"The investment case is growing: the scale of the opportunity has hit critical mass; future performance drivers are in place; and the fundamentals of the sector are differentiated to commercial real estate.”

Over the last 22 years, real estate investors with exposure to European residential assets are the cats that got the cream. Living assets have delivered stronger risk-adjusted returns than any other sector, as shown in Charts 1 and 2. The fundamental drivers of why the living sectors should form part of investors’ portfolios are well established, but the goalposts are moving. 

Demand and supply fundamentals across Europe’s major cities still support consistent cashflows and underpin long-term value in the sector. There are 10 million more renters in Europe today than in 2011 [1] , while new housing development is set to fall 10% over the next two years [2]. At the same time, the population of European cities is expected to grow by an average of 6% by 2035. Despite the supportive drivers, there are important nuances that investors need to consider. They need to limit risk to the performance from their investments, as pressures in the urban environment edge higher. The consequences of housing affordability pressures and the need to decarbonise the built environment are the two dominant forces re-shaping strategies in the sector. The predominant focus of these pressures are within Europe’s metropolitan areas.

Scope and scale

Firstly, it’s important to highlight that the scope and scale of the investment universe for living assets has grown across Europe’s cities. We believe the size of the European investible universe has reached critical mass to support pan-European residential strategies. And there is more growth to come. At an estimated €1.5 trillion, living assets represent 36% of the broader investible European real estate market [3]. In the definition of ‘living’, we include private-rented residential housing (PRS), purpose-built student accommodation (PBSA), and senior-living accommodation. Other forms of living are also included, such as serviced apartments, micro-living and some forms of healthcare. Investor allocations to living segments in non-listed funds have increased to nearly 15%, which has surpassed retail sector allocations [4].

“Policymakers are trying, and mostly failing, to address housing shortages; investors must understand the implications of increased policy intervention.”

Sector fundamentals

The fundamentals driving investment performance remain supportive, having survived a significant stress-test during the Covid-19 pandemic. Demand drivers – net-migration, urbanisation, ageing populations, increasing numbers of international students, and lifestyle choices – have structural tailwinds that bridge economic cycles. Chart 4 shows how we believe thematics and economic cycles will affect different real estate sectors.

Urban populations shrunk during the Covid-19 pandemic, but the urbanisation trend has roared back since the pandemic restrictions were lifted. Europe’s cities are once again thriving because of the broad appeal of job prospects and cultural attractions that stretch across generational brackets. Cities are expected to grow at a much higher rate than country-level populations, as shown in Chart 5. This trend is placing significant pressure on urban infrastructure and housing supply. Vacancy rates in residential portfolios are below 3% in many cities, according to reporting by listed real estate funds and our own data from abrdn’s portfolios. Supply is simply not keeping pace with the growth in demand for urban living. While this is supportive for cashflows, it is creating pressures in affordability across the housing market spectrum.

Affordability in the homeownership market is a further key pressure point. Homeownership is becoming increasingly unattainable as incomes struggle to keep pace with rising house prices and substantial downpayment requirements. Since 1960, median UK house prices have grown four times faster than household incomes [5]. In 2022, one in 10 European households spent over 40% of their income on housing costs [6]. Factors such as higher house price multiples, tighter bank lending standards, increased stamp duty, and higher mortgage rates contribute to this issue. Eurostat data reveals that between 2015 and 2023, Eurozone house prices rose 12% more than rental costs.

Supply is the other side of the coin, and this will fall short of meeting demand across living segments. In terms of rental housing, the UK and Germany need to deliver somewhere between 300,000 and 500,000 new housing units per annum to meet housing demand. These figures will not be met any time soon. New housing completions are well below these targets in Europe and they are set to fall by 10% in 2024 and 2025, compared with the last five-year average. Forward-looking indicators are depressed too, with the German IFO indicator for residential construction business expectations at a 30-year low. 

While supporting consistent cashflows, the rental housing shortage (now clearly a crisis across Europe) is creating affordability pressures. This will lead to increased regulation. Six countries introduced rental caps during the pandemic, to ease the pressure on household finances from the spike in inflation. Regulation is not always detrimental to residential performance. Sweden, for example, has one of the most regulated housing markets in Europe, and it has delivered strong relative returns compared with other countries. Regulation can lead to longer tenancies, fewer voids, and more consistent cashflows. 

However, new regulation must be well considered, fairly implemented and form part of a wider housing policy that promotes affordable housing development. Failure to tackle long-term undersupply issues will only exacerbate the pressures. Berlin has been a clear example of this. Residential rents in this city have increased by nearly three times since 2010, despite the well documented and uncertain regulatory backdrop [7]. Dublin paints a similar picture, where policy has failed to resolve the housing crisis. Dublin’s open-market rents have doubled over the same period, despite rental indexation being capped at 2% in most of the city. In fact, since the caps were tightened from 4% to 2%, open-market rental growth in Dublin accelerated to peak at 9% per annum in 2022 [8].

For landlords, performance is dependent on reducing resident turnover, limiting voids, and controlling operational expenditure. Understanding regulation, affordability pressures, and the impact on net cashflows is critical. We have therefore built a framework for assessing affordability to ensure our residents are happy and any cost leakage is minimised. You can read more about that in our recent insight article.

“Surveys show that institutions have residential strategies at the top of their buy lists.”

Investment and performance

Investment in European residential real estate has grown significantly in recent years and now accounts for more than 20% of total investment [9]. We believe it will converge with the maturity of the US investment market to reach a third of all capital deployed in the next five years. Cross-border capital and institutional investors make up a growing portion of the active investment market, eclipsing listed real estate investment trusts. 

According to index data from MSCI, pan-European residential returns have proven more resilient than commercial property, with rental cashflows mitigating some of the negative yield impact that we have seen since the market dropped in June 2022. The sector acts as a strong diversifier for institutional real estate portfolios, strongly reducing overall portfolio volatility and supporting returns. Unsurprisingly, sentiment surveys show that institutions have residential strategies at the top of their buy lists. 

“Any assets that will be detrimental to investors’ portfolio sustainability ratings, such as those awarded by GRESB, or that fall short of minimum energy efficiency standards, will become toxic.”

Quality and sustainability 

Investors must be aware of this gamechanger. Any assets that will be detrimental to investors’ portfolio sustainability ratings, such as those awarded by the Global Real Estate Sustainability Benchmark (GRESB), or that fall short of minimum energy efficiency standards, will become toxic. Quality and sustainability are having a demonstrable and growing impact on relative performance in the sector. Data and studies from Belgium, the Netherlands and Germany show how these pressures are materialising.

Firstly, there is a clear link between energy-efficiency ratings and value in the homeownership market, according to two studies in Germany and Belgium. The first is a study by the University of Duisburg, which found a 51% spread in house prices between residential properties with A-rated and H-rated energy-performance certificates. The second study, conducted by KULeuven University, found a 17% spread in prices between average efficiency housing and the lowest carbon-emitting properties. With energy bills rising, it’s not surprising that more energy-efficient properties are commanding higher values. 

Taking a forward-looking view, specific efficiency regulation in Germany was passed by the Bundestag Federal Government in 2023. It’s directly increasing the share of carbon taxes for landlords if they own and operate inefficient residential properties. Based on the new laws and on expected changes to carbon pricing next year, we estimate that carbon taxes liable to be paid for H-rated German residential rented properties could cost 5% of the total rental revenue [10]. The landlords’ share of carbon taxes is shown in Chart 7. 

While this doesn’t sound like a lot, carbon pricing will be determined by market forces from 2025 through the EU’s Emissions Trading System [11] , and the cost to offset emissions could increase sharply. In a sector where gross-to-net cashflow leakage is a major focus, every cent counts. We believe it will be an increasingly important determinant of relative performance in the future. Investors must focus on this crucial area.

Performance outlook

We believe the prospects for performance are compelling across the living segments. The key considerations are shown in our overall Living Houseview (Chart 8). Investors are particularly focused on the prospects for purpose-built student accommodation and standard private-rented sector strategies as we move into 2024. The senior-living sector is more in its infancy but carries strong long-term tailwinds from the ageing population demographic trend in Europe. The number of over 75-year-olds in Germany is nine million and over six million in France, yet bespoke senior-housing provision accommodates less than 4% of this age cohort, despite an ageing population outlook. Less than 1% of the provision is via private residences [12].

Following the current pricing correction, we expect returns from the sector to begin to recover in 2024, ultimately delivering a five-year annualised unleveraged total return of 8.3% [13] (see Chart 9). While rent controls and yield levels differ between markets, the country performance differential will be less important than the quality and sustainability dispersion. We advocate using our GlobalRiskNavigator to ensure market risks are balanced with return expectations. Portfolios must also remain focused on market risks when comparing the relative appeal of opportunities across cities.

Investment strategy

In addition to our market risk and total return forecast framework, our investment approach also includes an asset-level assessment of what we call AAA characteristics – a clear focus on affordability, amenities and accessibility - of our living investments. We believe that assets need to carry certain qualities within these three areas to prove attractive to residents and therefore to investors over the long term. Held assets that fall below these criteria are improved or sold and new acquisitions must meet them to find their way into our portfolios. 

“Energy efficiency will be a growing determinant of performance and liquidity in the market, while rental levels need very careful consideration given the pressures in affordability.”

Final thoughts

The world of residential investing is expanding and institutional capital is becoming well established in the sector. The investment case is growing: the scale of the opportunity has hit critical mass; future performance drivers are in place; and the fundamentals of the sector are differentiated to commercial real estate.
The big question for existing and future strategies is how best to adapt to the changing pressures in the market. As we have learned from the retail and office markets over the last decade, standing still and failing to adapt to disruption in the market can leave you exposed to obsolescence – both in terms of assets and investment strategy. For abrdn, energy efficiency will be a growing determinant of performance and liquidity in the market, while rent levels need very careful consideration given the pressures in affordability. Identifying and measuring these elements of performance will be a key differentiator across strategies.