European economic outlook
Activity: Activity data is sending mixed messages. Gross domestic product (GDP) contracted by 0.1% in the first quarter of 2023, taking the economy into technical recession. However, the weakness was not broad based. The composite purchasing managers’ index (PMI) slipped to 50.3 in June, but this still points to positive, albeit modest, GDP growth. Likewise, the economic sentiment indicator has fallen back in recent months but is consistent with modest growth. The industrial sector is shrinking, bank lending conditions are tightening, the impact of monetary tightening is building, and retail sales are slipping back. We expect the economy to fall into a full-blown recession in the fourth quarter of 2023.
Inflation: Inflation is dropping back but remains high. Headline inflation fell to 5.5% year-on-year in June and will continue to fall sharply as energy base effects moderate. Core inflation ticked up to 5.4%, pushed higher by base effects from Germany’s public transport subsidy scheme. Inflation should continue to fall modestly, given global disinflationary forces in the goods market. But core services inflation is being boosted by all-time lows in the unemployment rate and strong negotiated wage rounds.
Policy: The European Central Bank (ECB) is still in rate-hiking mode and its recent signals have been hawkish. It increased the deposit rate by 25 basis points (bps) to 3.5% in June, and a July hike seems all but certain. Policymakers have left the door open for a September hike, citing strong wage growth and sticky inflation risks. However, whether this September hike materialises remains very much data-dependent, with a hike requiring high underlying inflation measures. A recession would likely mean a rate-cutting cycle during 2024.
Eurozone economic outlook
Source: abrdn July 2023
Forecasts are a guide only and actual outcomes could be significantly different.
European real estate market overview
We estimate that the European real estate market has seen a peak-to-trough fall in values of roughly 20%. Interest rates set by the ECB are now broadly expected to peak at the end of 2023. The ECB is expected to hike a further 25-50 bps, taking the cumulative hike to between 4.25% and 4.5% since mid-2022. This leads us to believe that we are around three quarters of the way through the yield revaluation phase and that this pressure will subside as we move through the second half of 2023.
Some markets seem to be lagging the correction, relative to their market risks. We believe Sweden, Finland, Poland and the Czech Republic will need to see a stronger correction in values from here for pricing to reflect risk.
Our expected turning point for continental European real estate has been pushed back to the turn of this year. This is because of stickier inflation and the higher peak level of interest rates. We are also receiving mixed signals from the listed market. Steep discounts to net asset value (NAV) are taking longer to erode than previously anticipated and debt refinancing issues are weighing on the outlook. Furthermore, fixed income yields seem to have peaked in this cycle (at 4.2% for BBB-Eurozone corporate bonds, 3.2% for AAA-rated corporate bonds and 2.3% for German long-term government bonds, as at 29 June) but they have not contracted as we had expected. This means spreads have further to widen to restore fair value.
There are signs of optimism returning to the market and some investors are already taking advantage of better entry prices. However, transparency around where valuations truly lie is taking time to come through. We believe that as more fixed-term loans approach the point of refinancing, there will be more willing or forced sellers. We believe there will be another 5-10% fall in asset values in the second half of 2023, taking the total decline to over 25% in aggregate.
As we move into the weaker economic environment, the pressures in the real estate market will switch to focus on the quality of income and those asset types that are more closely linked to economic trends.
Weaker occupier trends in the sectors most linked to the economic cycle are clear. Logistics and office take-up fell sharply in the first quarter of 2023. Retail has held up above expectations in the face of the cost-of-living crisis, but eurozone retail sales turned negative in May and consumer confidence indices remain close to record lows. Higher mortgage and household loan costs will continue to limit disposable incomes, while excess savings are running lower. As expected, demand in the living sector and supply fundamentals remain strong, with high occupancy rates helping to support consistent cashflows.
Finally, we are monitoring a significant increase in regulation. Firstly, residential rent regulation has increased further. We have also seen revisions to the Plan Local d’Urbanisme (PLU) bioclimatique in Paris, which will significantly affect office holdings in certain areas. Furthermore, the introduction of the European Commission’s Energy Performance of Buildings Directive and the broader European Green Deal will act to accelerate obsolescence. Discussions around the regulation of energy supplies for German residential property, as well as the expropriation laws tabled in Berlin, are back in the spotlight.
European real estate market trends
Office vacancy rates are rising quickly now. A combination of weaker economic fundamentals and structural oversupply, resulting from hybrid working, is biting. The total vacancy rate was 7.3% in the first quarter of 2023, up from 5.6% in the fourth quarter of 2019. JLL estimates that this will continue to rise towards 8% in 2024, but these forecasts could be revised up after very weak leasing data recently. While the trends are clearly polarised between core central business district (CBD) locations and those in out-of-town markets, this data implies a weaker outlook for the sector.
Occupiers are consolidating into the most energy-efficient buildings, which means the prime end of the market remains undersupplied and headline rents are rising. Savills reported a 7% increase in 'green' office rents over the year to the first quarter of 2023. Investment in offices dropped sharply to represent just 28% of total investment in the first quarter of 2023, the lowest share on record. Investors are clearly aiming to reduce office exposure. Average net initial office yields increased by 50 bps in the second quarter of 2023, taking the weighted average to 6.4%. Prime yields increased by 20 bps in the second quarter, moving up to 4.6%. This reflects the growing importance of quality and efficiency, and the decoupling that is taking place between best-in-class buildings and the rest.
The logistics sector is showing signs of slowing down, in line with the economic backdrop. Take-up has fallen 40% since the peak in the fourth quarter of 2021. Vacancy rates remain low and the availability of best-in-class warehouses remains scarce. The European vacancy rate is up slightly from a record low of 2.6% in the first quarter of 2023 to 3.5% in the second quarter. We expect vacancy rates to edge-up further during the recession. Completions have accounted for around 8-9% of stock and this supply is giving tenants more choice while overall demand is subdued. We remain positive about the long-term demand drivers of ecommerce, near-shoring, supply chain diversification, and modernisation.
Logistics rents have increased by 30% since 2008. But given the short-term impact of the weak economic backdrop, we expect rental growth to slow from recent highs. In the longer term, we expect rental growth to exceed inflation and to attract investors back into the sector as the market turns.
Liquidity is currently low given the mismatch in buyer and seller pricing expectations. The cost of debt remains elevated, which is squeezing leveraged investors out of the market. Where values have fallen the most, we are starting to see more deal activity. Values in the Netherlands have fallen by roughly 30% and some investors already consider the sector to be offering better value today. Since June 2022, yields have moved out 150 bps in the sector across Europe.
The retail sector has been out-of-favour for the past few years. However, retail has recently been a relative winner given the significant boost from the rise in the savings rate during the pandemic. The shorter-term outlook doesn't look promising, though, considering the expected recession. Consumer confidence levels are also expected to remain subdued.
In the first half of 2023, retail attracted 19% of total investment, a notable increase compared with recent years. Retail parks have been the clear preference for investors. The appeal of this format has held up better than expected coming out of the pandemic, as flexible working practices have reinforced the purchasing power within catchments and physical retail stores have enjoyed a resurgence.
Retail yields have moved out 100 bps since June and we expect yields to expand this year. However, retail values have been under pressure since 2016 and the sector has been through a significant period of rebasing already. The spread is historically high, and the decompression will likely be less severe compared with offices or logistics. Low construction activity, following a decade of negative sentiment, should support cashflows too.
The occupational fundamentals of the rented residential market have proven to be resilient during the pandemic and this current downturn. The tight market dynamics are leading to double-digit rental growth in the open market in some cities. Green Street estimates that overall European residential rents increased by around 8% in 2022 and that they are likely to grow at 4% per annum over the next three years.
Affordability pressures have not abated. New regulations have been introduced in the mid-market in the Netherlands and at the national level in Spain. France has extended the cap on consumer price index (CPI)-uplifts from the second quarter of 2023 to the first quarter of 2024. In Berlin, the expropriation of privately owned rental accommodation has been passed by an expert commission, and a new law could be implemented by the new government within six months. Landlords holding over 3,000 units could be affected, although the details are still unclear. Once introduced, the new law could have another two years before it comes into action to allow for any challenges by the national constitutional court.
The living sector is coming under pressure from higher borrowing costs. European residential yields have moved out by 110 bps from their cyclical lows in mid-2022 (3.4%) to 4.3% in June 2023. In contrast to the commercial sectors, the pace and consistency of the re-pricing has been more stable in living assets than in other sectors. The impact on valuations has been offset by rental growth and indexation from CPI too. We expect the living sectors to continue to show resilience due to low supply, but investors must be wary of new rent regulations and their impact on cashflows.
Outlook for performance and risk
Following the 20% decline since June 2022, we anticipate a further 5.5% fall in All Property values over the year to June 2024. The yield revaluation phase appears to be closer to the end than the beginning, although risks of another step down are higher because of the weakening economic outlook and the ongoing difficulties in debt refinancing.
We forecast European All Property total returns of -1% over the year to June 2024, before a healthy recovery kicks in with three- and five-year annualised total returns of 5.3% and 6.1%, 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.
Given the elevated risk levels and the delay in the turning point to early 2024, we currently believe in a low-risk approach. This means reducing leverage and development exposure, reducing voids and retaining higher cash weights. We also believe that strong opportunities may arise for investors over the next 6-12 months, so being ready to take advantage of better pricing points will be crucial.
Chart: European total returns from June 2023
Source: abrdn June 2023
Forecasts are a guide only and actual outcomes could be significantly different.