‘Air of caution’ as industry braces for late-cycle downside risk

While the prevailing view is that real estate retains its appeal over other asset classes, the annual Emerging Trends in Real Estate Europe forecast, published by PwC and the Urban Land Institute, shows investors adapting to the challenges of a ‘tough’ market.

Europe’s real estate industry remains positive about business prospects in 2019 although the outlook is more sober in most markets than this time last year, if only because they are “one year further into the cycle and one year closer to the end”.

There is clearly a late-cycle edge to familiar industry concerns around sky-high values and the scarcity of suitable assets, according to Emerging Trends in Real Estate Europe, the annual forecast published jointly by PwC and the Urban Land Institute.

Though the prevailing view is that real estate retains its appeal over other asset classes, many of the interviews and survey responses reflect an undeniable air of caution.

As one pan-European investment manager says: “At this stage in the cycle, a lot of risks are on the downside, not the upside. The challenge now is assessing those risks and adding value, and so outweighing potential, wider market risks and the risk of [interest] rates increasing, yields moving out.”

This is a common sentiment among the 885 survey respondents and interviewees, which helps explain why the industry has lowered its expectations around the availability of equity and debt. Some 32 percent of survey respondents believe the amount of debt available for refinancing or new investment will increase, compared with 49 percent last year. The figures are similar for equity.

Yet, with few exceptions – notably a troubled retail sector in the UK – real estate markets remain highly liquid despite some nervousness that pricing of prime assets is high by historic standards. Though some express unease at rising loan-to-value ratios in a particularly highly priced German market, there are no undue fears over leverage across Europe as a whole. Indeed, most interviewees draw comfort from the financial discipline in place among lenders – compared with the previous, 2006-07 peak – as well as reasonable occupier demand.

“The market is tough,” says a global investor, “and that’s largely because valuations are very high right now in most places. The good thing is that the occupier market is fundamentally still quite healthy, and that positive is underpinning that strong valuation. That’s the key.”

“A lot of sovereign wealth funds but also a lot of wealthy individuals see a generational opportunity to buy a trophy asset and take a very long-term view,” one agent adds, picking up on a big theme this year – increasing inflows of equity from wealthy individuals rather than just institutions.

“The interesting thing we’re seeing – and Asia is a part of this – is increasing capital from high-net-worth individuals, not only directly into real estate trophies but into funds and real estate across the board,” says one private equity investor. “We’re seeing an increased flow from high-net-worth or super-wealthy individuals who view the equity and bond markets as no longer offering them return and are therefore looking at real estate as a place to get return. It’s pretty significant.”

As for the lowering of expectations around capital availability, the difficulty in putting money to work at this point in the cycle is clearly a factor. “It’s challenging to find good assets to invest in, and the temptation to stray from quality assets in quality locations is hard, but you have to stay disciplined,” says a global fund manager. “And with that kind of investing environment, raising capital for new funds is certainly not getting easier, because investors aren’t stupid. They see what’s going on in the underlying market and how challenging it is to find good investments. So, they’re more cautious about where they want to commit their money.”

At the same time, there is very little fear that debt will precipitate another downturn in the short or medium term. “Financing is stable and supportive of transactions without posing a risk,” one global private equity investor says. “The pricing of debt, both senior and mezzanine, feels appropriate,” another says. “One thing that happened in the previous crisis is that debt became very mispriced. We think the returns you can generate are appropriate for the amount of risk you have to take. We don’t see a credit bubble, and we are in a functioning market.”

Perhaps the most surprising survey finding for this stage in the cycle is that around the same proportion of respondents believe debt for development will increase as those who expect it to increase for refinancing and new investment – 34 percent versus 32 percent – although this figure is down from 46 percent last year.

On the other hand, with the price of core assets at record highs in almost every market, bar those with serious macro issues such as Moscow or Istanbul, investors are presented with the challenge of how to hit return targets. For some in the industry, this means allocating more capital to value-added real estate, and, indeed, marginally more survey respondents (35 percent) expect to be able to secure senior debt here than for core assets (33 percent). However, twice as many people think debt for value-added will decrease compared with core – 16 percent against 8 percent – and so this is a mixed picture. It is worth noting that in interviews, the value-added contingent say they do not want to take on too much extra risk.

A key trend here is the move of core investors towards “develop-to-core” or “manage-to-core” strategies. Rather than heading to secondary markets or buying in secondary locations, such investors are increasingly comfortable taking leasing risk, but in strong locations in core markets, either through refurbishment or even ground-up development. The develop-to-core movement is one reason why a relatively high 29 percent of respondents believe access to development finance will increase in 2019.

Another important aspect of real estate finance in 2019 will be the number of sources borrowers can tap. Banks still play the major role in the market, but this is diminishing while alternative lenders continue to grow. In the UK, for instance, data from Cass Business School show that banks now hold 74 percent of the £164 billion ($216 billion; €188 billion) of debt outstanding against commercial real estate, compared with 98 percent in 2007.

This shift is likely to continue. Some 58 percent of survey respondents believe lending from non-traditional debt providers will increase in 2019. Just 27 percent predict lending from banks will rise, compared with 42 percent last year, while 29 percent forecast a fall.

For insurance companies and institutional investors, debt is increasingly viewed as a way of investing defensively at the top of the cycle, whether it is being undertaken directly or through investments with debt fund managers.

“I see us being far more conservative on the equity side and far more focused on income return, and that takes us down the debt route as a debt provider,” one global institutional investor says. “This year, more than 70 percent of our flows will be in commercial real estate debt.”

“We have finished raising capital for a [pan-European] mezzanine debt fund,” another global player says. “We closed that with a little over $1 billion of commitments, and it could have been more. My preferred investments in this kind of market are debt and develop-to-core. That’s where I see, from the investment side, the best risk-reward balance.”

For the banks, memories of 2008 and the collapse of Lehman Brothers remain fresh. And for some, at least, their greater caution compared with last year is seen as partly attributable to not wanting to be burned again.

“There is a lot of liquidity targeting the market, which creates risk, and loan-to-values are increasing, and we don’t really want to increase our LTVs too much,” one banker says. “We are holding firm on our LTVs and our pricing. A lot of our competitors are not, so we are losing business, but we don’t want to take on more risk.”

However, Emerging Trends Europe suggests there is faith in the regulatory regime embodied by Basel III, which has been designed to limit systemic risk in the banking sector as real estate prices increase across Europe.

“The European Central Bank regulates this market very heavily, every lender has to fulfil strict capital criteria and hold more equity against real estate loans,” another banker says. “As values get higher you have to put aside more equity, so those requirements will always limit the volume of new loans.”

No one is complacent at this late stage in the cycle. But as one global investment manager concludes: “Real estate has grown as a proportion of the balance sheets of many institutional investors because it has provided the yield and returns that other asset types have not. In that sense, they are more exposed. But the good thing is that if leverage levels remain modest, the debt providers really shouldn’t be bearing that much risk in the next downturn. The equity providers will be holding that risk, and that’s arguably where the risk should be.”


This late in the cycle and with commercial real estate values already very high, the search for secure, long-term income is the main, guiding narrative for European real estate investment in 2019 and beyond.

Many investors are scaling down their return expectations for the coming year while establishing strategies that will deliver “sustainable cash flows” for the medium to long term.

As one pan-European private equity partner says: “The late cycle could go some time still. But in terms of any cap rate or yield shift, that is no longer going to be what drives real estate values, and so we’re going to work around income creation.”

But if sustainable income is a common goal, there are numerous ways to achieve it. Many market players are what one global fund manager calls “exit yield agnostic”. They are focused entirely on income – in other words, “the return component investors can control”. With this approach, they are essentially sticking to core or core-plus real estate with strong income streams, almost irrespective of pricing.

Many others are looking beyond the cyclical mainstream. Alternative real estate and residential – in all its forms – dominate the sector preferences of survey respondents, marking a remarkable shift in industry sentiment over the past few years.

In 2015, just 28 percent of survey respondents said they would even consider investing in alternatives. This year, almost 60 percent of respondents are already investing in alternatives in some way, and 66 percent wish to increase their holdings in 2019. Hotels, student housing and flexible offices are the sectors where current exposure is highest, while student housing tops the wish list going forward.

All the signs are that the need for sustainable income and the push into alternative real estate – or “demographic investing” as some call it – will continue long after 2019. Nearly half the survey respondents expect the availability of conventional core assets to worsen over the next five years.


Interest rates

Interest rates have moved on to the industry watch list following the European Central Bank’s decision to end quantitative easing by the end of 2018.

The prospect of mainland Europe following the UK and the US and raising interest rates is not considered a threat to business in 2019, largely because modest increases would be offset by growth in rents.

In that respect, Emerging Trends Europe reflects little change from last year’s report in its immediate outlook. Longer-term, however, it is another matter.

Many industry players believe that a geopolitical shock to the monetary system would accelerate rate rises and, as one German fund manager acknowledges, “could cause some trouble so that alternative investments become more attractive [than real estate] and we see outflows of money”.

At the same time, some of the bankers canvassed this year report a brisk trade in prudent property clients refinancing loans at favourable rates while they can.


Brexit is uppermost in the minds of many as the due date of 29 March 2019 approaches without any clear idea of the outcome.

An overwhelming 83 percent of respondents to the Emerging Trends Europe survey expect a divergence in economic growth between the UK and the European Union in 2019. As many as three-quarters of survey respondents believe business relocations out of the UK will increase.

Brexit requires some perspective because London is likely to remain a magnet for long-term, global investors – particularly from Asia. But for pan-European investment managers, their institutional clients are “nervous about their allocations to the UK” going forward, despite capital and rental growth. “They just look at the UK and think it’s fraught with risk,” says one.

A good number of interviewees equate such risk with opportunity. For the majority, the eurozone is seen as a safer and more fruitful investment destination than the UK in 2019.

New sources of equity

When it comes to equity flows into Europe; as soon as one door closes, another opens.
Chinese investment – such an influence until recently – has fallen dramatically because of capital controls introduced by the government to control capital flight. And yet, more than two-thirds of survey respondents think investment from Asia will increase – the highest proportion of any region.

Koreans and Singaporeans remain big players in Europe. But there is a lot of anticipation among interviewees about an influx of capital from Japanese pension funds, notably Japan’s Government Pension Investment Fund (GPIF), which has recently awarded its first real estate fund of funds mandate. Japan Post is also looking to diversify beyond its domestic market.

“For most Japanese institutional investors, they are not investing directly but via funds and multi-managers,” says one global fund manager. “Most market participants won’t see it as Japanese capital, but just in deals by investment managers. But it is very significant in volume and will help mitigate the fall in volumes from Chinese investors.”


The late stage of the cycle is informing sentiment in all aspects of European real estate, including the surprise choice of Lisbon as the top city – out of 31 covered by Emerging Trends Europe – for investment and development prospects in 2019.

That is some accolade for the Portuguese capital, which last year was in a respectable but hardly inspiring 11th position in the rankings.

The rise up the table owes a lot to Portugal’s economy, which is growing at a healthy rate, and so Lisbon is now an international destination for companies, investors and tourists. Interviewees also cite the city’s “quality of life” and “positive” leadership – important factors in attracting talent.

“It’s on everyone’s platter of cities they like,” says a European fund strategist. One local interviewee adds: “In the previous peak, the market was mainly Portuguese property funds and German funds that were all essentially looking for the same type of product. Today, there is such a diversity of capital: of origin, of risk profile, of asset classes targeted.”
Above all, Lisbon is considered a classic, late-cycle play. Whether or not the investors stick around for the next cycle is a moot point.