cycle, as our portfolio valuations have now been stable or marginally up for the past four quarters. Once markets stabilize, we expect more positive sentiment to drive pricing higher.

Learning from History: Where We Are in the Current Recovery

The recent downturn has traits in common with the GFC, starting with its magnitude. Property values declined 20%-40% and yields widened by 100-200 basis points (bps) on average depending on the country and sector (Exhibit 1 and Exhibit 2). Unlike the GFC, however, the repricing was driven solely by rising interest rates and inflation and was not accompanied by an economic downturn and rise in unemployment. The lack of construction activity we see now is not driven by a lack of demand, but largely by the fact that it has become more expensive to build.

EXHIBIT 1: Declines in Property Valuations Mirror the GFC, but Are Reversing

All Europe, All Sector Capital Values Index

EXHIBIT 2: European Real Estate Markets Have Re-Priced at Different Rates

Change in Prime Yields: Current Yield vs Peak Yield (2020–2022)

Valuations have started to recover, as shown in the upturn in the All Europe Valuation Index in Exhibit 1. In prior downturns, valuation trajectories have turned positive approximately eight quarters after repricing began. Nine quarters into the current cycle, we see that valuations have been stable or slightly improved for the last three quarters in publicly traded investments (Exhibit 3). Transaction volumes are still down 76% across Europe from their 2021 peak, but the trend is changing, following a similar upswing as the one that followed the trough during the Global Financial Crisis (Exhibit 4).

EXHIBIT 3: We Are Past the Market Trough 

EXHIBIT 4: Transaction Activity Is Starting to Recover

European Real Estate Investment Volumes

The last four major re-pricing events in Europe, starting the early 1990s, highlight two important trends. First, as markets are becoming more transparent and sophisticated, the duration of down-cycles is shortening. Second, some of the strongest post-crisis returns have come in the first two years following the market trough (Exhibit 5).  In other words, investing earlier in a recovery than later is important, and it may be becoming more important over time.

EXHIBIT 5: Cycle Duration Shortening, Performance Rallies Following Historical Downturns

For private value-add and opportunistic real estate funds in the years following the Global Financial Crisis, there is a strong inverse correlation between capital scarcity, reflected in the smaller average fund sizes in years when markets were volatile, and outperformance. One of the best-performing average vintages for European value-add and opportunistic real estate funds was 2009, when real estate markets were still very turbulent and average fund sizes were relatively small at less than $500 million. On the other side of the spectrum, the smooth years of steady growth in 2017-2019 produced relatively big funds with relatively lackluster results. We think the characteristics of the 2024-2025 vintage are more in line with that of 2009 than that of 2017.  Fortune has historically favored the brave early movers.

What Does the Recovery Look Like So Far?

Financing is recovering in Europe, with banks lending more aggressively ahead of potential further interest rate cuts and non-bank lenders providing alternative sources of credit. Non-bank lenders comprise approximately 40% of the real estate credit market, up from 14% a decade ago. 

For the coming period, we think equity investors with scaled capital to deploy are at an advantage due to the lack of competition in the market.  While investors have tended to view tighter financing conditions as a signal that the market remains too risky, we think it is instead an opportunity to take advantage of buying opportunities while market competition remains muted.

Continuing a trend we described in our May 2024 market outlook, many real estate owners are facing some degree of liquidity pressure that creates a need to sell assets. For some, the pressure comes from capital structures that worked in a low-rate, low-inflation environment but are no longer suitable after a repricing and a rise in interest rates. In other cases, real estate funds are reaching the end of their lives and must begin selling property to return capital to investors. For open-ended core funds, many of which are overexposed to office and retail, a steady drumbeat of redemption pressure is driving property sales. These funds typically sell their most liquid assets first, which tend to be in popular sectors with strong demand tailwinds, including logistics, residential, and student housing. When these funds are ready to start buying again, they will look to rebalance through buying property in the same sectors they are now selling.  We think it is very possible that scaled players with access to capital will end up both buying assets from this group now and selling to them later.

What Will Drive the Recovery Going Forward?

We expect the tight supply and strong long-term demand trends in our preferred sectors (logistics, multifamily, student accommodation, and hospitality), rate moderation, and stronger capital flows into private real estate to drive returns going forward. 

This downturn has also sharpened a bifurcation between prime and secondary properties, as well as the importance of understanding local dynamics.

KKR’s dedicated local operating platforms that specialize in areas such as pan-European logistics, U.K. hotels, U.K. residential, German residential, and Irish residential lending provide on-the-ground resources and sector expertise to source properties in our preferred sectors and implement value creation plans.

Conclusion

In our preferred European real estate markets and sectors, we see a compelling, time-sensitive investment opportunity, owing to reset valuations and strong supply-demand dynamics. Motivated sellers and a lack of market competition is enabling those with dry powder to acquire high-quality assets with the potential for strong risk-adjusted returns. However, we are also seeing market activity and sentiment pick up as lending markets re-open. Once the feeling is widespread that real estate markets are back and “safe” to invest in again, we suspect it will already be too late to take advantage of this market dislocation.