European Market Commentary: Q2 2022

The economic outlook has continued to worsen over the last three months with the Eurozone facing a number of headwinds.

Eurozone inflation has continued to increase and hit a fresh all-time in June at 8.6%. While this remains majorly driven by energy prices (despite government intervention in many countries), more worryingly, core inflation has also continued to increase. While sentiment indicators have been somewhat resilient at the start of the year boosted by optimism over the end of Covid-restrictions and pent up demand, PMIs and sentiment indicators are now firmly pointing downwards. Especially consumer confidence that has continued to erode, which does not bode well for private consumption. And at a global level, lower export demand from dwindling growth in the US and Asia is further impacting growth in Europe. With no end in sight to the war in Ukraine, the eurozone economy is set to remain subdued we now expect growth to slip to 2.5% in 2022 and 1.9% in 2023.

Occupier markets have so far not seen any significant deterioration in conditions. In the office sector, take-up seems to have been robust in H1. Vacancy has continued to nudge upwards as new schemes complete. However, vacancy rates remain at moderate levels overall and low for high-quality space. And as a result of high finance, construction costs and the subdued growth outlook, future supply after 2023 is now expected to be lower then previously forecast. Consumers and retailers are hit by strong inflation, but excess savings from the pandemic has so far avoided a large scale drop in retail sales. The current situation will however lead to lower spending which adds pain in a sector that continues to feel the pressure from online sales and the fallout from the pandemic. And in the industrial/logistics sector high levels of supply in recent years, high fuel-costs and potentially lower demand (online and offline) from consumers hang over the sector.

The ECB has vowed to fight inflation and has signalled, that it will start to hike interest rates with a 25 bps move implied for July and another 50 bps in September, bringing the deposit rate back to 0% and the refi rate to 0.75%. As a result, bond yields have seen significant increases.

This  turning point in monetary policy and the effects of the worsening outlook are now starting to materialise in real estate investment markets. After increasing investment volumes through 2021 and early 2022, investment activity has now started to slow with volumes in May and June trending downwards.

While on the plus side, high inflation, should soon feed through to portfolio incomes, given that most rents are index-linked, on the downside, real estate yields and capital values are sensitive to the economic outlook, interest rates and bond yields.  And while the consensus at this stage remains, that the eurozone should avoid a recession this year and that the economy will see growth in 2023, as inflation eases, consumers spend again and industrial production recovers as supply bottle-neck eases, significant risks to that outlook remain.

First, Russia might halt gas supplies, disrupting industry and causing a further spike in energy prices.  Second, it is possible that high inflation will trigger a wage-price spiral, although this is probably less likely than in the USA and UK, given that unemployment in the eurozone is still quite high at 6.6%.  Third, it is possible that the increase in interest rates provokes a new sovereign debt crisis as governments in southern Europe struggle to service their debts.  That would cause the euro to depreciate and add to inflation.

Moreover, the prospect of higher official interest rates has pushed up the cost of longer-term debt by 1.25% since the start of 2022.  As a result, the  total cost of debt including banks’ margins now exceeds prime office yields in some markets and some potential acquisitions using debt have unravelled, because the rent no longer covers the interest.  Similarly, the spreads between 10 year bond and real estate yields are now at their narrowest since 2008 (except for shopping centres).  While the gap between real estate and 10 year bond yields is not fixed, we think the fact that it has shrunk at the same time as there is so much uncertainty over the economy. There are over a half dozen key risks clouding underwriting and pricing, resulting in many investors withdrawing from the market and waiting for re-pricing and clarity.

Which parts of the market are most vulnerable to rising interest rates? In theory the assets and sectors which are most exposed are those with relatively fixed, or insecure income streams.  In other words, assets with weaker occupier fundamentals.  These include non-food shops, shopping centres, business hotels, offices in secondary locations and in general, any building with poor energy efficiency.  The sharp increase in construction costs (>15%) and tightening in bank loan terms is also likely to lead to a fall in the prices of land and re-development projects.

Conversely, the assets and sectors which will probably be most defensive over the next 18 months are those with good prospects for income growth over the long-term.  These include a number of “operational” real estate types which are benefitting from long-term structural changes including data centres, care homes, doctors surgeries, self storage, laboratories and student halls.   We also think that multi-let industrials, offices with strong energy efficiency and well-being features and food stores will be relatively defensive.  We are more cautious on big logistics warehouses given the high level of new building over the last three years and their high exposure to retail.  In the short-term consumers are likely to cut back on-line, as well as in-store which will limit rental growth.

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