European real estate set for recovery despite Middle East conflict

Despite immediate pressures from the Middle East conflict, the European prime real estate market is expected to recover and remain strong over the next five years (2026-2030), according to research by AEW.

Real estate - AEW

While the conflict has slightly impacted GDP growth (10 basis points annually), it's not expected to significantly affect long-term inflation or bond yields. However, a prolonged conflict could lead to lower GDP, higher inflation, and increased bond yields.

The underlying strength of occupier markets is boosted by a decrease in new construction across all sectors. This will lead to lower vacancy rates for offices and logistics, supporting strong prime rental growth forecasts of 2.4% annually in the base case and 2.1% in the downside scenario for 2026-2030.

In the base case, office yields are projected to tighten by 40 basis points over the next five years, followed by shopping centres (25bps), logistics (24bps), and residential (17bps). In a downside scenario, logistics and high street retail might see some yield widening.

Before the conflict, investor sentiment was positive, suggesting strong transaction volumes in 2025. While the current conflict is delaying some deals, pent-up investor demand is expected to drive long-term transaction volumes higher once confidence returns.

European real estate is projected to deliver an average total return of 8.7% annually in the base case for 2026-2030. Even in a downside scenario, returns are still a respectable 7.6% annually, demonstrating the market's ability to withstand external shocks due to high income and rental growth.

Among sectors, prime office markets are expected to have the highest returns at 10.0% annually, followed by shopping centres (8.9%), logistics (8.5%), residential (7.7%), and high street retail (7.2%).

However, it is crucial to select markets carefully, as local office market returns can vary significantly (e.g., Zurich at 4.5% vs. Canary Wharf at 16.9%).

The total returns in the base case are primarily driven by income return (5.3% annually) and rental growth (2.4% annually), with a smaller contribution from yield shifts (1.1% annually).