The next few years will be difficult ones for the European property market. Earlier this month, real estate investor association INREV released the results of a survey showing that European real estate investors were the most conservative in the world, with 37% planning to reduce their real estate allocations over 2023 and 2024. This was in contrast to 20% and 5% of North American and Asian Pacific investors, respectively.

However, when you start looking under the surface, you start to see that there are indeed some national differences within Europe. Fifty percent of investors in the same survey ranked Germany as having the best investment prospects, with 44% ranking the Netherlands as such. The UK and France both scored 37%.

In the case of UK real estate, this sentiment reflects an unsettling reality. There are worries that the UK's property downturn will be much worse than the rest of Europe's, despite London's long reputation as the continent's most alluring city for property investment. British property values are expected to fall more quickly than in other European countries, and the country's long-term economic outlook is less promising as well. If those concerns come true, London could lose its status as Europe's financial hub.

With a brief tenure comes a lingering afterglow

Looking back at when the real estate downturn in Europe began will help shed light on the current situation in the UK. The third quarter of 2017 was the worst performing financial quarter for the MSCI European Real Estate Index since the third quarter of 2008. The drop from a positive return of 2.5% in the second quarter of 2022 was the largest quarterly change in the index's history.

The country with the worst performance in the index. That would be the United Kingdom, which had a return of -4.1 percent in the third quarter of last year.

The European economy slumped because of the sharp increase in interest rates implemented by governments across the continent in response to the soaring inflation caused by Russia's invasion of Ukraine. Over the past three months, the European Central Bank (ECB) has increased its deposit rate from 0.50% to 0.75%. UK interest rates increased from 1.25% to 2.25%. However, the UK's dismal showing is partly attributable to the Mini-Budget introduced by former prime minister Liz Truss. The subsequent confidence crisis resulted in record high interest rates for government borrowing. The yield on UK commercial property briefly fell below that of government gilts. Warehouse assets in Britain took a particularly hard hit in value because of the historically low yields available at the time.

Although the UK government's borrowing costs have decreased since the Budget, the Bank of England is still fighting an uphill battle to bring inflation under control. Although the Bank of England started its rate-hiking cycle ahead of the ECB, the UK inflation rate remained marginally higher than its Eurozone counterpart throughout most of last year.

Real estate values in the UK would fall as a result of rising interest rates because of the higher cost of debt incurred by buyers and developers. Europe will start to look better and better in comparison the longer this goes on. Opportunities arise when prices drop, but a sustained drop in prices would be a different story.

This information explains why the INREV survey found that German and Dutch real estate was a better investment than British real estate. This helps shed light on why the number of deals completed in the UK increased at a slower clip than in other European countries in 2017. It's true that some of these countries are emerging economies in eastern Europe, which explains their faster rate of growth. However, this is not to blame for the increased volume of real estate transactions in Germany. Economically, it's a juggernaut, and the numbers show that it's also becoming a real estate hub.

Tenant demand could fall in the UK as a result of a deeper recession and a higher number of business failures, adding to the country's woes of slower deal volume growth compared to many European nations. Economists polled by the Financial Times earlier this month are in agreement that Brexit is a major contributor to the gloomy growth forecast for the United Kingdom.

Sirius Real Estate (SRE) CEO Andrew Coombs shares these worries about the UK economy. He predicts that inflation in the UK will be higher and last for a longer period of time than it will in Europe.

A little more than a quarter of Sirius' assets are located in the United Kingdom, while the rest are in Germany. CLS Holdings (CLI), a competitor, has roughly half of its assets in the UK and the rest in France and Germany. Recent results for CLS show a slight reduction in the company's exposure to UK assets and a slight increase in its exposure to German assets.

This slight change cannot be attributed to the UK real estate market's dimmer outlook, but the company's UK assets are clearly underperforming when compared to its German and French holdings. It was reported in the company's trading update from the end of last year that the vacancy rates (a percentage representing unlet space) for its UK properties had increased to 8.9 percent as of September 30 from 7.6 percent as of June 30. Its vacancy rate in Germany decreased from 7.5% to 7.3% over the same time period, while its vacancy rate in France barely budged from 2.3% to 2.4%.

The experiences of CLS, despite being limited to a single business, are instructive. If the United Kingdom continues to lag behind the rest of Europe, British developers with European exposure, such as CLS and Sirius, may continue to prioritize acquiring assets in continental Europe over those in the United Kingdom.