European property values have only moved down marginally and have a long way to go to reach a level that reflects the higher interest rate environment, says Zachary Gauge, Head of Real Estate Research & Strategy at UBS Asset Management, in his latest Real Estate Outlook. The UK is an exception, which after a –13% correction in 4Q22 appears attractively priced versus other global markets.
There is a sizeable discrepancy between UK and eurozone direct property performance, as inferred by the MSCI index. Between 2001 and 2021, the UK property index outperformed the eurozone by 1.2 percentage points, but at a level of volatility that was in theory three times higher (see Figure 2). Taken literally, on a risk-adjusted basis, this would be deemed to be a pretty poor pay-off for the much higher volatility.
The issue of course, is we’re not comparing like-for-like. More European valuers use DCF models, which are naturally smoothed compared to the marked-to-market approach which is dominant in the UK. During a bull-run, this rarely causes an issue – most investors are happy to find that their assets can be sold at levels above their most recent valuation. But when the market turns, unrealistic valuations start to create liquidity problems.
Official numbers are yet to be released, but Oxford Economic forecasts values to decline by just -2.8% in the eurozone in 2022. With UK direct values falling by 13%, the gap is likely to be around 10 percentage points – a huge difference even by historic standards.
There are a few factors one could point at to explain the UK’s apparent underperformance, and the disastrous mini budget undoubtedly accelerated the correction in 4Q22. But the reality is that methodology and a reluctance of European valuers to move the numbers to anywhere near a level that transactions would realistically happen at, is the biggest reason behind the discrepancy.
If assets never had to be sold during a downturn in Europe, perhaps this wouldn’t be a problem – the valuation can be seen as more of an accounting mechanism rather than a realistic sale value. However, that’s not the reality of the market – if anything, liquidity events increase during a downturn as redemption requests build and refinancings become more challenging. But potential sellers are unwilling or unable to accept large discounts on their most recent valuations. Potential buyers, on the other hand, need substantial discounts to underwrite deals to get to target returns which are appropriate in the new interest rate environment.
As a result, transactions have fallen dramatically to EUR 31.9 billion in the eurozone in 4Q22, from EUR 86.1 billion in 4Q21. The lack of liquidity means an absence of market evidence to base values off, but rather than take a view on the fact that bids are coming in well below previous valuations, many European valuers have opted to leave values largely stable.
Unrealistic performance data doesn’t help the market, or real estate as an investment asset class. Values fall sometimes as markets are cyclical and will be impacted by wider macrotrends. It happens across all asset classes, and a value correction in one or two years does not make the sector a bad long-term investment. But when values don’t move during periods of uncertainty, the sector might appear even more illiquid and opaque. In the UK by contrast, the recent movements have restored credibility in the system, and with pricing now reaching a level where investors can now see attractive returns, we may see a recovery start for some sectors as early as 2Q23. In Europe, as was the case post GFC, this could continue for much longer until there’s a willingness to accept reality.
Here you will find the complete Real Estate Outlook from UBS Asset Management.