European Market Commentary: Q4 2022

Schroders forecasts that the eurozone will suffer a mild recession in the first half of 2023, before recovering in the second half and returning to growth in 2024.  The main area of weakness is consumer spending, as high inflation squeezes real incomes and people save more because of concerns about energy costs and job security. However, we think that headline inflation peaked in late 2022 and that it will slow from 7% in the first quarter of 2023 to  4% in Q4. The main reason is that energy prices, while elevated, have started to come down. In addition, global supply chain pressures are easing as China exits it’s “zero-Covid” policy. Core inflation is however likely to remain more sticky as labour markets remain tight, with companies trying to hold on to staff.  Consequently, we expect the European Central Bank (ECB) to raise the refi rate to 3% by March and then hold in order to ensure a lasting reduction in inflation. The main downside risks are a wage-price spiral, which would force the ECB to act more aggressively and a shortage of gas next winter if the region fails to replace imports from Russia.

After a brief respite following the lifting of pandemic restrictions, retail real estate is again under pressure. Consumer sentiment fell to record lows last autumn, before partially recovering over the last couple of months.  In the short-term the fall in discretionary spending will have most impact on electrical, fashion and household goods retailers, restaurants and leisure operators.  In the longer-term, once the recession ends, the sector will continue to adjust to the growth of discount formats at the expense of mid-market retailers and e-commerce.  In-store sales in the eurozone are forecast to fall by 1.5% p.a. in volume terms between 2022 and 2027, as on-line penetration rises from 12% of total sales to 20%.  Smaller food stores are likely to be the most stable part of the market and see rental growth of  2-3% p.a.  Big box retail parks should also be relatively defensive, as low rents and service charges help to attract discount retailers.  By contrast, the decline in in-store fashion sales means that shops and shopping centres are likely to struggle and we expect prime shopping centre rents to fall  by 5-10% in most cities over the next two years, before stabilising in 2025. Secondary centres will see larger rental declines and a large number of retailers are continuing on discounts initiated from the pandemic.

Despite the prospect of a recession, office leasing markets continue to see robust levels of demand. Employees have increasingly returned to the office and occupiers continue to commit to high quality space to execute their new workspace strategies, retain and attract staff in tight labour markets and improve their ESG-credentials. While completions peaked last year, 2023 will see another year of significant new supply before volumes drop in 2024. For the moment, this has led to an increase in vacancy as occupiers move into new, or refurbished offices and their old space remains empty.  Occupiers’ focus on high quality space continues to support prime office rents, which saw further increases over the quarter in a number of market. At the same time, the pressure on secondary space continues to increase, though space in accessible locations and leased off affordable rents is showing some resilience. For the first half of this year, we expect prime rents to remain largely stable before showing some renewed upward pressure towards the end of the year and into 2024.   

After an exceptional couple of years, logistics rental growth in the eurozone is likely to slow to 2-3% p.a., from 4-5% in 2021-2022. While logistics will continue to benefit from long-term structural trends including the growth in on-line retail and companies holding higher inventories to safeguard supply-chains from disruption, the slowdown in economic growth will inevitably lead to a cooling in demand in 2023. In addition, we anticipate that development will continue to run at relatively high levels as developers offset the impact of higher interest rates and construction costs by paying less for land. Vacancy rates for modern units have however remained low and are not likely to see significant increases which will support further rental growth. In general, we expect that supply constrained cities such as Barcelona, Paris, Munich and Rotterdam will see the strongest growth in logistics rents over the next few years. There is also much greater emphasis from occupiers on securing modern space which is sustainable and suitable for sophisticated automation.  “Green” buildings with solar panels, LED lighting, EV charging points, etc should see less vacancy and deliver superior investment performance.

The jump in interest rates over the last 12 months has depressed investor sentiment, liquidity and prices. In Germany the total cost of hedged bank debt on good quality assets has risen from 1.5% at the start of 2022 to 4%, its highest level since 2011 and other countries have seen a parallel increase in finance costs from a higher starting point.  As a result, a lot of debt-backed buyers have been priced out of the market and many institutions have put purchases on hold, as the premium over bond yields has shrunk.  The total value of investment deals in the eurozone in the second half of 2022 was less than half that in the same period of 2021 and prime yields rose by 0.75-1.0% between March and December. Capital values which were protected to some extent by index-linked rents, fell by 5-7% in the second half of last year.

Given the uncertainty over inflation and interest rates it is difficult to predict how much further capital values will fall.  On the downside, some investors with loans which are due this year will struggle to refinance (or only at reduced LTV’s) and are likely to consider asset disposals.  The rise in interest rates means that interest coverage ratios which looked comfortable 12 months ago may have fallen to 1.5x, or lower.  However, on the upside, institutions will probably re-enter the market, assuming the economy starts to recover, government bond yields stay at current levels (German 10 year bund yields at 2.2%) and real estate yields continue to rise. The latest INREV Investment Intentions Survey found a small, positive balance of investors planning to invest and a further 0.5% increase in yields would restore the gap with bond yields to around its long-term average (1.75%).  On average, we expect capital values will fall by 10-15% in 2023 and then stabilise in the first half of 2024.  That would result in negative total returns this year, factoring in an income return of 4%, but positive total returns in 2024.       

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