Asian investments into European real estate: Does the story need to be retold?

Continental European real estate markets were booming during the 2010s but are now going through an extended restructuring phase that started at the beginning of 2022.

Sven Wortberg and Heike Schmitz in Frankfurt and Benjamin Lohr in Hong Kong explore the lessons to be learned from the prior cycle for European GPs and Asian LPs.

Real estate investments in the 2010s

During the boom years, Asian LPs – like many others – were looking for attractive and stable returns and (thought that they had) found them in European real estate investments.

European real estate was seen by many Asia-based investors as one of the best sectors in which to invest because of attractive rental yields paired with good value appreciation.

Their allocations to real estate consequently increased over European listed equities (which were expected to offer attractive gains but with greater volatility) and government bonds (which offered marginal coupon).

In fact, in some instances the pitch to Asian LPs by European GPs was that real estate was essentially as safe as a government bond, only with better returns. This pitch contributed to Asia-based investors in particular putting their focus on European prime or landmark assets – many of them office buildings – which promised the highest degree of stability.

Check against current reality

Since 2022, the stability of European real estate investments has been subject to a reality check. It has become apparent that the investment does not offer the government bond-like stability that many attributed to it.

Real estate assets are complex structures with unique risks and opportunities, some of which only become apparent over time. Post-Covid-19 working habits have changed significantly: working in the office is no longer a must and agile working is here to stay. This significantly reduces the office space needed in inner cities.

The growing awareness of tenants, banks and co-investors of climate change and other ESG topics forces asset owners to provide material capex even for real estate assets, which were previously regarded as fully functional and only requiring regular maintenance and repair.

In sum, what has previously been seen as a straightforward, low-maintenance investment with a very stable income stream is turning out to be an asset class requiring material management and substantial post-acquisition capex to ensure that the rental income keeps flowing.

Consequences

All market participants are faced with these recent developments, which were not foreseeable at the time of investment and have permanently reshaped the real estate market. However, market participants were prepared to different degrees.

Those who have treated real estate as a government bond-type investment had no reason to build contingencies into their deal structures. Asian LPs in particular typically structured transactions as club deals or co-investments in joint venture form, oftentimes with small tranche syndication to several third parties.

What was meant to be a measure of risk mitigation through risk sharing has in some instances resulted in difficulties in agreeing on necessary cash calls to provide capex or equity injections. Having to deal with a diverse set of investors made it substantially more difficult to stabilise a distressed asset.

The only option in such scenarios is often a sale to a more flexible buyer that can inject further cash. At a time where real estate prices have declined significantly throughout Europe this is not a very attractive alternative for Asian LPs.

As a result, we see a number of Asian LPs rethinking their European real estate strategies. Their blind pool fund allocations into this asset class are being adapted to the actual risk-return profile considering the developments described. In most cases this leads to a reduction. Some Asian LPs even appear to be staying clear of European real estate for the time being as a result of the losses they have suffered since 2022.

Lessons learned

European GPs will likely need to adjust their commercial narrative to the new realities in the European real estate market when marketing their funds to Asian LPs. They will need to clearly articulate the risks of European real estate investments while at the same time highlighting the remaining opportunities.

European GPs will also need to develop their management capabilities to provide Asian LPs with comfort that they are equipped to successfully generate returns in the current market.

To manage the risks, known and unknown, procedures need to be put in place that allow the shift to a more active and involved management of real estate assets in the portfolio. This needs to include a demonstration that the GP can finance additional capex when needed. This in turn is expected to have an impact on fund terms (for example, more flexible borrowing terms and recycling provisions).

In deal structures, we expect firmer additional capital contribution obligations. If this is not feasible, European GPs need to be able to obtain third-party financing without individual LPs being able to block the corresponding process.

If such prerequisites are implemented, there is a good chance that it will be possible to once again convince Asian LPs of the opportunities that lie in European real estate – however, this time with more robust risk management.