Four key issues property investors should know in wake of Covid

Key European economies including the UK, Germany and France are embarking on their post-Covid recovery, say Brian Klinksiek  (pictured left) and Simon Marx (pictured right) of LaSalle Investment Management.

But the economic path which matters to investors in real estate is measured over quarters and years, not days and weeks, and the pandemic ultimately plays a smaller role in determining how real estate investment performs.

We have identified four factors in our latest research, the Mid-Year Investment Strategy Annual, that will ultimately determine the performance of different real estate sectors and geographies in the mid- and long-term. These factors will define the post-pandemic phase, splitting the market into investments that perform well and those that do not. 

Take structural changes to real estate use cases first. Office and retail in particular have undergone fundamental changes to their established societal functions, albeit to varying extents. For example, remote working will have a less lasting impact in continental Europe than the UK where it has already been well established, and commutes are longer.

Second, these structural changes will create impediments for office/retail and tailwinds in logistics/residential. Investor preference for the latter over the former has prompted property market polarisation with a finite supply of opportunities for office/retail assets. This in turn, has led to a recovery in office/retail assets which dominate European investments and so offer scale.

Third, in the event of elevated levels of inflation, borrowing costs and property yields will be impacted. However, we think entrenched inflation remains less of a risk in Europe than in the US due to lower stimulus levels and structurally weaker underlying price pressures. While we do not expect persistent inflation, there is little harm in building resilience among portfolios.

Fourth, political uncertainty particularly in Germany and France remains an important consideration. In the UK, the aftermath of Brexit is being felt in supply-chain problems and retail stock shortages with policies affecting the property sector, such as business rates, getting little attention.

Anticipating how these dynamics will play out in each real estate sector and market will be key to determining performance.

Office space has been fundamentally re-oriented as a market following Covid.

While corporates still value physical offices space, ESG/wellness are driving demand and pricing. A modest 150bps rise in office vacancy rates to Q2 2021 obscured larger increases in key markets like London and Paris La Défense. The return-to-market of a still-to-be-determined quantity of second-hand space deemed surplus to post-pandemic requirements is expected to play out over the coming years.

Retail recovery will continue as shoppers return.

Government aid and grocery-anchored retail have been resilient, but closures and insolvencies are still driving down rents. That is especially the case in the UK, Germany and the Netherlands. Although investors should exercise caution with poorly located assets, European urban retail warehouses and stand-alone units continue to attract counter-cyclical buyers.

Last-mile urban logistics remains in demand and will see rental pressures for several years. However, inflows of capital are pushing yields to record lows and encouraging risks with location or development. The big question is, after years of flat logistics rents in most of Continental Europe, whether sustained rental growth will become widespread as it has in the US and UK; our expectation is that it will.

The residential market has also been an exceptionally strong performer across the board, especially in perennially strong cities (Munich and Berlin) and those that experienced softness pre-Covid (Stockholm, Helsinki, and London). However, amenity-poor areas offering adjacency to office jobs were not well positioned for the remote working trend. Yet despite low absolute yields amidst fierce bidding for assets, the minimal downside volatility exhibited by the sector offers compelling risk-adjusted value.

This is complemented by the sector's expansion into other 'living' areas.

Savvy investors will diversify into emerging sub-types, such as Continental European student housing or the UK single-family rental sector. Temporary Covid challenges were felt in sub-segments like care homes and student housing, but there was minimal lasting damage, underscoring the durability of the underlying demand.

While Covid is far from gone and the effects of the acute phase of the pandemic are still being felt in European property markets, the world is moving forward and there are new dynamics for real estate investors to consider because of it. Those who can appropriately understand—and price—risk in each real estate sector and geography will see ample opportunities to drive attractive risk-adjusted performance in the coming years.  

Brian Klinksiek is head of European research and global portfolio strategies and Simon Marx is managing director, European research and strategy at LaSalle Investment Management