– Avril 2023
Anthony Somian: Consecutive increases of interest rates throughout the continent made headlines, and have been quite im- pactful on Europeans daily life. How does it impact your activity?
Cédric Kaison: First of all, it is important to differentiate the residential real estate market from the commercial real estate market. The office market makes up for the most part of the commercial real estate market and it represented 82% of the investments in 2022. We all see that the residential real estate market has been quite impacted by interest rates raises, as becoming a landlord has suddenly become more difficult. Either one finds and buys the house of their dream but will have to assume a higher monthly reimbursement, or one must review their budget lower as interest payments now weigh way more. We can clearly see a decline in housing sales. How much is the decline of sales? What impacts the values? On these questions, I would let the official statistics speak.
However, it is clear that there is still money to be invested in residential real estate in 2023. Individual investors have recently been offered alternative investments (alternative to real estate, i.e. bonds, etc.) which could have been considered for a long time as less attractive, so today they are obviously stepping back and consider to diversify. Once it will be done, it is more likely they come back onto the market. Keep also in mind that professional investors are also looking at residential investments, meaning purchase of apartment buildings. We initiated a couple of transactions two years ago but some developers did not see the benefit as the VEFA was more comfortable and the offered price more competitive. For professional investors, residential is still a great way to diversify from the office investment, especially when the exposure is significant. When a type of purchasers reduces their activity, another one is taking over. It is time for built-to-rent residential.
In the commercial segment, the increase in financing costs in 2022 led to a repricing mainly in the second half of the year. Consequently, we had a second half of 2022 marked by a wait-and-see phase. In Europe, this translates into investment volumes that fell significantly in the second half of the year to reach €248 billion, a decrease of 14% compared to 2021), and 7% below the average over the last 5 years. The volume recorded in the fourth quarter of 2022 amounted to €47 billion (-57% vs Q4 2021) and is thus the lowest quarter of the year (where Q4 is generally the mostactive quarter). These are average figures; on the contrary, some markets have recorded an increase in investment volumes compared to 2021. This is the case for Spain (+29%), Italy (+29%), Ireland (+19%) or even Belgium.
The Luxembourg market has followed the European trend: a decrease of the investment volume by ‑38% in 2022 vs 2021. We landed at the end of 2022 with an investment volume of €854 million. By comparison, the record year of the last ten years was 2018 with €2 billion of capital invested in commercial real estate. This drop in volume is significant, but should not be read as a lack of investor interest in this segment. Indeed, faced with the ECB’s multiple increases in interest rates, players have taken a wait-and-see stance. Because of this, some transactions which were initially planned for 2022 will simply be executed in 2023.
Figures for Q1 2023 are being fine-tuned by our research team at the time we speak, but I can say that on the professional segment there is much more activity right nom than in H2 2022!
Anthony Somian: Where does the capital invested in Luxembourg come from?
Cédric Kaison: In Luxembourg, the origin of capital is mainly European. The contribution of international actors exceeds that of local actors. This is all the more evident in years with higher investment volumes than in 2022. In slower or wait-and-see phases, international players tend to refocus on their domestic markets, so that the share of Luxembourgish capital invested in the market is proportionally higher. In 2022, local actors contributed 20% of the total volume. The Belgians and Germans respectively contributed 38% and 20%. These figures exclude land purchases.
Anthony Somian: What about the prices correction you mentioned above?
Cédric Kaison: Individuals are not the only ones who suffer from rising interest rates. Developers, investors, investment funds, insurance companies and real estate companies, to name but a few, have all been hit hard by this event, which is not a local event. There are two topics in the rise of interest rates. The first is very easy to understand: the direct cost for an investor/buyer who uses financing as part of their operation. For their cash flow, this increase of the interest rate means an increase of costs. For a given rental income, if the cost increases, then the available or distributable income decreases and profitability is affected. If an investor needs to maintain their profitability target (regardless of whether it is high or low) you can imagine that price must necessarily be adjusted… This aspect is easy to calculate and any investor knows how much his financing costs are today compared to yesterday. To speak concretely, acquiring a building that generates a 3.5% profitability when you finance the acquisition at a rate of 1.5% made sense 12 months ago. But today with a financing cost of around 4%, the 3.5% profitability is no longer enough.
Anthony Somian: What if the acquisition is made without financing?
Cédric Kaison: Well, that is the second topic or rather consequence: the rise in the cost of capital, or cost of equity. In the face of higher paying bonds and other investment products, investors now expect a higher return on real estate. The rental profitability of real estate must technically follow; and here we are not talking about potential capital gains, but more about the ratio between the income generated and the money invested, in a distribution perspective. In this context, all real estate players had to review their investment criteria. New vehicles have sometimes been created to ensure greater profitability across a portfolio. Consequently, an actor who does not use a financing and who therefore does not directly suffer from the rise in interest rates in its operations, will also review of its investment parameters.
Luxembourg prime office yield is therefore not any longer at 3,40%, but rather at 4%, so +60 BPS (Q4 2022). The entire continent has witnessed a yield increase, most affected cities are Amsterdam (+100bps), Berlin (+80 bps), Prague, Milan and Hamburg (+75 bps), Frankfurt and Munich (+70 bps). Let’s wait for the Q1 2023 figures to be published by our research team.
Anthony Somian: In this context, how are investors doing?
Cédric Kaison: As mentioned before, the first reaction was to adjust their investment parameters with a business plan in line with the new market reality. The second one is to negotiate or adjust the price they offer. Thirdly, investors may look for a return where it can be found, which may mean to get out of the city and invest in more volatile districts. Fourth, buyers may capitalize on the various transitions that real estate is facing: higher environmental standards and the redefinition of office spaces. On the environmental side, for example, investors can raise their buildings to standards that make them eligible for European taxonomy. This standard, for example, is fully marketable, and in terms of resale prospects, there is no doubt that buyers are demanding – within a few months – that their investments comply with this new regulation. The same applies to the redefinition of workspaces: yesterday’s office is no longer today’s. There is a greater share of emotion in the choice of offices: it is a transition from a philosophy of efficiency and rationality of spaces, to a philosophy of well-being and talents retention.
Anthony Somian: Why do professional investors target Luxembourg for their real estate investments?
Cédric Kaison: Fundamentals are good: economic indicators are positives, infrastructure is excellent and the office real estate market is healthy. When we describe a healthy real estate market, we consider parameters such as a good occupiers’ diversification and a low vacancy rate. The presence of the European institutions and many internationally renowned companies provides a very solid base for the rental market. Moreover, in 2022, the Luxembourg market recorded a vacancy rate (the percentage of unoccupied office space) of 3.5% compared to 3.9% in 2021, while the average vacancy rate in Europe (in the 26 markets monitored by BNP Paribas Real Estate) was 7.1%. This figure reveals Luxembourg is at the top at European level and this obviously brings comfort to investors. This situation puts the owner in a comfortable position when discussing with his tenants and prospective tenants. At the same time, rents are gradually moving up and are not volatile.
We see a strong presence of investors from neighboring countries. There are several reasons for this. First of all, the country’s multilingualism: even if English dominates, communication in the mother tongue is easier. In addition, investments in Luxembourg are carried out in a framework very similar to what investors experience in neighboring countries. Here I’m talking about similarities such as a common basis for the civil code or the registration of transactions. One more point, the central position. Luxembourg’s geographical and central position is also an asset in attracting capital from its neighbors. An investor based in Paris is closer to its assets located in Luxembourg than to those located in Marseille. These players are close to their investments and this makes the management of these assets easier. Then the presence of a player attracts the interest of their compatriots… The presence of their peers reassures the investor.
During MIPIM, the largest international real estate event that occurred in March, I had the opportunity to meet plenty of investors, either already active in Luxembourg or “new-comers”. They do agree on the opportunity to (further) invest in Luxembourg for the reasons I have already mentioned before. Today’s market conditions and evolution make it difficult for them to read the market though. The investment strategy and criteria have to adapt accordingly. And this is why the market activity is slowing down because it is experiencing adjustments. However, some players have accepted and integrated these changes earlier than others and are more confident, that is why for example we expect to see French capital flowing into the market this year.
By Anthony Somian, Consulting Manager Square Management.