European economic outlook

Activity

Data suggests European economic growth will contract again in the fourth quarter of 2023. This follows a 0.1% contraction in the third quarter. While this would confirm a technical recession, the substantive difference between a quarter of very modest growth and one of very modest contraction is small. Either way, the economy is experiencing recession-like conditions. Any recovery in 2024 is likely to be slow. Policy is unsupportive and the global backdrop is challenging, although positive real wage growth will provide some support from the consumer side.

Inflation

Following sharp declines in October and November, headline inflation rose 0.5 percentage points in December, taking the rate to 2.9%. However, the increase wasn’t related to anything fundamental. Rather, statistical distortions combined to push the headline rate higher. The removal of various government energy bill support packages poses upside risks in the first quarter of 2024. However, disinflation in core components is likely to continue, as past monetary tightening continues to weigh on prices. We expect the headline rate to return to target in the second half of 2024.

Policy

The European Central Bank (ECB) kept key rates unchanged last month and is expected to deliver another hold at January’s meeting. Despite an eye-catching rally in short-end rates, officials have yet to signal a change of strategy. While the central bank has acknowledged faster-than-expected disinflation, it remains concerned about strong wage growth. The commentary attached to the ECB’s latest decision suggests it will adopt a more flexible approach in the future, opening the door to earlier cuts. In addition, the ECB confirmed it will begin tapering its pandemic emergency purchase programme in the second half of 2024. We expect the first interest rate cut to come in April.

Key takeaway

Recession-like conditions persist in the region, weighing on tenant confidence, activity, and rental growth. Cooling inflation and the likelihood of rate cuts in 2024 support the outlook for real estate yields to stabilise in the second half of the year. Geopolitical risks are elevated and the raft of elections in 2024 mean the outlook remains more uncertain than the market would like.

European real estate market overview

The European real estate market entered a seventh quarter of decline in the fourth quarter of 2023. Values fell a further 3.5% over the three months, according to our preliminary data. This takes the average peak-to-trough decline to 17%. Our analysis suggests that valuations still lag market pricing by around 8%, yet there are signs that values will begin to stabilise as 2024 progresses. 

The sharp 25% rally in share prices for European listed real estate investment trusts (REITs) during November and December 2023 cooled-off in early 2024. But the rebound served as an indicator that negative pressures on direct real estate values are easing. The combination of higher real estate yields, disinflationary pressures, and peaking long- and short-term interest rates, is helping to reduce refinancing pressures and to rebuild real estate’s relative value.  

Weighted average European prime real estate yields have increased from 4.3% in June 2022 to 5.4% in December 2023. The spread between All Property prime real estate yields (5.3%) and government bond yields (weighted average Eurozone 2.8%) is now 260 basis points (bps). Against long-term averages, this implies core real estate is moving back to a position of fair value. 

However, what this measure ignores is the growth quality that real estate income carries, relative to fixed-income coupons. When looking at the attractiveness of real estate, an internal rate of return approach (which factors in net income growth) shows that real estate is beginning to look cheap at current market pricing. 

Operationally, real estate has been performing well overall. Prime office rents increased by 8% and logistics rents by 7%. Retail REITs have been reporting healthy like-for-like rental growth in 2023, against a backdrop of benign economic growth and the cost-of-living crisis. Take-up has been slow across most areas of the market, but the polarisation in tenant demand towards better-quality space has supported cashflows in good-quality properties.

Debt-refinancing challenges have been an ongoing issue for the market. An estimated €265 billion of European real estate debt, across private credit and bonds, was due to be refinanced in 2023. However, that debt was either refinanced, repaid, extended, written down, or defaulted without any significant systemic market implications. We believe this shows that most borrowers have been successful in managing their loan maturities, so far. 

Financing is accessible for many investors, albeit at a higher cost. Fears of a greater fallout have largely failed to materialise into a systemic issue for the market. Swedish banks have generally been less happy to renegotiate or to extend finance deals, given the overexposure to real estate, compared with their counterparts. 
A further €300 billion requires refinancing in Europe during 2024. But a 100 bp drop in the five-year Euribor swap rate more than offsets a 15 bp increase in lender margins in the fourth quarter of 2023. This reduced some of the pressure on costs. 

While we anticipate the outlook to be challenging in the short term, as we edge through the downturn and the expected recession, the prospects for real estate performance are improving. For those with equity to deploy in the coming months, both opportunistic and core strategies should benefit. For those running existing mandates, we still advocate a cautious approach and a focus on our Houseview recommendations. 

European real estate market trends

Offices

European office vacancy rates are rising steadily, up by 10 bps to 8.5% in the fourth quarter of 2023. Levels are still just short of the long-term average, but overcapacity is likely to persist at the overall market level. A combination of weaker economic fundamentals and structural oversupply, resulting from hybrid working, is biting. Savills suggests the overall loss of structural demand between 2024 and 2026 ranges between -5% in Berlin to -14% in Prague. While the trends are clearly polarised between better-placed, core, central business district locations and those in out-of-town markets, weak take-up 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 an 8% increase in prime office rents over the year to the fourth quarter of 2023, although we anticipate this to drop back to more modest levels this year. 
Investment in offices dropped sharply to represent just 26% of total investment in the fourth quarter of 2023, the lowest office share on record. Investors are reducing office allocations. Prime net initial office yields increased by 90 bps over the year to the fourth quarter of 2023, taking the weighted average to 5%. 

Logistics

The logistics occupational market has begun to stabilise after a sharp post-pandemic slowdown. Tenants are still taking a cautious approach to signing new leases. The latest available take-up data for the third quarter fell 9% year-on-year, a notable improvement from the 31% drop in the second quarter. Vacancy rates remain low at around 5% and the availability of best-in-class warehouses is scarce. Completions have reached around 8-9% of stock, but this is expected to fall to 4% this year. 
With conflict in the Middle East escalating at the time of writing, the case for nearshoring supply chain activities and for diversifying risks in logistics operations is likely to strengthen demand ahead of previous expectations. Therefore, we remain positive about the long-term drivers of demand from ecommerce, nearshoring, supply chain diversification, and modernisation.
Logistics rents increased by 6.9% over the 12 months to December 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.
Given the strong fundamentals and sharp correction in logistics values since June 2022, sentiment is likely to turn a corner ahead of most other sectors in Europe. 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. 
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 110 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. 

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 at the end of 2023. Green Street estimates that open-market European residential rents are likely to grow at 3% (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 extended the cap on consumer price index (CPI)-uplifts 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 4.7% in December 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 performance and risk

The outlook for European direct real estate returns is improving each quarter. We forecast European All Property total returns of 1.8% over the year to December 2024. This is before a healthy recovery kick in with three- and five-year annualised total returns of 7.4% and 7.8%, respectively. Following the 17% decline since June 2022, we anticipate a further 3% fall in European excluding-UK All Property values over the year to December 2024 (offices -5.7%, industrials –2.3%, retail –4.4%, and residential +0.4%). Now that interest rates are likely to have peaked, we believe the yield revaluation phase is nearing the end.

We are still breaking down the outlook into three phases:

Downside risks to our forecasts are elevated because of the weak economic outlook. Given the persistent uncertainty, we are still advocating a low-risk approach for existing mandates in the first half of 2024. This means reducing leverage and development exposure, reducing voids, and retaining higher cash weights.

However, we also believe that strong opportunities to benefit from better entry prices for core and value-add assets will arise for investors from today.