Rated European REITs' property valuations have been under scrutiny since central banks started increasing interest rates in an effort to reduce inflation in 2022. Strong rent increases, supported by inflation-linked indexation, weren't enough to compensate for the rate increases and prevent valuation declines, as S&P Global Ratings expected (see "European REITS: The Great Repricing Continues," published on July 18, 2023).

However, although we foresee a further 4% average decline in property valuations by mid-2024, we expect a stabilization thereafter. Moreover, we believe that cash flow expectations rather than interest rates will determine future valuations.

Property Valuations Should Stabilize This Year

We think that stabilizing interest rates and improving financial conditions--as evident from REITs bonds' reduced spreads and the gap between their share prices and net asset values--should help steady property valuations this year (see chart 1).

Chart 1

However, our ratings assume further value corrections beyond the 9% that REITs reported between June 30, 2022, and Dec. 31, 2023, across all property segments. This is because the volume of transactions is still subdued despite the recent improvement in financing conditions.

We understand that allocation limits are constraining large institutional real estate investors. At the moment, transactions mostly originate with family offices, cash-rich end users, and some private-equity investors.

We therefore assume an average peak-to-trough decline in valuations of 13% for rated REITs since June 30, 2022, up from our previous assumption of 10%, and a maximum of 30%, up from 24% previously (see charts 2 and 3).

Chart 2

Chart 3

Cash Flow Expectations Will Drive Valuations In 2025-2026

From mid-2024, we expect cash flow expectations rather than interest rates to drive valuations. This is because, by then, capitalization rates will have largely adjusted to the new interest rate environment, with average yields increasing by 50 basis points (bps) for retail properties or 130 bps for office properties (see charts 4 and 5). We expect the 10-year German bond yield to remain in the 2.40%-2.50% range until 2027. Rent forecasts will therefore start to influence valuations more.

Chart 4

Chart 5

Nonprime Offices Could See Headwinds Persist

Office REITs reported an average valuation decline of 11.7% between June 30, 2022, and Dec. 31, 2023. However, we continue to think that nonprime offices, which represent a major share of the market but a limited number of our rated issuers, will experience most valuation pressure among the asset classes.

This is because they should see more rent pressure--either from lower occupancy rates or negative rent reversion, or both--and high capitalization rates due the long-term challenges of hybrid working patterns and tenants' preference for energy-efficient buildings. Our ratings assume a valuation decrease of up to 30% for certain nonprime office REITs between June 30, 2022, and Dec. 31, 2023.

We generally define nonprime offices as those located outside city centers or central business districts, and therefore further away from public transport. We also consider offices to be nonprime if they have lower-than-average energy efficiency, as indicated on their LEED, BREAM, HQE, or energy performance certificates.

Residential Property Valuations Will Likely Stabilize

Residential properties have low yields in general because they benefit from sustained demand and long-term socio-demographic drivers. This could imply a lower risk premium than for other asset classes. However, rent indexation is lagging inflation, particularly in Germany, and yields--rents over valuations--have adjusted to the new interest rates, mostly through the effect on the denominator. This has resulted in an average valuation decline of 15.3% for our rated companies in Germany and 10.7% for those in the Nordics since June 30, 2022, for an average yield increase of 70 bps.

The Swedish market has also adjusted well thanks to its higher exposure to floating interest rates and greater vulnerability to institutional investments. We believe that valuations should stabilize gradually as the volume of small transactions increases. We think that stable mortgage rates, growing housing scarcity, elevated building-replacement costs, a resilient job market, and rising real disposable incomes should help valuations stabilize. Lastly, market rents have increased significantly in the past two years and should continue to have a positive bearing on valuations.

Logistics Asset And Prime Office Valuations Could Benefit Less From Rent Growth

After years of strong declines, the capitalization rate in both asset classes has risen sharply, with healthy cash flow growth partly offsetting this. While the effect of the capitalization rate will likely fade, we think that cash flow growth could slow because of a reduction in corporate expansion, higher unemployment, and, for logistics assets, the stabilization of e-commerce sales.

Positively, logistics assets represent a growing share of the investment market: 21.6% in first-quarter 2024, versus 10.8% in 2019, according to data from real estate company CBRE. Offices have historically dominated this market, but their share dropped to 21.6% in first-quarter 2024 from 41.6% in 2019. Demand from investors could be an important catalyst for logistics asset valuations.

Retail, Data Center, And Health Care Asset Valuations Are Likely To Be The First To Bottom Out

These three asset classes have seen average valuation declines of less than 5% since June 30, 2022. Their high yields at the start of the European Central Bank's rate hikes, along with their strong capacity to increase rents, has allowed them to cope with interest rate increases better than other asset classes.

Retail yields have already widened significantly since 2019 thanks to the rise in e-commerce and COVID-19 pandemic-related rent losses. Landlords' ability to raise rents and pass on inflation to tenants in the past 24 months has been remarkable, considering that cost-of-living concerns have hit consumer confidence and retailers' sales.

We believe that international retailers' ongoing flight to quality, some online retailers' development of omni-channel models following profitability struggles, and a low supply of new retail assets should continue to support the cash flows, and ultimately the valuations, of prime European shopping centers. AI and cloud-related demand should continue to boost data centers' cash flows. Health care, particularly acute care, should also benefit from undersupply and an aging population.

What Could Go Wrong?

Given the correlation between property valuations and financing conditions, we believe that a material rise in long-term rates, such as German 10-year bond yields, or another disruption of the capital markets due to political or geopolitical risk, for example, could derail the recovery in REITs' valuations. A strong and unexpected deterioration of the economy could also have negative implications for cash flow expectations, particularly if unemployment rates rise significantly. However, these scenarios are not part of our base-case assumptions.

Related Research

• Highlights From Our 2024 European Real Estate Conference, June 20, 2024
• German Residential REITs Remain Supported By Funding Access And Solid Rent Fundamentals, May 31, 2024
• AI In Real Estate: What To Watch As Adoption Accelerates, May 28, 2024
• Swedish Real Estate: The End Of The Slump Could Soon Be In Sight, Feb. 29, 2024
• Industry Credit Outlook 2024: Real Estate, Jan. 9, 2024
• European REITS: The Great Repricing Continues, July 18, 2023