European real estate: the core plus opportunity

It’s a tough time for investors. Geopolitical tensions, tariff wars, and economic uncertainty mean volatile markets. In such times, diversification benefits and a steady income stream become all the more valuable. We believe on both counts one of the strongest answers could be European core plus real estate – investing in existing buildings in proven locations with no development risk and minimal operational risk, while seeking to maximise income and returns through active management.

For one thing, real estate stands out for having one of the lowest correlations with either equities or bonds. In a world where many investors are largely allocated to North America, the diversification benefits are further strengthened by focusing on European markets rather than the US ones.

And it isn’t just a matter of diversification by region or by asset class. European real estate also offers diversification by return drivers – it provides almost mirror image dynamics to the US, with forces that are headwinds in the US actually being tailwinds for Europe.

Rising prices, rising rents

Fundamentally, returns from real estate investments depend on two factors – one is the cap rate,¹ and the second is rental income.

Cap rates have moved out very, very strongly in recent years, as a result of interest rates rising. That has been the principal headwind for real estate since the pandemic, and this headwind is now turning into a tailwind as rates come down, especially in Europe.

With prices some 20-40% below pre-pandemic levels, in contrast to other major asset classes which still feel pricey, we believe this creates an attractive entry point for European real estate investors.

In Europe rental income also looks stable or is moving in a positive direction (see chart), but not for the reasons investors might think. Normally if you have a weaker economy, you have fewer tenants looking for the same space, so you don’t get rental growth. Today’s reality is slightly different because of the supply-demand imbalance. What’s dominating rental outlook is the lack of high-quality supply in Europe. To give an example, we at Pictet are building our new head office in Geneva and it took us more than 10 years to get approval to build on an unused lot, whereas in the US it normally takes six months. These restrictive planning laws in Europe have resulted in such limited supply that even when the economy has been weak we have observed strong rental growth. This is in contrast to the US where planning is readily available as mayors of cities want to maximise their tax income, creating abundant supply in many cases.

As a result, rents in many key US cities have been falling due to oversupply of buildings, despite relatively strong economic growth. Contrast this with London, as a European example. Here, residential rents increased by a remarkable 11.5% last year despite the UK economy growing by only around 1%.  

Income needs

As a result of Europe’s shortage of quality real estate (together with our asset selection and value add work) we have been able to generate double-digit rental growth in our core plus real estate strategy despite near-zero economic growth.

These income streams are increasingly attracting the attention of institutional investors, many of whom until recently had kept their money in money market or fixed income funds, content with yields of around 4% in euros and more in dollars. As interest rates – and thus bond yields - come down, the attractiveness of core plus real estate increases, with an ability to continue to offer attractive yields at levels no longer easily available from money or fixed income funds.

The average lease term in our portfolio is 11 years, which gives investors a lot of certainty in terms of future rental income. These investments not only benefit from secure, long-term rents but also offer the potential to boost returns through building refurbishment, repositioning or re-development.

Logistics and data centres

The key is to identify the sectors, regions and individual buildings best placed to safely deliver those returns. For our core plus portfolio, we see particularly attractive opportunities in the logistics sector. In an environment where international trade is constrained, local supply chains are more relevant than ever. That means we are going to need more logistic facilities locally, putting upward pressure on rents in a sector where vacancy rates are already close to zero. Crucially, rents account for only around 4-7% of total production costs for logistics businesses, so they are less sensitive to rent increases because it’s a small share of their cost base.

Of course, like in every investment today, it is also essential to be prudent, for example avoiding locations that are driven by auto manufacturers whose key markets are over the Atlantic and who could thus be negatively impacted by tariffs.

Another area that many consider promising is data centres, given that we live in an increasingly digital world and that European governments are keen to develop their tech credentials. We believe that data centres are an extremely exciting operational asset class for real estate investors. We have invested in two, in Madrid and Stockholm – both before AI boomed as a theme.

However, despite AI’s potential and seemingly infinite need for data, we are now more cautious for two reasons. First, there is abundant capital chasing this sector – from private equity to infrastructure investors, as well as real estate managers like us. Second, despite their seeming novelty for many investors, it’s sometimes overlooked that data centres face obsolescence risk with ever increasing rack densities, cooling efficiency and evolving design requirements. There is also the issue of exit given the amount of assets that will be on the market concurrently in a few years’ time. So, amid the enthusiasm, we will remain disciplined and focus on assets that are smaller and are in or near major cities, where there are supply constraints, where we can add value, and where we can invest at the right price.

Sustainable returns

Refurbishment of existing buildings is a key pillar of our value add and core plus real estate strategies, and we focus primarily on improving the sustainability credentials of the properties we invest in. That could mean, among other things, replacing conventional boilers with heat pumps (which can both heat and cool), sourcing only renewable energy, using sensors to help optimise energy and water consumption, and additional insulation of walls and windows. It might also involve using sustainable building materials (such as laminated timber), installing photovoltaic panels to generate renewable energy or committing to sending zero waste to landfills. The refurbishment and repositioning of a data centre we owned in Sweden, for example, succeeded in cutting carbon emissions by 62% compared to what they were when we acquired the property.

Such developments pay off financially. Occupancy is, on average, 4.3% higher in green-certified buildings, while rents are about 4.6% higher, according to a review of data across the developed world. They also have lower operating costs and higher sales prices.²

With the combination of rental growth and the potential for rate cuts to drive property values up, we believe the case for European real estate right now is clear and compelling.

By combining tactical refurbishment and active ownership practices with investment in strong, core assets, core plus real estate can thus offer attractive returns, uncorrelated with other asset classes, and a sustainable income stream.