European real estate fell only marginally in value last year and is far from reflecting higher interest rates. In the UK, the situation is different, notes Zachary Gauge in the latest Real estate Outlook from asset manager UBS. After a -13% correction in the last quarter of 2022, the UK appears attractively priced compared to other property markets.

“The performance of direct real estate investments in the UK and those in the eurozone varies widely, as the MSCI index shows. Between 2001 and 2021, the UK Property Index outperformed the eurozone by 1.2 percentage points, but at three times the volatility. If you take the risk into account, that’s a pretty bad reward for the much higher volatility.”

“But actually we compare apples with pears. In Europe, DCF (discounted cash flow) models are often used, which are naturally flattened compared to the marked-to-market approach dominant in the UK. During a bull run, this rarely poses a problem-most investors are happy to be able to sell their assets at a price above their most recent valuation. But when the market turns, unrealistic valuations begin to lead to liquidity problems.”

“It remains to wait for official figures, but Oxford Economic expects values in the eurozone to have fallen by only -2.8% in 2022. Since the direct values in the UK fell by 13%, the difference is likely to be around 10 percentage points – a huge difference even by historical standards.”

“There are a number of explanations for the seemingly subpar performance of the UK, and the disastrous mini-budget last year has undoubtedly accelerated the correction. But the main reason is the reluctance in Europe to bring valuations to a level at which transactions would realistically take place.”

“If you never have to sell assets during a recession, that reluctance may not be a problem-the valuation then follows from an accounting mechanism rather than a realistic selling value.”

Unrealistic valuations

“That is not the reality of the market. During a market downturn, investors are more likely to liquidate their investment positions and trade them in for cash as redemption requests increase and refinancing becomes more of a challenge. But potential sellers are unwilling or unable to accept large discounts on their most recent valuations. On the other hand, potential buyers need significant discounts to close deals. Otherwise, they will not achieve the intended returns that fit the new interest rate climate.”

“As a result, transactions in the eurozone fell dramatically to 31.9 billion euros in the fourth quarter of 2022, against 86.1 billion euros in the fourth quarter of 2021. The lack of liquidity also means a lack of market data on which to base values. Nevertheless, many European valuers have left the valuation largely stable, even though bids came in well below previous valuations.”

“Unrealistic performance data does not help the market, nor does real estate as an asset class. Valuations sometimes fall because markets are cyclical and influenced by broader macro trends. This happens in all asset classes, and a correction in one or two years does not make the sector a bad long-term investment. But when values do not move in periods of uncertainty, the sector can appear even less liquid and transparent.”

“In the UK, on the other hand, recent movements have restored the credibility of the system. Prices reach a level where investors can see attractive returns. For some sectors, we can see the beginning of recovery as early as the second quarter of 2023. In Europe, this can take much longer. As after the financial crisis, one must first be prepared to accept reality.”