European economic outlook
The deterioration in Eurozone’s activity data has come slightly sooner than expected and the Eurozone is currently experiencing recession-like conditions. As the impact of past monetary tightening is building, and no relief is forthcoming, we expect this weakness to continue into the fourth quarter of 2023. Leading indicators suggest that German activity might be nearing its trough, setting the stage for the ongoing recession to peter out at the start of next year. However, a recovery during 2024 is likely to be slow, given unsupportive policy and global economic headwinds.
Inflation fell sharply in September, driven by powerful base effects from Germany’s public transport subsidy scheme and last year’s sharp rise in energy costs. However, there are signs of moderation in short-term rates of core inflation, suggesting monetary policy is starting to have some success in normalising underlying price pressures. For now, index base effects will continue to drag the headline rate lower, especially in October and November. Over the longer term, enduring tightness in the labour market means underlying inflation dynamics will take some time to return to target-consistent rates. Nonetheless, we expect core inflation to drop significantly in 2024.
The European Central Bank (ECB) has probably finished hiking rates, having delivered a dovish increase at its latest meeting. October is almost certain to be a hold. And only a very large upside surprise to price data will trigger another hike in December. Having signalled that rates will remain restrictive until the underlying inflation outlook becomes consistent with the ECB’s target, we expect the Governing Council to keep rates near their current highs well into 2024. This is despite the bloc’s expected contraction this year. However, we anticipate a slow but deep cutting cycle once the impact of the downturn on price dynamics becomes apparent.
The macroeconomic backdrop remains uncertain. For real estate values, a faster drop in inflation could provide much-needed respite on interest rate and debt cost pressures, but this could be at the expense of weaker economic growth and subsequent rising income risk. In the event of stubborn inflation, the European letting structure with consumer price index (CPI)-linked contracts should support performance.
Eurozone economic outlook
Source: abrdn October 2023
Forecasts are a guide only and actual outcomes could be significantly different.
European real estate market overview
Since our last outlook report in July, the real estate market has moved another quarter further through the correction. The current valuation correction has entered its 16th month in October and has proven to be more painful than the Global Financial Crisis. As such, European real estate has endured a lot of pain already.
All eyes remain on inflation and central bank decisions. Inflation has cooled to 4.3% as at September 2023. Having increased by 25 basis points (bps) in September to reach a record 4%, the ECB deposit rate is likely to have now peaked. We believe this negative pressure on yields has probably plateaued.
The debate has now shifted to the shape of the rate outlook and whether we will have a ‘Table Mountain’ or ‘Matterhorn’ interest-rate cycle from here. There are some downside risks to rates given inflation is cooling, the Eurozone manufacturing purchasing managers’ index data fell to 43.3 in September, and Germany’s economy is contracting.
With a significant value correction already behind us, the question is when, not if, sentiment will improve. If growth remains resilient and interest rates are held at 4% for longer, then European real estate should show some resilience because of the strength of underlying cashflows and income growth. If the macroeconomic backdrop weakens and inflation falls, then interest rates should also fall. This would improve the relative attraction of good-quality real estate. The cost of debt should also moderate, but this is unlikely to ease the pre-existing refinancing challenges that are hampering the market. Whichever outcome prevails, the outlook for the asset class is likely to improve during the first half of 2024.
Markets that have lagged the re-pricing are now catching up. Sweden was the weakest market in MSCI’s Pan-European Funds Index for the second quarter of 2023. It had a quarterly return of -5.9%, compared with -1.0% for All Property. Spain and Finland delivered positive returns over the quarter at 0.5% and 0.1%, respectively. However, more current datasets in the third quarter show that these markets are now clearly falling, too. According to CBRE, Finnish yields moved out by (25 bps) in August. In Spain, Madrid’s central business district (CBD) and Barcelona’s office yields moved out 25 bps and 35 bps, respectively, in September. Central and Eastern European (CEE) markets, including Poland and the Czech Republic, are also now catching up with 25 bps increases across their key office markets in September.
There are signs of optimism returning to markets that have corrected and some investors are already taking advantage of better entry prices. However, broader confidence in where valuations truly lie is taking time to come through. We believe that as more fixed-term loans approach the point of refinancing in the coming quarters, better prices will emerge and the gap in expectations will narrow.
As we move through the cycle, the pressures will switch to quality and security of income. We are currently seeing various measures of tenant risk starting to rise, such as insolvencies, vacancy rates or tightening credit standards. This means we expect a greater dispersion in performance between prime and secondary property.
Finally, the one differentiating factor this cycle is the low level of supply coming through in the next few years. After a decade of low activity, renewed developer caution, 20-to-30% higher construction costs, labour constraints, and uncertainty around exit values, the supply pipeline has stalled. Germany reported a 36% year-on-year fall in housing permit issuance in August, UK office development starts hit a 22-year low in the first half of 2023, and the outlook for office completions in Europe is less than 0.7% per annum (pa) of existing stock. Insolvencies in the construction sector are spiking sharply in many countries. Even if permits increase, the capacity to deliver new projects in the future is likely to be restricted until the economy picks up. Low supply offers significant upside risk to rental growth expectations, in our opinion.
European real estate market trends
Office vacancy rates are rising steadily. A combination of weaker economic fundamentals and structural oversupply, resulting from hybrid working, is biting. Total vacancy rates were 8.3% in the second quarter of 2023, up from 5.8% in the fourth quarter of 2019. Lettings were 22% below the long-term second-quarter average and 32% below the rate in the first quarter of 2022. While the trends are clearly polarised between better-placed core CBD locations and those in out-of-town markets, this data implies a generally weaker outlook for the sector during the recession.
Competition from occupiers consolidating into well-located and energy-efficient buildings means the prime end of the market remains undersupplied. Headline rents are rising still. JLL data shows a 6.7% increase in office rents over the year to the second quarter of 2023. This clearly demonstrates the relative resilience of core locations.
Investment in offices dropped sharply to represent just 30% of total investment in the third quarter of 2023, the second-lowest office share on record. Investors are reducing office allocations. Average net initial office yields increased by 90 bps over the year to the third quarter of 2023, taking the weighted average to 6.4%. Prime yields increased by 25 bps in the third quarter, moving to 4.5%.
The logistics occupational market continues its slowdown. Tenants are taking a cautious approach to signing new leases. Take-up in the second quarter fell 41% year-on-year and by 17% from the first quarter. Vacancy rates remain low and the availability of best-in-class warehouses is scarce. The European vacancy rate is up slightly from a record low of 3.3% in the fourth quarter of 2022 to 4.7% in the second quarter of 2023. Completions have reached around 8-9% of stock, but this is expected to fall to 4% next year. We remain positive about the long-term drivers of demand from e-commerce, near-shoring, supply chain diversification and modernisation.
Logistics rents increased by 10.4% over the 12 months to June 2023. While this represents strong performance, the pace slowed to 1% quarter-on-quarter in the second quarter of 2023. We expect rental growth to remain subdued next year. In the longer term, we expect rental growth to exceed inflation and to attract investors back into the sector as the market turns.
Given the sharp correction in logistics values since June 2022, sentiment could be turning a corner. Investment in the second quarter increased by 23%, albeit from a very low base. Where values have fallen the most, we are starting to see more deal activity. Values in the Netherlands have fallen roughly 30% and transaction activity is returning.
The retail sector has been out-of-favour for the past cycle. However, the sector has recently been a relative winner, given the significant boost from the rise in the savings rate during the pandemic and the resilient labour market since.
Year-to-date, retail has attracted 19% of total investment – a notable increase compared with recent years. Retail yields have moved out a comparatively modest 100 bps since June 2022 and we expect this to continue in the fourth quarter. However, retail has been through a significant period of rebasing already. In our view, investors still need to be cautious of income risk in the sector.
The occupational fundamentals of the rented residential market have proven to be resilient during the pandemic and the current downturn. The tight market dynamics are leading to double-digit rental growth in the open market in some cities. Green Street estimates that open market European residential rents increased by around 8% in 2022 and that they are likely to grow at 4% (pa) over the next three years.
Affordability pressures have not abated, despite rent controls. New regulations have been introduced in 2023 in the mid-market in the Netherlands and at the national level in Spain. This means that six countries now have rent caps in place. France has extended the cap on CPI-uplift from the second quarter of 2023 to the first quarter of 2024. Where caps have been introduced, they have typically resulted in supply shrinking and open market rental growth accelerating. In Dublin, where rental indexation is capped at 2% in large parts of the city, open market rents increased by 13% year-on-year.
Like all sectors, living is coming under pressure from higher borrowing costs. European residential yields have moved out by 120 bps from their cyclical lows in mid-2022 (from 3.4% to 4.6% in September 2023). In contrast to the commercial sectors, residential has generally been more resilient. The impact on valuations has been offset by rental growth and links to CPI, where caps are not in place. We expect living sectors to show resilience given the low supply, but investors must be wary of new rent regulations and their impact on cashflows.
Outlook for risk and performance
Following the 20-25% decline since June 2022, we anticipate a further 4.5% fall in European excluding UK All Property values over the year to September 2024 (offices -7.4%, industrials -1.7%, retail -7.1% and residential -0.4%). Now that interest rates are likely to have peaked, we believe the yield revaluation phase is nearing the end. Downside risks to forecasts are elevated because of the weakening economic outlook and the ongoing difficulties in debt refinancing.
We forecast European All Property total returns of 0.7% in the year to September 2024, before a healthy recovery kicks in with three-year and five-year annualised total returns of 6.6% and 7.5%, respectively. Debt is not likely to be accretive until yields are above the all-in cost of debt and values have stabilised. The sector splits are highlighted in the chart below. During the forecast period, we expect a three-phase outlook:
- Yield revaluation – we believe that the yield correction is nearing the end as rates peak, yet price discovery will take more time as liquidity remains low.
- Economic recovery – we expect income risk and quality polarisation during the recessionary environment (the second half of 2023 and the first half of 2024).
- Supply driven rental rebound – we expect low supply pipelines to support rental growth prospects, while sticky inflation should support income growth.
EMEA Real Estate Outlook Chart 1: European Total Returns from September 2023
Source: abrdn October 2023
Forecasts are a guide only and actual outcomes could be significantly different.