Real Estate Outlook – Europe, Edition May 2024

The European real estate market is healing. But the next few months will be crucial in determining how robust the recovery will be.

Olaf Margeirsson, Real Estate Research & Strategy – Europe

We’ve come a long way from the highs of inflation and interest rates – and the ensuing capital value correction. A new cycle is in its infancy, but the effects of the last one still linger.

Choppy inflation waters

The European economy, despite lackluster growth, continues to surprise on the upside. The eurozone’s gross domestic product (GDP) expanded by 0.3% in 1Q24, its strongest pace for more than a year and up from two consecutive quarters of GDP contraction, thereby marking the end of the recession. A key contributor to the growth was Germany, where the economy expanded by 0.2% in 1Q24, up from -0.5% in the last quarter of 2023. The Spanish economy, in the meanwhile, has now expanded by 0.7% two quarters in a row while France and Italy saw GDP growth of 0.2% and 0.3% respectively in 1Q24.

Across the Channel, the UK economy has exited its recession already, growing 0.6% in 1Q24. Purchasing Manager Indices (PMIs) also signal a growth trend, with PMI for services coming in at a solid 55.0 in April 2024, its highest value for almost a year. The manufacturing sector is somewhat struggling though, with April PMI coming in at 49.1. A similar story is to be told in the eurozone, where services are expanding (April PMI: 53.3) at a pace not seen for a year while manufacturing (April PMI: 45.7) is hampered by secure access to gas and cheap-enough energy, especially in Germany (manufacturing PMI: 42.5).

Overall, we expect the eurozone economy to expand by 0.6% and 1.2% this year and next, while the UK should see only 0.2% growth this year before rebounding to 1.5% in 2025. The two-speed dynamic between the service and manufacturing sectors should however be kept in mind, as it may create a downside case in the form of unequal growth between areas and parts of the economy which may affect the growth dynamic down the line.

Parallel to the resilient economy, the inflation dynamic continues to improve – albeit perhaps not enough. Headline annual inflation in the eurozone and the UK is currently around 2.4% and 3.2% respectively, edging towards the 2.0% inflation targets of the region’s key central banks. However, the most recent data points imply that annual inflation has begun to flatten, repeating the pattern visible in the US economy: the annualized 6-month inflation is now equal to the 12-month inflation for the first time since autumn 2022. This implies that the momentum in inflation has stabilized around the current value (see Figure 1) and that value is still too high.

Figure 1: Eurozone inflation and interest rates

Our base case is that inflation in the eurozone ends the year around its current value (2.4%) before softening marginally to 2.1% in 2025. The numbers are similar for the UK. This would, we expect, push interest rates on the short end of the yield curve somewhat down as policy rates are cut to 3.0% (deposits) and 4.25% in the eurozone and the UK respectively by the end of the year.

However, the risk exists that inflation momentum builds up again, especially as services inflation is still elevated at 3.7%. If that happens, the expected policy rate cuts are likely to be delayed to later this year. Longer-term risks to the inflation outlook are then also likely to spill over onto long-term interest rates, which are the key risk-free pricing standard for real estate investments. We can already see this risk being priced into interest rates as the 5-year EUR swap rate is now around 3.0% having dipped below 2.5% around the end of last year. This has raised the debt financing costs again, shrinking the set of attractive risk-adjusted investment opportunities at any given capital value.

The European real estate market is healing. But the next few months will be crucial in determining how robust the recovery will be. The key dynamic to watch is the inflation development, as it determines how aggressively central banks will be able to release their brakes by lowering policy rates. The dynamic will also affect mid- and long-term interest rates, and will consequently greatly affect how firm the recovery in real estate capital markets is set to be.

Transaction levels continue to be suppressed

Total annual commercial transaction volume in Europe amounted to EUR 95.7 billion by the end of 1Q24 according to preliminary data from MSCI: the lowest investment volume in real terms since 3Q09 (see Figure 2). Both the office and retail sectors are at their all-time lows in terms of (real) investment volume as of 1Q24, seeing EUR 36.9 billion and EUR 27.5 billion respectively traded in the year ending in 1Q24. The wider industrial sector, however, saw assets worth EUR 31.3 billion change hands over the same time period and apartments worth EUR 29.2 billion.

Figure 2: Europe, inflation-adjusted investment volume by sector (EUR billion)

The disconnection between sellers’ and buyers’ price expectations is still in place, standing at ~20-25% in many cases. This gap can only be closed in two ways: sellers capitulate eg, due to valuations reflecting better the low level of liquidity in transaction markets, or buyers’ risk-adjusted required returns are lowered eg, due to lower interest rates or easier access to debt financing. The latter is somewhat unlikely still, as the risk of higher-for-longer interest rates has increased again while data from the UK tells us that debt financing has hit its lowest value in over a decade.

The probability of sellers capitulating is also somewhat low: external debt was largely kept under control in the years after the GFC, keeping debt-service coverage and loan-to-value ratios at levels which allow investors today to absorb a considerable increase in debt costs. Indeed, distressed sales are few, amounting to less than EUR 2 billion in 2023 (compared to EUR 3–6 billion p.a. in 2016–2019).

Their share of total transaction volume is rising though, and as such they may increasingly become important data points in valuations as appraisers look for sales comparables in the market. Nevertheless, it is difficult to see transaction activity rising significantly while the new level of interest rates is digested by appraisers and investors alike. High-equity buyers are likely to continue enjoying the lack of competition in the transaction market.

However, there are some green shoots in place. First, the annual drop in transaction volume is somewhat improving despite it still being negative. This applies primarily to the industrial (logistics) sector, where the annual drop in inflation-adjusted investment volume is now -28% compared to -47% in 4Q23. So while the change in transaction volumes is still negative, the momentum has begun to improve.

Second, many contrarian investors would highlight the fact that investment volume has been so weak eg, hitting an all-time low in the office and retail sectors on an inflation-adjusted basis, and take it as a signal of a recovery being around the corner. Any investor that entered the market during the lows of 2009 would eg, tell you that the timing was optimal. However, the dynamic in leasing markets is now considerably different and calls for a granular and selective approach.

Leasing markets painted by structural trends

Two trends have generally continued in the office leasing market. First, total demand is soft (see Figure 3). Looking at the sum of some key European markets – 20 markets in total¹ – we see that only three of them are seeing gross demand (take up) for offices over the last year being higher, than over the last five years: Milan, The Hague and the City of London. Other markets’ gross office demand is often 10-20% below the five-year average – which includes the COVID-19 affected numbers for 2020 and 2021. Looking at the sum of take up over the 20 markets we see it is approximately 7% below the 5-year average.

Furthermore, trailing annual net absorption (net demand) is negative by 266,000 sqm in the 20 markets and well below the average 5-year trailing net absorption. With office completions in 1Q24 totaling 853,000 sqm, only some of which were pre-let, the amount of vacant space has generally increased. However, vacancy rates still only sit around 8% on average over the region as a whole and out of the 28 markets we have up-to-date data for. Nearly half (11) saw their vacancy rates drop in 1Q24.

Furthermore, prime rents continue to rise over the past four quarters in many markets, up 13.5% in Madrid, 10.7% in London West End and 14.3% in Munich to name some of the cities with the strongest prime office rental growth. Only one market, Dublin, saw prime rents drop (-3.9%) over the past 12 months as vacancy rates, now at 17.7%, climb to levels last seen in 2013. The need for a nuanced view in European office markets is therefore high. Demand is clearly weak but it has shifted towards the high-quality assets which continue to see their rents rise despite the weak overall demand, the reason being that tenants want to rent high-quality assets in order to entice workers back from their desks at home.

Figure 3: Annual gross and net demand in 20 office markets in Europe

Demand in logistics markets continues to moderate around the pre-COVID-19 level of approximately 4 million sqm per quarter. After the soft economy affected demand during the latter half of 2023, net absorption hit 3.8 million sqm in 1Q24 in Europe’s main logistics markets, up 12% QoQ. Net completions have recently kept pace with absorption, with 4-quarter trailing net completions amounting to 17.8 million sqm vs. net absorption of 12.7 million sqm over the same period.

Vacancy rates have consequently risen but from a low base, standing now close to 5% in the UK and France, but below 3% in Germany and the Netherlands. Prime rents are consequently still rising: out of 81 logistics markets in Europe, 64 are seeing rents rise over the last year, thereof 20 where rental growth is more than 10% YoY.

The residential sector is another sector where rents are rising on the back of shortage of housing for rent. Vacancy rates in the sector hover just above 1% in Europe as a whole, clearly showing how acute the supply shortage on the rental market is. Rents are consequently rising, with rental growth hitting 5.9% YoY by end of last year, beaten only by the industrial sector. Student housing rents are especially under pressure, a key reason why annual rental growth in the Spanish residential sector rose by more than 12% in 2023.

The life sciences sector also continues to prove its attractiveness from landlords’ perspective. Lab vacancy in the Golden Triangle remains very low or around 1% in Cambridge and London but 4% in Oxford. The sector is slowly but securely transforming from the old owner-occupied model towards landlord-tenant setup as pharmaceutical companies wish to use their capital to invest in research and development R&D and other capex rather than bind it in buildings.

There is an acute shortage of flexible lab space in multi-let life-sciences buildings, especially for companies that are outgrowing their incubator space and are looking for space to accommodate them during their next growth stage. The life sciences industry is also facing multiple new trends – mRNA vaccine development, implementation of artificial intelligence (AI) in R&D and manufacturing and home-shoring to name just a few – that are likely to continue driving the leasing demand for life sciences buildings.

Finally, the retail sector continues to see improvements in the leasing sector, albeit mixed across countries. In Germany, vacancy rates in the sector have hit 11% as of year end 2023 while they are at only 4% in France. Even the UK, where the retail sector was struggling the most, has seen vacancy rates drop from their highs of 10% back in 2021 down to 6.5% today. Annual rental growth has now been positive, albeit low (1% by 1Q24) in the UK for five consecutive quarters, confirming that while the sector’s recovery is weak it is far from the precipice, we were looking at 2–3 years ago.

Given how high yields are in the sector – ca. 6.0% for a well-let retail warehouse in the London area – income-driven investors may consider entering it again now that leasing fundamentals have improved significantly. In fact, the London retail warehouse segment has seen yields drop since the beginning of the year, sparking the question: are we at the trough in capital values?

The direction of capital values is a tug of war for now

There are four distinctive yet interconnected factors to consider when we estimate where we are in the capital value cycle: the gap between appraisals and transaction values, (long-term) interest rates, leasing market fundamentals and market sentiment.

We know that appraisal and transaction values can become disconnected, especially when fundamentals, such as interest rates, change quickly. The UK appraisal methodology focuses more on updating valuations so that they reflect potential transaction prices, while eg, German appraisers have the tendency to change appraisal models slowly. The latter creates a smooth valuation trend, which is welcomed by many long-term real estate investors, compared to the potentially sharp valuation corrections that are more often observed in the UK.

But smoothing valuations over time risks creating a wedge between transaction prices, which are a function of what potential buyers consider the fundamental value of real estate to be eg, interest rate levels, and valuations. At the same time, potential sellers anchor themselves at the appraisal value and are very reluctant to sell assets below it. If they are not forced to eg, due to limited need to de-lever portfolios, the number of transactions drops. This is indeed the situation in many European office markets.

Low transaction volume affects sentiment: many market participants want to see at least a normal level of transaction volume to have the confidence to enter markets. Weak market sentiment can cause the number of prospective investors to drop, which affects transaction values as fewer investors bid against each other on the assets that are sold. This can cause a pressure on transaction values, which then, with time, feed onto valuations as appraisers consider sales comparables when they estimate properties’ values.

In our last commentary from November 2023, we discussed how common it is to see interest rates drop by ~150bps over the next two years after their cyclical peak. We penciled in a target of seeing the 10-year Bund and the 10-year Gilt around 2.3% and 3.5% respectively around the end of 2024 and, if history is any guidance, around 1.5% and 3.0% by end of 2025.

While we recognize the upside risk of policy rates staying higher for longer – see previous discussion – we see nothing that fundamentally changes our view regarding the longer end of the yield curve. We will need to see a few more negative inflation measures before we change our minds. Until then, however, our view from November on the interest rate influence is largely unchanged.

The same goes for the leasing market fundamentals. The key trends are: contraction of office demand but a simultaneous shift towards central and high-quality assets creating a wedge between prime and secondary rental growth; moderating but healthy logistics demand where increased supply reduces pressure on rental growth towards its structural trend; shortage of life sciences and residential housing driving rents where regulation allows and; weak but persistent rental growth recovery in the retail sector. There are few signs in leasing markets, bar secondary-quality offices and ESG non-conforming assets, that spell serious trouble for investors.

It is the first two factors – weak market sentiment and the gap between valuations and transaction values – which are heavy weights on European real estate markets. The other two, interest rates and leasing fundamentals, are however neutral or supportive by now.

Consider the following. As interest rates rose in 2022, so did risk-adjusted required returns across all real estate investment strategies. Higher required returns call for a) lower going-in price or b) stronger rental growth. Where rental growth was inadequate, values dropped and net initial yields rose. This is what happened in Paris CBD offices (see Figure 4).

However, now that yields have corrected and leasing fundamentals are sound, the gap between yields and market-risk driven yields has narrowed. This is the time when one should be investing in a market as values have largely corrected and the cyclical peak in yields – accompanied by the cyclical trough in values – is near. There is a tug of war happening between the first two factors, delaying the capital value recovery, and the fundamentals, which point to rising capital values.

Figure 4: Paris CBD offices – prime yield and our estimate for market-risk required prime yield (%)

On your marks!

The Paris 2024 Olympics start in July. Every runner knows that while the race only begins when the starter pistol goes off, the competition begins long before the training sessions: “train hard, win easy” as was once said about what Kenyan runners do. Injuries must also sometimes be endured, a period when runners may change their training and race schedule to recover. A successful race is also only performed if the runner has a good warm-up and is fully prepped on the line when the pistol fires.

Many investors in European commercial real estate markets have suffered injuries over the last two years. Some are likely to endure further setbacks, depending on when, if and how the gap between valuations and transaction prices is closed. Many investors are wary, burned by recent experiences. They are waiting for the starter pistol to go off before they re-enter the real estate market.

Other investors are not. They are warming up already, knowing that while they cannot with 100% accuracy predict when the market’s pistol goes off, they certainly want to be ready at the starting line when it happens. They are the ones who are likely to outperform, the ones who train hard and win easy.

¹ Vienna, Brussels, Paris Ile-de-France, Berlin, Dusseldorf, Frankfurt am Main, Hamburg, Munich, Dublin, Milan, Amsterdam, Rotterdam, The Hague, Utrecht, Lisbon, Bratislava, Barcelona, Madrid, London City, London West End.