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

2020 2021 2022  2023 2024 2025
 GDP  -6.2  5.3  3.5  0.6  -0.2 1.9
 CPI  0.3 2.6  8.4 6.0 2.2 1.6
 Depo  -0.50 -0.50  2.00 3.75  1.50  1.50

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.

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.