In July, the head of the world’s biggest real estate investor predicted that a year-long deal drought might soon be over.

Speaking as Blackstone unveiled its Q2 2023 results, president Jonathan Gray said the pain of inflation had peaked and he believed markets had absorbed the ‘shock’ of higher interest rates, paving the way for a return to deal activity.

Although his comments were mainly about the US market where the inflation rate was down to 3.2% in July, some of what he said could read across to Europe where inflation has also started to decline. Yet, interest rates are still on an upward trajectory, valuations are a moving target and real estate investors remain extremely cautious.

Savills associate director of European research Mike Barnes says average activity across the whole of Europe in H1 2023 was 61% lower than last year. In most markets, deals crashed by two-thirds, with a handful of exceptions in southern Europe where the fall was less.

Even optimists who last year were predicting a bounce back by now are keeping quiet after their summer holidays; it’s hard to find anyone who believes the volume of European real estate transactions will jump significantly in the second half of this year.

‘It is too soon to say we’re over the worst,’ thinks Savills chairman of Central London and international investment Stephen Down, someone who speaks regularly to some of the world’s major real estate investors. But he adds that in London at least: ‘It does feel there is a momentum beginning to build into the market – if gently’.

Core market
‘What’s been happening in the last six months’, he continues, ‘is tentative steps at probing that core/core+ market where particularly in the West End, we’ve seen a number of investors buying good quality assets in central locations: Mayfair and St James’s; Soho and Fitzrovia.

‘Typically liquidity is down, it’s investments between £50 mln and £100 mln that are most liquid right now. We have seen a few larger transactions that have traded – they are the exception at the moment.’

‘Proper green, A grade’ office buildings, like the Fitzrovia office at 33 Foley Street let to Kier on a long lease which Pontegadea bought from abrdn in April, have traded at yields over 4%, whereas ‘18 months ago we would have expected that to trade at sub 4%’, he says. The vendors have often been UK funds that need to sell down and which turn to the West End as the best source of liquidity.

The Spanish family office buyer of the Kier building is a good example of private money or institutional capital coming in to buy core/core+ property, often paying with all equity as they are elsewhere in Europe.

Other West End transactions landing at between 4.25% and 4.75% in the summer have included Kajima buying 27 Soho Square for £45.5 mln and JPMorgan acquiring 19-22 Rathbone Place from UK fund Lothbury for £60 mln for its core/core+ fund. The latter is multi-let with a short WAULT with a genuine recovery story from current rentals on the building. ‘The market is nuanced and best in class limited, so has offered only a 5%-10% discount from where they were 18 months ago; yet other non-core assets have offered up to a 40% discount. This demonstrates how polarised demand is,’ Down says.

In July, Lothbury went under offer on a second London building, this time market-rented, and in a more prime location at 55 St James’s Street. Sun Venture of Singapore came out on top after a good level of bidding at what’s thought to be pretty much the £75 mln asking price, equating to 3.75%.

By contrast, the City is at least six months behind in terms of finding its feet. The handful of large sales this year all closed early in H1 – Winchester House to Gamuda Berhad, One New Street Square sold to ChinaChem and Sancroft bought by Mitsui Fudosan – sales that had all been in the works since last year.

The buyers were able to knock down the sellers on price as liquidity evaporated for large lot sizes and valuations fell rapidly during the sales processes. One New Street originally went on the market at £450 mln and sold at £350 mln, while Sancroft sold for £315 mln, £55 mln less than Goldman Sachs had discussed paying early in 2022.

Debt concerns
James Burke, one of Down’s colleagues in Savills’ European capital markets and global cross-border team, observes that the reason that tickets of £100 mln upwards are less liquid is because they are ‘so closely linked to the cost of debt, since they are assets where buyers would normally take on financing as a means of helping to mitigate the larger quantums.’

The largest City transaction to close more recently, Lion Plaza in July, is not a prime asset, a fact reflected in the 6.25% yield achieved. The 265,000 ft² (25,000 m²) office of law firm White & Case was another block which had been put up for sale back in 2022, then with a £263 mln asking price, and the Vietnamese buyer paid £207.5 mln.

Some sellers of better-quality assets have been able to refinance albeit for the short term, preferring to take their chances on an improved market in 2024 in order to sell.

One such asset is 20 Old Bailey where Korean owners Mirae and NH invited bids at 4.75% and it is understood that interest was closer to 5%-5.75%.

Further out of prime central London, London office valuations are even more turbulent. In fact, confided one agent, discussions in the room can feel like ‘pinning the tail on the donkey’.

In the West End, however, Down sees the signs of momentum building on the foundation of the successful prime, core/core+ sales this year, with both unforced and forced sellers deciding to press the button this autumn on new product that includes both bigger core/core+ lot sizes and value-add investments.

Langham Estate owner Samuel Tak Lee has instructed JLL and Savills to seek a reported £500 mln for the 27-strong Lotus Portfolio around Great Portland Street, a more ambitious volume than anything else seen so far in London this year. It is 83% let and generates a contracted rent of £18.06 mln pa.

Shaftesbury Capital, formed by the merger earlier this year of Shaftesbury and Capital & Counties, appointed CBRE to seek a buyer for 28 leisure and restaurant, retail and office properties plus 56 flats in Fitzrovia.

Last valued at £118 mln, the properties are located in an area of the West End north of Oxford Street, whilst the bulk of the UK REIT’s assets are south of Oxford Street. CEO Ian Hawksworth said the Fitzrovia portfolio did not meet the group’s investment criteria and it would instead focus on increasing its rent roll in its core Covent Garden and Soho estates.

With these two portfolios comprising multiple small and medium-sized, mixed-use investments, they are hefty and complex transactions but don’t require potential buyers to take a view on single large office buildings. Both are expected to appeal to sovereign wealth funds and overseas investors.

Value-add opportunities
Another sign of momentum is buyer attention shifting towards value-add opportunities, as more forced sellers break cover. Down says a significant early test of buyer appetite for value-add product was the sale in July of Film House in Soho. An empty office which had been vacated by its struggling owner WeWork, there was good bidding for the building from private equity investors as well as UK REITs looking for opportunities for their flex office businesses.

US investor Hines clinched the deal on behalf of its third European value add fund, paying circa £135 mln for the 103,000 ft² building. It will be refurbished to BREEAM ‘Excellent’, EPC ‘A’ and net zero carbon operation.

Paul White, senior managing director and HEVF 3 fund manager at Hines, says: ‘As a fund we have exercised high discipline over pipeline for the last year, despite raising a great deal of dry powder. When our origination channels do deliver a quality asset, in one of our most favoured locations in all of Europe and with the potential to deliver top ESG credentials, we will invest.’

Potential buyers for Film House were expected to figure again in Q3 in the line-up competing to acquire 125 Shaftesbury Avenue. An even larger West End lot size, at 180,000 ft² and a £150 mln-£200 mln ticket, it’s another vacant possession sale due to WeWork’s woes, in a popular location, just south of Tottenham Court Road tube station. Agents CBRE and Savills had significant levels of viewings, thought to be from the likes of Hines, Tishman Speyer, Blackstone and Brockton as well as UK REITs in the run up to bids.

Like 20 Old Bailey in the City, Shaftesbury Avenue’s current owners are Korean investors who need to sell. Vestas IM bought the building in 2018, adding £147 mln of debt from Legal & General to bolster cash on cash returns and sold part of the investment down to Korean Federation of Community Credit Cooperatives. They are part of the balloon of refinancings across Europe due this year and next. Deka is the lender on Old Bailey.

Ed Daubeney, EMEA co-head of debt & structured finance at JLL, believes: ‘There is going to be more activity, a lot more consensual sales because lenders are at the point where they won’t keep rolling loans. Interest rates are still going higher and interest cover is going lower while valuations are adjusting. Next year will be pivotal and hugely busy.’

Savills’ Down agrees. ‘Sellers are those that find themselves with a refinance where the banks are just simply saying: “unless you’ve got a very convincing business plan we want our money back”. To extend and pretend in an environment where interest rates continue to go up is a difficult one and the Basel 3 regulations create more pressure for banks in terms of their lending.’

Central London sales precipitated by unpaid, maturing underwater loans include 20 Canada Square at Canary Wharf where receiver Alvarez & Marsal appointed Knight Frank as selling agent in August. Hong Kong Cheung Kei Group paid £410 mln for the 556,000 ft² office in 2017 with a £265 mln loan from Lloyds Bank. The asking price now is £160 mln and the building will be vacant imminently. ‘We’ll see where pricing for value-add product of that scale will be, I suspect below replacement cost,’ comments one agent.

Lloyds also lent £175 mln on a second Canary Wharf building bought by Cheung Kei for £270 mln shortly afterwards. A competitive process to select an agent to sell 5 Churchill Place is underway and the market expects the 319,000 ft² asset will be a little more liquid as it is leased until 2029 to JPMorgan which has sublet it.

In the City, Hana Alternative Asset Management and Bank of Ireland have instructed Cushman & Wakefield to seek £130 mln-£140 mln for One Poultry, which the Korean investor bought for £182 mln in 2018. The loan against the 110,000 ft² office building, where WeWork is the tenant, expires in December and the bank has said it will not refinance.

More than half the circa £2 bn under offer in the London office market in Q3 2023 was classed as value-add by Colliers in its EMEA Capital Markets snapshot published in August. In the update, Damian Harrington, head of global capital markets research, said that the cost of rolling over debt should trigger more sales in other markets too, especially Germany and the Nordics ‘where value corrections and exposure to debt are high’.

Nordics and Germany
Harrington’s Nordics research colleague Mikael Söderlundh says a dramatic 68% drop in transactions in the region, partly due to price expectations adjusting very slowly to higher interest rates makes directly owned property expensive, ‘and so the capital is finding new paths.’

Opportunistic investors have turned their attention to Nordic listed companies trading at deep discounts, many of which borrowed billions on local bond markets and need to refinance or recapitalise. An example was Morgan Stanley Real Estate Investing, which in August took a stake in a portfolio of SBB Swedish regulated residential properties via preferential shares with no payment obligation, relying on return of capital on exit or SBB redeeming shares based on a 13% IRR. This year, SBB’s credit rating was downgraded to junk.

In Germany where investors used relatively high levels of debt, with senior finance from banks often topped up by subordinated capital from funds, leverage is already wreaking havoc in certain parts of the market. Combined with record high construction inflation, a string of developers are now in trouble: Essen-based Fakt became insolvent and closed; Stuttgart’s Paulus Wohnbau and Hamburg’s Revitalis both recently filed for insolvency in self-administration; restructuring experts appointed to Development Partner are trying to raise additional finance to complete large projects in Berlin and Stuttgart.

Düsseldorf-based project developers Centrum and Gerch also filed for self-administration. Gerch is in talks with its financing partners and applied for restructuring proceedings in self-administration for four holding companies after another struggling real estate group, Corestate, didn’t complete the €120 mln payment agreed for Gerch’s flagship project Laurenz Carree in Cologne. In September, Project Immobilien filed for insolvency.

One of the highest-profile casualties was revealed by Thomas Daily News and Costar. In August, Imfarr, the Austrian family office of Nemat Farrokhnia and Swiss partner SN lost control not only of Frankfurt’s Silver Tower – which they tried unsuccessfully to flip in 2021/2022 after paying €630 mln for it in December 2020 – but also Highlight Towers and the Elementum project in Munich bought in 2021. Oaktree Capital Management as junior lender has taken over the trio of trophy assets. Helaba was sole underwriter for the senior debt for Silver Tower.

Other borrowers have been able to agree refinancings, though Daubeney says negotiations are often tough and getting them through credit committees is a protracted process. Success is predicated on strong relationships and a business plan the lender can bet on. Patrizia on behalf of Samsung SRA recently secured a significant refinance of Commerzbank Tower in Frankfurt with a club of German banks and will invest to improve the landmark’s ESG credentials. Bayern LB’s head of international real estate finance, Oliver Sill, said the transaction was thanks to long-standing relationships with all the partners. Samsung SRA also agreed a three-year extension with Nuveen for a 385,000 ft² City of London office, 200 Aldersgate, when the original loan matured earlier this year.

Borrowers will be hoping banks will be more sanguine about extending if interest rates were to fall in 2024. However, Down concludes: ‘I do think the tail of this slowdown is quite long; there are going to be assets that are stranded; there are going to be investors who don’t have the capex ability that is needed to convince lenders to lend.’

Small is beautiful
As in London over the last 12 months, the best liquidity in other European markets has been for investments with good green credentials in central locations in the €30 mln - €80 mln sweet spot, bought by buyers able to pay solely with equity, and operating with less competition from rival investors.

Prime office yields moved out again during Q2 2023, to 4.46%, says Savills’ Mike Barnes.

Despite the relatively narrow spread between prime yields and key government bond yields, Savills’ James Burke says that ‘we are seeing investors like French SCPIs and medium-sized institutions buying, as well as high net worth investors, and focused on higher yielding product.’ French retail fund manager Corum has bought in Glasgow and added to its Irish holdings, acquiring George’s Quay Townhouse for €80 mln from Henderson Park at a yield over 6%. La Française REM picked up assets in France and London while SCPIs Eurovalys and Iroko Zen invested over the summer in German office and logistics and an Utrecht office and hotel complex (pictured) respectively. The Dutch asset traded for €17.5 mln.

Burke says sales processes for smaller ticket, value-add office investments are gradually starting to increase as owners selectively target disposals, either to build up liquidity for forthcoming refinancings or to cut free properties from their portfolios that are not ESG-compliant. ‘It’s all about the forecast uplifts from investing in sustainability initiatives and there is healthy demand for well-located offices with short-term income at prices reflecting 7%-8%.’