T he once-predictable nature of residential real estate has been disrupted over the past two years, reshaped by profound shifts in the way we work, live and invest. In this article, we delve into the transforming housing market in Luxembourg and Europe, exploring current trends, challenges and opportunities faced by both industry players and investors alike in this post-COVID and inflationary era. Razvan Mara and Clotilde Buriez, EY Luxembourg Real Estate Assurance Partners, share their thoughts.
The two biggest changes we have seen in the past three years
As underlined in the latest ALFI REIF Study (2022) , since the global pandemic, the multi-sector strategy has increasingly been favored as a strategy of choice, accounting for 49% of the surveyed market, compared to 33% in 2019. Given the substantial growth of e-commerce accelerated by the pandemic, customers are demanding quicker, more efficient online purchase deliveries. So it is no surprise that we are seeing more and more fund managers managing logistics real estate assets, focusing specifically on addressing consumer needs (e.g., self-storage, last mile distribution centers, data centers, etc.). This is further exacerbated by the supply chain crisis, a consequence of the war in Ukraine, triggering a global reshuffle in logistics chains.
We also observe another shift: residential real estate, a single-sector strategy, has increased (accounting for 12%), recovering its 2020 levels, jumping again since 2021 (9%). The initial slowdown in home sales has now transformed into a seller’s market, and the surge in remote work has prompted many urban dwellers to seek larger living spaces. The economic environment has put negative pressure on individuals wishing to purchase a property, leading to many fund managers incorporating residential assets at the heart of their real estate fund strategy, providing for leasing solutions.
What trends and related opportunities are having the biggest impact on residential real estate?
The evolving real estate market can be explained by a handful of trends, namely the inflationary context, housing megatrends and ESG.
Increasing interest rates – disadvantaging some but benefiting others
In the residential real estate market, there has been a persistent upward trajectory of interest rates throughout 2022 and into 2023. The European Central Bank (ECB) has been hiking the interest rate since the summer of 2022 . This has significantly altered the dynamics. Banks, constrained by these rising rates, are becoming more cautious in their lending practices, while individuals find themselves with reduced borrowing capacity. This, coupled with the already elevated house and apartment prices resulting from a period of historically low interest rates and constrained housing supply, has limited the opportunities for aspiring homeowners. As such, housing affordability, particularly for future generations, has become an increasingly pressing concern, prompting discussions around the necessity for subsidized housing initiatives and a growing emphasis on private rentals in both urban and suburban settings.
The rise in interest rates has also cast a shadow on the valuations of Core and Core+ real estate investment strategies, as higher capitalization rates have exerted downward pressure. However, there is a silver lining for savvy investors with available capital. The rising interest rates, while posing challenges for some, have created opportunities for value-add investors, especially those with sufficient dry powder to capitalize on potentially undervalued assets. Additionally, many lease contracts in the market feature indexation clauses, allowing investors to capture a portion of inflation, helping to maintain a decent level of yield.
Modern megatrends: demographics, urbanization and decarbonization
Amidst concerns about potential economic recessions, long-lasting inflation, volatile energy costs, and geopolitical instability, it has become imperative to return to the fundamentals of real estate investment. Demographics, urbanization, and the drive towards decarbonization are expected to be the primary drivers of yields in the medium and long term:
New ways of living and working (urbanization and nomadism)
One significant trend is the emergence of new living and working paradigms driven by urbanization and a more mobile (nomadic) workforce. This shift has given rise to niche segments such as co-living, student and senior housing, which cater to specific age profiles and lifestyles. These segments are becoming increasingly defined by location, facilities, and services that mirror the diverse needs of individuals at different phases of life.
Aspirations of younger generations
The objectives of younger generations are challenging the traditional concept of home ownership (rent vs. own). The ability to lease rather than own premises offers flexibility, frees up capital and enables access to more convenient locations and green high-tech housing. The proportion of renters has grown steadily in the last decade. This surge in residential renters can be attributed to choice, the benefits of flexibility and freedom from the costs and responsibilities associated with home ownership, and necessity or constraint, with factors like rising mortgage rates and housing supply shortages playing a role in this paradigm shift.
These megatrends are reshaping the offer of housing: we see a resurgence of servitization. If we make an analogy with the automotive industry in the last decades, many car manufacturers shifted from a product-centric approach to become mobility services providers.
Sustainable real estate ambitions
The most impactful trend may well be the implementation of new ESG regulations, driving resource reallocation and innovation in construction techniques. Being among the main contributors to CO2 emissions (residential and commercial property represent approximately 40% of carbon emissions ), the residential will need to go green, and at an accelerated pace to meet the EU leading ESG regulation timelines – set in the Green Deal making the EU climate neutral by 2050. France, for example, has adopted rules restricting the renting of apartments/houses with poor energy performance, starting from 2025 . A large proportion of housing stock in Europe has yet to be modernized. The valuation of assets crystalizes the difference between assets which meet the energy performance standard and those which do not: there is an observable shift in pricing dynamics between prime and secondary real estate, with an expected widening gap as the market prioritizes sustainable and energy-efficient properties.
We see a real ambition in key market players who are focusing on the social elements to support the strategy shift – constructing quality eco-friendly buildings, but at affordable prices. Municipalities are increasingly looking to strengthen the permit options which not only set environmental requirements measuring energy performance, but also in many instances mandate a portion of the construction be dedicated to affordable housing. These trends generate a need for massive investments, in which real estate investment funds will have a role to play. Not only we observe a change in the target investments but also broader investment vehicle options to attract more diverse profiles, such as retail investors through ELTIF.
What are some of the most significant challenges for the real estate investment industry?
Hurdles to be overcome before embracing ELTIF as a vehicle for real estate investing
ELTIFs have so far not been a successful vehicle for real estate, yet recent activity – and the evolution of ELTIF 2.0 – demonstrates increasing interest from sponsors. While Core real estate presents an intriguing asset class for ELTIFs under 2.0, one of the primary hurdles lies on the investor side, as unpacked by our colleague, Norman Finster, in his article “The road to ELTIF 2.0 ”. In contrast to larger, but fewer institutional investors, ELTIFs under this new framework will target a significantly larger pool of retail investors. ELTIF 2.0 enables investments in both real assets and UCITS eligible liquid assets simultaneously. This presents multiple challenges, such as, for example: liquidity management for alternative asset managers, aggregating real assets and liquid assets for fund accountants, providing connectivity to retail distribution networks for registrar agents, and marketing to retail investors for fund distributors. The crucial element for success will then lie in the operational readiness amongst asset managers, servicers and distributors.
Difficulties in practical management of residential properties
For real estate managers venturing into the residential market, there are notable challenges to contend with. Residential properties typically incur higher running costs, requiring deep involvement in property management to address the unique needs of individual tenants, as opposed to larger corporate occupants. This shift in focus brings with it exposure to recoverability risks, demanding vigilant monitoring, and heightened tenant screening requirements, and a stricter regulatory environment. These operational complexities may prove daunting if asset managers do not embed sufficient technology supporting their operating platforms. The readiness of the real estate industry to fully embrace AI and leverage its capabilities in property management and tenant relations remains an open question.
As outlined, real estate is currently facing many challenges forcing the shift of target investments. As a result, asset managers, now more than ever, need to be agile in maintaining the expected level of return across sectors which operate differently. Modernizing operating platforms is seen as a challenge considering its higher effort required to run efficient integration of numerous properties located in various countries. This may mark a turn in the history of European real estate which will force actors to use a higher degree of technology, such as AI and PropTech, among others.
Despite setbacks, the real estate market has displayed resilience. Remote work’s rise fuels demand for adaptable offices, while e-commerce drives logistics and warehousing growth. Sustainability gains traction, propelling eco-friendly building practices forward. All this has pushed asset managers to shift the focus of their investment strategies, adapting to the needs of the market, creating new segment opportunities as for residential. To succeed, the industry must prioritize innovation, flexibility, sustainability and embrace digital tech. Challenges are substantial, but the future signals opportunity for growth in European real estate investment.
