European economic outlook
Activity
After avoiding a technical recession in 2023 by the thinnest of margins, the Eurozone should return to positive, albeit modest, growth this year. Household consumption will lead the recovery, with consumers benefiting from the recent period of strongly positive real earnings growth. However, a negative fiscal impulse will pose a headwind. High-frequency activity data reflects a weak but strengthening economy. We expect the return to growth to accelerate as the year unfolds and as the lagged impact of rate hikes fully unwinds. Growth should normalise over 2025/2026, with gross domestic product (GDP) climbing over 1%.
Inflation
The Eurozone’s disinflationary process is well advanced but still has further to go. Forward-looking indicators of goods inflation suggest price growth in that component could slow even further. However, the ‘last mile’ of inflation will be made more difficult by sticky services inflation. Upward pressure on services prices from elevated unit labour cost growth remains strong. Indeed, short-term run rates of services inflation have been climbing. Nonetheless, below-trend growth should eventually prompt the labour market to loosen, causing these pressures to unwind. Overall, we expect inflation to at least temporarily drop below 2% before the year ends.
Policy
The European Central Bank (ECB) is gearing up for a cutting cycle. However, concerns about second-round effects from elevated wage growth remain pronounced. Speaking at the “ECB and Its Watchers” conference, President Christine Lagarde suggested the central bank is likely to wait for sight of first-quarter wage data and updated staff projections before loosening monetary settings. We therefore expect the first cut to come in June, and for the ECB to lower rates four times this year. The crystallisation of ‘last-mile’ risks to the disinflationary process could prompt the ECB to punctuate its cutting cycle with pauses.
Key takeaway
Cooling inflation and the likelihood of rate cuts in 2024 support the stabilisation of real estate yields in the second half of the year.
Eurozone economic forecasts
| (%) | 2021 | 2022 | 2023 | 2024 | 2025 | 2026 |
|---|---|---|---|---|---|---|
| GDP | 5.3 | 3.5 | 0.5 | 0.5 | 1.3 | 1.2 |
| CPI | 2.6 | 8.4 | 5.5 | 2.3 | 1.7 | 1.8 |
| Deposit rate | -0.50 | 2.00 | 4.00 | 3.00 | 1.75 | 1.75 |
Source: abrdn March 2024
Forecasts are a guide only and actual outcomes could be significantly different.
European real estate market overview
The European market went through a phase of relative stability in the first quarter of 2024. Yields proved to be remarkably stable, with 70% of the 380 segments covered by CBRE remaining static in March – the highest number since June 2022. After the global financial crisis, yields moved out for around 25 to 30 months. Yields have moved out for 21 months so far in the current market downturn, taking the two market corrections towards a similar duration.
The benign feeling of the first quarter has delayed real estate’s journey back to good value. We estimate that values edged lower by around 2%, on average. This would take the valuation-based peak-to-trough capital value decline to 19% since June 2023. Our analysis suggests that valuations lag market transaction pricing by around 7%, on average, across sectors and by 15% in offices.
The three big themes in the first quarter of 2024 were the outlook for interest rates, signs of distress among Europe’s lenders (and borrowers), and the expected turning point for the asset class. The first two of these have conspired to delay the likely turning point, as hawkish central bank messaging and a rise in non-performing loans have dragged on sentiment.
At the tail-end of 2023, there was a surge in expectations for interest rate cuts by the key central banks and fixed-income yields fell sharply. Lower borrowing costs and improving relative value against fixed-income assets drove a 25% rally in global REITs (real estate investment trust) share prices. However, this cooled-off during the first quarter, with expectations for the ECB main deposit rate cut pushed back to June. Swap rates have been volatile during this period, meaning overall debt costs have remained stubbornly high.
Banking-sector jitters returned. Non-performing loans have increased, and several banks have announced increasing loss provisions to cover impaired real estate loans. While lender risks have increased as values have fallen and loan-to-value (LTV) covenants have come under pressure, we consider most of the risk to lie with borrowers. Banks are well capitalised, with common equity tier-one ratios in excess of 15%. They have less than 6% exposure to real estate debt, the high-interest-rate environment has driven strong profitability in other banking activities, and we have seen banks working with borrowers to protect value rather than to foreclose.
It is more problematic from the borrower’s perspective. The private real estate debt funding gap has grown to an estimated €100 billion, mainly because of shrinking LTVs and weaker lender appetite, leaving borrowers with refinancing challenges. However, most institutional investors have been running more conservative debt strategies since the global financial crisis. The operational performance of assets is holding up well and the issues are largely ringfenced to poorly capitalised investors. The collapse of René Benko’s Signa group is resulting in the distressed sale of assets that are attracting opportunistic bids. But Signa Prime lenders are likely to recoup just 32% of their outstanding loans under the latest restructuring plan.
We don’t see the increased concerns around real estate loans as a systemic problem for the asset class. Combined with the delay in interest rate cuts to June this year, we have pushed back the turning point for capital values to the second half of 2024.
With relative value improving (all-property prime yield spreads versus Eurozone government bond yields increased to 250 basis points (bps) in March 2024), we believe European real estate is on the road to recovery. We should see an attractive entry point for investors from 2024.
European real estate sector trends
Offices
The outlook for European offices remains challenging. Take-up reached just 7.6 million square metres in 2023. This was 19% lower than in 2022 and 16% lower than the long-term average. The quarter-on-quarter rate of decline slowed in the fourth quarter of 2023, though, recording just 8% lower leasing activity. The decline was broad-based, with 24 out of 31 markets covered by BNP Paribas falling. Weak take-up led to a further increase in the overall vacancy rate in December 2023 to 8% in Europe (+40 bps since 2022). This is still relatively low compared with 20% in the US.
While vacancy rates increased steadily, prime rents continued their steep rise in most cities, highlighting the deep polarisation in the quality spectrum. In central Paris, the overall vacancy rate increased by 100 bps to 10% in 2023, yet the prime rent climbed by 7% to another new record of €1,067 per square metre. A similar picture can be seen in other major markets, such as London, Amsterdam, Madrid and Berlin. Consolidation into future-fit offices will continue to dominate trends in the sector.
Average prime office yields have increased from a peak of 3.2% in June 2022 to 4.6% in March 2024, according to BNP Paribas. We believe prime offices have a further 30 bps to go before they stabilise. Weaker assets have a capital expenditure challenge to meet future-fit expectations and will suffer much more substantial value losses.
Logistics
The logistics occupational market has begun to stabilise. Take-up for European logistics increased in the fourth quarter of 2023 to reach 8.1 million square metres, beating the long-term average. Vacancy rates have increased from 3.3% in 2022 to 5.4% in December 2024, yet the availability of best-in-class warehouses is scarce.
Conflicts in the Middle East have acted as a reminder of the case for nearshoring and for diversifying risks in logistics operations. The cost of shipping a container doubled between November 2023 and February 2024. We remain positive about the long-term drivers of demand from ecommerce, nearshoring, supply chain diversification, and modernisation.
Logistics rents increased by 6.9% in 2023. While this represents strong performance, the pace slowed from 9% in 2022. We expect rental growth to remain above the long-term average and above inflation in 2024 and 2025, as supply in good locations remains tight. We remain very cautious of poorer-quality assets that face significant capital expenditure, unless they are extremely well located.
Given the strong fundamentals and sharp correction in logistics values, sentiment is likely to turn a corner ahead of most other sectors. Investment in the fourth quarter of 2023 retained its 19% share of the total, but we expect this to grow.
Retail
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. Furthermore, with the drop in inflation, real wage growth has turned sharply positive, which is further supporting consumers.
Retail warehouse vacancy rates in Europe have fallen to 3.8%, on average, and as low as 2% in the UK. Shopping centres have a structural challenge, with vacancy rates increasing in the fourth quarter of 2023 to 12.7%. While retail warehousing represents our preferred retail segment, data from MSCI shows that net operating income per square metre has been falling since the pandemic. It remains a tenant’s market when it comes to rental negotiations, while weaker retail parks require substantial capital expenditure.
In 2023, retail attracted 19% of total investment, a notable increase. Retail yields have moved out a comparatively modest 120 bps since June 2022 and we expect resilience to continue. In our view, investors still need to be cautious of income risk in the sector, but selectively consider retail warehouse opportunities.
Living
The occupational fundamentals of the rented residential market have proven to be resilient during the pandemic and the current downturn. Vacancy rates across the top 30 European cities are estimated to be 3%, down from a peak of 4% in 2021. The tight market dynamics are leading to double-digit rental growth in the open market in some cities, with an overall average of 5% reported in 2023. We estimate that open-market European residential rents are likely to grow at 3% per annum over the next three years.
We remain focused on rental affordability as a key driver of performance and risk in the sector. With inflation dropping back, indexation pressure has cooled sharply to below the temporary caps introduced during the pandemic. This should support low churn rates and help to reduce operational costs. Very low levels of new supply across Europe further support the resilience of cashflows from the sector.
Like all sectors, living has not been immune to higher borrowing costs. Yields have increased too. European residential yields have moved out by 140 bps from their cyclical lows in mid-2022 (from 3.4% to 4.8% in March 2024). 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 the consumer price index (CPI). 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 performance and risk
The outlook for European direct real estate returns is improving each quarter. We forecast European all-property total returns of 1.5% over the year to December 2024. This is before a healthy recovery kicks in, with three- and five-year annualised total returns of 7.5% and 8.3%, respectively.
Following the 19% decline since June 2022, we anticipate a further 4% fall in European excluding-UK all-property values over the year to March 2025 (offices -7%, industrials –2.7%, retail –4.4%, and residential -0.5%).
Now that interest rates are likely to have peaked, we believe the yield revaluation phase is nearing the end. Logistics and residential values will be the first to stabilise, as the market bottoms out this year. Offices are clearly lagging.
We continue to consider the outlook in three phases:
Yield revaluation
We believe that the yield correction is nearing the end as rates peak; yields are expected to stabilise by mid-2024.
Economic recovery
We expect income risk and quality polarisation during the recessionary environment. Prime assets should outperform.
Low-supply rental rebound
We expect low-supply pipelines to support rental growth prospects, supported by indexation to CPI in lease terms.
We believe that risks are evenly balanced to the upside and downside. The sharp correction in values means the downside risk is more limited. The resilience demonstrated in economic fundamentals from parts of the global economy offers some upside potential.
We also believe that the market will offer strong opportunities to benefit from better entry prices for core and value-add assets. We favour overweight allocations to logistics, rented residential, student accommodation (PBSA), modern retail warehousing, and alternative segments such as data centres.
European total returns from December 2023
