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Tariffs are no disaster for European real estate

The US administration, on 2 April, announced a new tariff structure between the US and the rest of the world, levying a 10% baseline tax on imports into the US with multiple countries facing additional (called ‘reciprocal’) levies. The tariffs’ level was higher than expected, causing volatility across multiple markets. Many economies retaliated, imposing tariffs on imports from the US. A week later (9 April), the US administration introduced a 90-day pause on the additional levies, with the aim of negotiating trade conditions between the US and individual countries. The 10% minimum levy remained in place; however, China was also excepted, effectively resulting in an import levy (tax) of 145% on imports from China into the US. China has retaliated with a tax of 125%.

There is, due to the ongoing trade negotiations, considerable uncertainty regarding tariffs, including their levels, timing, scope, exceptions, etc. Currently, countries in Europe face the 10% import levy but this may change as we edge closer to the 7 July deadline. Some agreements have already been largely hammered out, e.g. between the US and the UK.

Investing in direct real estate can be calming. As an example, the immediate impact from tariff changes for direct real estate investors in Europe is, in practical terms, non-existent. The listed real estate market, which is more subject to short-term behavioral factors, however, reacted immediately. Key sectors’ total return performance dropped by more than 10% in accumulated terms but that decline has since reversed as the outlook for trade negotiations improves (see Figure 1). Listed companies that focus on investing in European industrial assets are flat in terms of total return since the end of March. The residential sector, however, is up more than 13% over the same period – an important reason why is highlighted later.

In the long run, however, additional tariffs, if they are realized, are likely to shape the economy of Europe – and with it, its direct real estate markets. For one, economic growth is likely to suffer. The UK economy is e.g., expected to grow by only 1.1% p.a. over the next three years, below the 20-year average growth rate of 1.3%. The eurozone is looking at a similar growth trend. Much of that depends on access to energy though, and LNG imports from the US may be a part of any EU-US trade deal.

Weaker economic growth is a problem for cyclical sectors whose leasing demand depends on growing economic activity. This includes the industrial and office sectors.

Retail and residential are also not immune to weaker economic growth but the shortage of suitable stock is likely to shield the sectors from slower growth. The impact for direct real estate should therefore be considered in the context of supply-demand within each sector and location.

An important aspect is also the fact that slower economic growth is likely to push the Bank of England (BoE) and the European Central Bank (ECB) to lower policy rates. This would suppress risk-adjusted required returns for real estate assets, increase debt availability and support capital values. Indeed, we expect the BoE and the ECB to lower rates to 3.75% and 1.75% respectively, by the end of this year, as inflation should stay benign, being pushed downward by weaker economy. 5-year swap rates are also down for both the GBP (3.9%) and the EUR (2.2%) since the beginning of April. It’s this expected lower rate impact that has caused the residential sector to outperform amongst the listed real estate companies in Europe: the sector is relatively low yielding on the asset level, with lower rates bringing an important and outsized relief to capital values in the sector compared to others.

Figure 1: Total return (index), European listed real estate

Overall, direct real estate markets in Europe are relatively shielded from higher tariffs between the US and Europe. This makes the asset class as important as ever in terms of building the optimal risk-adjusted portfolio.

The downside protection of real estate

Repeatedly, the benefits of adding private investments, including real estate, to portfolios have been highlighted. Depending on the investment purpose, e.g. income generation or capital preservation, and the investment horizon, e.g. short- or long term, the allocation to private markets can lie somewhere between 10-40% (The new 60:40 portfolio). In practice, it may well be higher for many investors, e.g. if they own the home they live in. And from a pure risk point of view, one could argue the allocation should be even higher.

The allocation to real estate in a multi-asset portfolio is often justified from the standpoint of modern portfolio theory: maximizing the returns per unit of risk the portfolio is exposed to. ‘Risk’ in this case is usually defined as the annual standard deviation of the portfolio’s returns.

However, this has its downsides. The key issue is that investors’ preferences are biased towards avoiding downside risks, i.e. sharp drops in portfolio returns, while upside risks, i.e. sharp increases in portfolio returns, are welcomed. ‘Risk’ defined as standard deviation of returns, as per modern portfolio theory, does not consider this, as both upside and downside swings affect the standard deviation of returns in the same way.

Real estate is a famously viscous asset class: it takes time to trade real estate. This increases its illiquidity, but it also shields it from short-term market panics. Most real estate investors with a well-diversified portfolio enjoy restful nights while many equity investors may find the urge to stay up late or wake up early to see what the market on the other side of the world is doing. But fundamentals matter, of course, and real estate goes through cycles like any other asset class. The trick is to allocate enough funds to the asset class to enjoy restful nights, while having enough exposure to e.g., equities to enjoy the upside potentials there as well. The combined cycles of the underlying asset classes then merge into an overall portfolio cycle. Liquidity needs must also be considered.

Therefore, let’s consider the following case: an investor must allocate capital between real estate, equities and bonds while wishing to maximize the return per unit of risk, where risk is defined as the maximum drawdown in the portfolio returns. The investor also wants to have at least 50% of the portfolio liquid within six months. That means that the allocation to real estate is limited to 50%. We consider quarterly data from 4Q07 to 4Q24 relying on the total return of STOXX Europe 600, Bank of America Euro Government Index and MSCI’s Europe Quarterly Property Index, all denominated in EUR.

The outcome, ignoring potential fees, is shown in the graph below (see Figure 2). The allocation to real estate is 50% (maxed), 13% to equities and 37% to bonds. The annual total return is 4.2% with a maximum drawdown of 10.9% (in March 2009 and December 2023). In comparison, the maximum drawdown for each asset class over the period is 15.7%, 45.2% and 20.5% for real estate, equities and bonds, respectively. Annual total returns per asset class, in the same order, are 4.9%, 5.2% and 2.6%. A 60:40 equities/bond portfolio has a max drawdown of 26.6% and an annual total return of 4.5%. Many investors would sacrifice a 0.3% p.a. total return if they must only suffer a 10.9% drawdown instead of 26.6%.

One point to note: using modern portfolio theory, i.e. risk defined as standard deviation of returns, leads us to a 50%/3%/47% real estate/equities/bonds portfolio. Its maximum drawdown is 12.5% and annual returns 3.9%, i.e., underperforming the portfolio based on maximum drawdown. However, the returns per unit of risk are higher because a sharp increase in equity returns (such as in 2021) is interpreted as ‘risky’ – they increase the standard deviation of returns – even if the returns are positive. So, when constructing your portfolio, make sure you consider what ‘risk’ really means.

Figure 2: Annual return of model portfolio with 50% allocation (%)

Every investor must accept some illiquidity if the decision is made to invest in private real estate. Many do so when they invest in the home they live in, often lacking the capital to invest further in real estate. But for investors with the firepower to do so, real estate can provide the downside protection that allows them to sleep at night.

The trough in capital values is here

Real estate is famously cyclical and prone to over- and underreacting due to latency in its responses to signals coming from the demand side. The key question, therefore, is: where are we in the cycle?

°Â±ð’v±ð already entered positive territory in terms of all-property capital value development. As of December 2024, annual capital growth on the all-property level turned positive (0.2%), having been negative since December 2022 (see Figure 3). The residential sector (2.7% annual capital growth as of December 2024) outperformed other sectors, followed by industrial (1.4%) and hotels (0.4%). The retail sector was flat (0.0%) while offices (-1.9%) continued to see their values drop.

Figure 3: Europe, annual capital growth by driver (%)

In light of the challenges the European economy faces, it’s natural to doubt that this development can continue to improve. However, we’re not seeing negative pressures on capital values – rather the opposite, at least for high-quality assets.

The key reason why is very simple: interest rates and their development. Looking at how spreads have developed, we’re increasingly confident that pricing at its current level is in ‘fair’ territory. Z-scores of yield spreads crossed into that territory around beginning of 2024, depending on the sector, and since then, yields have been predominantly (in 75% of available markets) stable or dropping. In fact, out of the ca. 600 markets we follow in terms of yields across Europe, a third has seen yields drop since year-end 2023, while a quarter has seen yields rise.

The distribution of those yield drops is also not limited to a specific sector: since year end 2023, 23% of industrial markets have seen yields decline, while 38% of office markets have seen their yields drop (see Figure 4). In fact, no other sector has seen so many, in relative terms, markets experience yield drops since 2023, but the residential sector is close with 35% of its markets seeing yields drop. Perhaps not surprisingly, given the bifurcation in the office market in terms of leasing demand (a topic we have repeatedly covered in the past), the office sector also ranks at the top in terms of share of markets where yields are rising (see Figure 4). Truly, sector and asset selection has seldom, if ever, been so important.

Figure 4: Europe, no. and share of markets by yield movements since year-end 2023

In this context, it’s important to note that investment volume has begun to increase. MSCI reports that as of 1Q25, annual investment volume was EUR 213.9 billion, up 17% YoY. The residential sector, for the first time, topped the ranking in terms of investment volume with EUR 47 billion after an annual increase of 33%.

Furthermore, debt costs have dropped adequately to make the impact of leverage positive again at the income level for some assets. All-in costs on a well-leased prime office in the eurozone are around 4.0%, down nearly a percentage point over the last year. Meanwhile, prime Paris CBD offices are now trading close to 4.25%.

°Â±ð’v±ð previously highlighted in one of our focus articles on the UK that significant yield compressions in the near future are unlikely. Despite the current outlook for lower policy rates, we see no reason to change this opinion of ours. Yes, yield spreads are likely to support pricing, but economic uncertainty weighs on the outlook, dampening our expectations for yield compression.

Retail is staging a comeback

The fact that the residential sector came out on top in terms of capital growth in 2024 should not surprise anyone. From a leasing market perspective, the sector is under constant pressure from the demand side with inadequate supply. Consequently, rental growth has been strong across the region, with annual market rental value growth hitting 6.4% as of December 2024. The pace of rental increases in the residentials sector is now faster than in the industrial sector (see Figure 5).

Figure 5: Europe, annual rental growth by sector (%)

It’s also worth highlighting the recovery in retail. In Europe as a whole, annual rental growth in the sector was 2.2% in 2024. That’s the highest nominal rental growth the sector has seen since at least 2008. Rental growth in the sector has now increased for 16 consecutive quarters. Another point to highlight, is the fact that vacancy rates in retail warehouses in the UK have dropped to 3.2%, their lowest on record. Rents for this part of the market are up 2.1% YoY as of December 2024, at its highest since the summer of 2007. The same can be said about shopping malls, which saw their rents grow by 2.6% YoY as of December.

The recovery in retail is a good reminder of the cyclical nature of real estate markets. Retail had been largely ignored by investors since ca. 2017/2018, when the first signs of structural difficulties and the impact of fierce competition with the logistics sector (e-commerce) began to emerge. Now, the survivors in the sector have stabilized, with redundant retail space largely purged from the market. Consequently, rents are rising anew as supply and demand are in better balance than before.

Demographic shifts are coming, prepare accordingly

Offices are the next sector to undergo the cleansing process that retail has now endured. The sector continues to display the bifurcation trend that has been evident since 2020, despite some temporary rebound in office presence.

Fundamentally, the long-term issue that the sector faces is demographics. According to the United Nations, over the next 25 years, the population of 15-64 years olds in Europe will drop by ca. 13%. That means we’ll have fewer working-age people to go to the office than today. There is a high probability that we’re close to, or already at, the peak in terms of total stock of offices in multiple cities in Europe.

In the meantime, the office leasing demand that is in place flows towards ‘prime’ assets in ‘prime’ locations, where employees can find restaurants, cafés, entertainment and easy access to public transportation hubs. As a result, prime rents are rising, up more than 5% YoY as of 1Q25 in nearly 20 key European cities, including Brussels (6.7%), Prague (7.1%), Helsinki (14.0%), Paris (12.2%), Munich (11.5%), Milan (7.1%) and London (9.7%).

One point worth mentioning regarding Europe’s demographic profile: over the next 25 years, the population aged 65 and older is expected to increase by ca. 50 million from ca. 150 million to 200 million individuals. For comparison, the total population of Spain is ca. 49 million.

The investment implications of this demographic change are profound. Many of these individuals, given current supply, will not be able to find a fitting residential unit for themselves and possibly their partner. The demand for one- and two-bedroom residential units that are old-age friendly is set to increase substantially over the next 25 years. Given how little attention this market segment has received, and the lead time in planning and building those units, many investors should seriously consider their allocation to this part of the real estate market.

Another often under-allocated segment is life sciences real estate (LSRE). Europe will need to build more LSRE assets in the next 5-10 years to meet the demand for healthcare services and outputs, including medicine, that 50 million more individuals will be looking for. The expiration of drug patents before 2030 is also edging closer, making the mid-term demand for labs and other LSRE assets for the pharmaceutical industry relatively robust. Trade reorganization is likely to affect selected parts of the European LSRE leasing market, especially in Ireland (a hub of exports to the US), but the mid- and long-term trends are surely pushing demand upwards.