European core real estate: The importance of investing outside of domestic markets

Investors have historically been wary about investing in real estate outside their home country, reflecting an inherent home bias. Concerns about excessive risk in overseas markets, and an often limited understanding of local conditions, have led many real estate investors to solely operate domestically.

However, gaining overseas exposure can help strengthen real estate portfolios by adding diversification and potentially lowering risk. We believe that non-domestic allocation to European core real estate can benefit portfolios by adding exposure to liquid markets, while maintaining the stable income characteristics of a core real estate approach.

European core real estate is defined as those geographical locations which have dynamic and vibrant economies; feature dominant base industries; reflect strong consumption and/or export of goods and services; and in turn, underpin strong real estate performance over the long term.

Improved diversification

While core real estate generally provides attractive and stable risk-adjusted returns, home biases can lead to more concentrated risks, dependent on a property’s geographic location. These asset-specific risks could be influenced by a host of factors, including demographics, industry concentration, and local rules regarding tenants.

To achieve the broader set of benefits inherent in core real estate, cross-border investment is critical as it enables to minimise assets’ correlation. For example, dollar-denominated investors could enhance the overall diversification and risk- adjusted returns of their portfolio by gaining exposure to European markets.

One instructive example of these diversification benefits is the office segment in Europe which, in recent years, has demonstrated a low correlation to the NCREIF Property Index (NPI), a benchmark used to measure commercial real estate returns in North America. In fact, this correlation for total returns over the past 10 years has been -0.11,¹ a low level that may help U.S. investors, navigating through property cycles.

In addition, niche or non-traditional property types (e.g., student housing, built to rent, multifamily homes, data centres, health care) are growing rapidly and becoming more mainstream throughout Europe, allowing investors to gain diversification benefits while maintaining a core approach

Emerging property types have generated significant investor interest and received more capital allocations in recent years. In the UK there is significant demand for student housing, while other non-traditional sectors such as health care are more prevalent in countries with affluent and ageing demographics, such as Germany and Finland. Indeed, given their higher purchasing powers, German and Finnish elderly are more comfortable to move into private care homes or senior living accommodations.

These differences among markets allow for targeted opportunities that can add diversification value to a portfolio. Country-specific opportunities are especially important considering that a likely deceleration of the economy in 2023 may produce uneven outcomes among European member states and tenant types.

Access to new large, liquid markets

European commercial real estate is one of the largest and most liquid property markets in the world, estimated at roughly €8.2 trillion, a similar size of the U.S. market, and equivalent to 47% of nominal GDP.

In terms of transaction volume, a widely used liquidity measure, European real estate averaged $360 billion per annum over the last three years, almost double the average seen a decade ago, pointing at a significant increase in market breadth.

Other liquidity factors make Europe an attractive region. Market depth for example, as measured by the share of cross-border capital, has increased considerably over time. Today, overseas investors account for half the total deal activity occurring in Western Europe, with U.S. investors contributing for the lion share. Such a high degree of capital composition diversity ensures the market remains relatively liquid even in times of localised distress, as opportunistic buyers from overseas are more likely to step in and thus set a floor to asset values. We believe this dynamic is likely to occur during 2023 when a temporary weakness in the European economy and its currency will offer a unique opportunity window, especially for dollar-denominated investors

Attractive relative value along with income potential

The fast pace at which central banks are tightening monetary policy to blunt persistently high inflation has stifled economic growth and felled global capital markets so far this year. Against a dearth of liquidity and weakening macroeconomic conditions, property markets have not been immune. Several transactions were put on hold, yields softened, and returns eroded. Cautious investors have stepped aside, waiting for the pattern of inflation and central banks’ policies to become clearer, and asset prices to adjust accordingly.

We believe this cyclical weakness in the markets will offer unique opportunities to invest in those European real estate sectors with the right attributes, including core locations, favourable supply-demand dynamics, and sustainability credentials. In fact, the breadth of European real estate market allows to invest in sectors with positive structural drivers, lower beta and inherent income growth potential such as build to rent, multifamily accommodations, student housing, health care and data centres.

The income characteristics of these sectors can also provide additional inflation benefits. This is not only due to strong occupier demand, but also many European countries’ rents are increasingly indexed to inflation, a practice less common for U.S. leases. Looking at the distribution of INREV² total returns relative to inflation since 2000, positive quarterly returns have far exceeded the number of quarters with negative returns and typically exceed inflation, as shown in in the chart above.

Distribution of total returns relative to inflation since 2000

Moreover, the cost of materials and labour for new development also acts as a natural hedge to inflation. Because real estate has the potential to provide a stable income return to investors, this hedge is critical for pensions and other investors with active capital requirements.

Additional considerations

Non-domestic investments provide real estate investors access to new sectors and strategies, as well as the potential to take advantage of price dislocation in times of heightened volatility. Another consideration is environmental, social, and governance (ESG). Europe has been at the forefront of ESG in commercial real estate buildings. Gaining exposure to this region is one way to help real estate investors meet ESG goals and requirements.

Additionally, monetary policies disparity between central banks across the Atlantic have sunk the euro to a 20-year low against the dollar, while the sterling hovered around an all-time low against the dollar in September, before recovering some ground. This makes European real estate a good opportunity to generate returns through the currency play alone. If we then overlay diversification benefits, favourable fundamentals, price dislocation opportunities and income growth potential, an exposure to European real estate becomes an appealing proposition for consideration in 2023.

The end result: Improved portfolio outcomes

Ultimately, we believe exposure to European core real estate improves portfolio outcomes for long-term investors. We conducted a recent analysis which modeled the addition of European core real estate to a portfolio. The addition led to an expansion of the efficient frontier due to an improved risk/return profile.

Going forward, we believe strategies that remain too focused on domestic investment will miss out on a broader set of opportunities that will help build more resilient portfolios. By investing outside of home markets, investors will find they’re able to capture more of the opportunity arising from thematic drivers as well as from geographic idiosyncrasies.

Portfolio risk/Return allocations
Q1 2001 - Q2 2022

Portfolios shown are hypothetical in nature and are shown for Illustrative, informational purposes only. This material is not intended to forecast or predict future events and they do not reflect the actual or expected returns of any portfolio strategy managed by Principal Real Estate. No representation or warranty is made as to the reasonableness of the assumptions made or that all assumptions used in achieving the returns have been fully considered. All data is shown before fees, transactions costs and taxes. Management fees, transaction costs, and potential expenses are not considered and would reduce returns. Actual results experienced by clients may vary significantly from the returns shown.

¹ INREV/NCREIF-NPI, Principal Real Estate, October 2022
² The European Association for Investors in Non-Listed Real Estate Vehicles (INREV), Q2 2022