European real estate market commentary: April 2024
Oliver Kummerfeldt, Head of European Real Estate Research, discusses the economic landscape and provides insights for decision-making in European real estate investments.
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The Eurozone economy seems to be past the worst having avoided a meaningful recession. Eurozone GDP growth for Q4’23 was revised down to -0.1% from 0.0%. However, Q1’24 is likely to see a return to subdued growth with leading indicators such as the composite PMI improving through the first few months of 2024. Consumer expenditure remains supported by ongoing strong labour markets with the Eurozone’s seasonally adjusted unemployment rate remaining stable at 6.5% in February.
Markets are still expecting borrowing costs to decrease with inflation easing with the HICP for March showing a lower-then-expected 2.4% versus 2.6% thereby remaining on a path towards the European Central Bank’s (ECB) 2% p.a. target level. This, in combination with muted growth, continues to fuel expectations that despite the more hawkish shifts in US interest rate expectations, the ECB could start cutting interest rates during the summer months. The ECB continues to stress that it needs “more evidence” before contemplating monetary easing with a particular focus on wage growth which remains elevated. Upside risks to inflation also remain given the volatile geopolitical situation. German 10-year government bond yields have increased during Q1 from around 2.0% at the end of 2023 to level of ca. 2.3%-2.5% but are below the levels of 2.7%-2.9% recorded during autumn 2023.
Occupier markets continue to show tight supply conditions, particularly for high quality ESG-compliant space, continuing to support rental level. For offices, demand was muted at the start of the year and take-up in Q1’24 was ca. 25% down on Q4’23 and ca. 20% below the historic 10-year Q1 average. Demand is highly polarised, with competition for scarce, high-quality stock with strong sustainability credentials in accessible locations remaining high driving further rental growth though prime rental growth in Q1’24 was witnessed in fewer locations then in prior quarters. Vacancy rates have increased in many markets in the last 12-18 months but remain below historic averages. Supply conditions further support rents given completions are projected to drop significantly after 2024 given the lack of projects that commenced during the pandemic, and the elevated finance and construction costs that will act to constrain further new starts.
Prime industrial rental growth was also less broad based in Q1’24, but locations such as Antwerp, Amsterdam, Berlin, Frankfurt, and Barcelona did see positive momentum. We expect rental growth in the sector to be 3-4% pa through 2024 and 2025 given demand remains well supported by the structural growth in ecommerce, near-shoring trends and firms seeking more inventory to improve supply chain resilience. On the supply side, relatively high building costs, interest rates and more restrictive planning environments in should restrict speculative development and maintain low vacancy levels.
Easing inflation and further wage growth are pointing to retail sales recovering during H2’24, which should start to ease retailer margin pressures. Consumer sentiment remains negative but has improved notably in the last 12 months. The growth of online retail continues and means that in store sales are set to decline by 1-2% p.a. in volume terms through 2024-2027, ensuring vacancy will remain elevated. Rents for prime retail are expected to remain broadly stable this year having already experienced significant falls to date. Rents and occupancy levels in secondary locations will however remain under significant pressure.
Turning to capital markets, investment activity remains highly subdued with ongoing uncertainty over pricing and high debt finance costs constraining markets. Preliminary numbers from MSCI show ca. €34bn traded in Q1’24, representing a fall of ca. 20% on both Q4’23 and Q1’23 and the Q1’24 volume is now almost 50% below the Q1 average of the last 10 years.
Pricing is however showing signs of stabilisation with the unweighted average of CBRE’s Monthly Yield Monitor for the 13 largest European countries (incl. UK ex. CEE) only moving by less then 10 bps across all major prime sectors in Q1’24. Indeed, Green Street Advisors transaction pricing data shows minimal improvements for industrial and residential pricing over the quarter and offices and retail only showing slight declines. This a significant change from the falls observed in previous quarters.
Valuation movements continue to lag corresponding transaction prices and whilst repriced opportunities are becoming increasingly visible, notable bid-ask spreads still prevail in many instances between buyer and seller expectations limiting transaction activity. As such, price discovery is set to remain a feature across European markets in the coming months. Given these movements our proprietary market valuation model suggests that many markets now provide “fair or better value” on a risk -adjusted basis. Given the extent of the repricing observed, we view the asset class to present a broader sequential cyclical buying opportunity. We recommend a patient approach ordering opportunities as they rebase across geographies, sectors and investment structures.
Large scale material distress has not been observed to date, in part due to the positive impact of regulations that have inhibited excess levels of leverage being employed by European banks in recent years. However, upcoming refinancings and the significant increase in debt finance costs will likely drive asset disposals with highly leveraged investors struggling to re-finance loans falling due. This will help stimulate liquidity and transaction evidence for investors to reference.
At a sector level, we view industrials and logistics to be attractively priced and demand tailwinds remain supportive. We favour last-mile distribution and regional logistics in strong clusters and/or benefitting from supply-chain reorganisation and see an opportunity to capture mispriced reversionary potential. The office sector in Europe has been impacted by changed working patterns, and we continue to see a polarisation in demand and performance in the sector between “best in class” and “the rest”. Assets with a strong sustainability profile and good amenity provision, in major metropolitan CBDs should continue to perform. Given the emerging lack of highly sustainable space, we also see an opportunity to upgrades and refurbishments of well-located workspaces in supply constrained major capital and regional CBD capitalising on the expected supply gap.
The prevailing lack of supply of residential space across major Western European markets and continuing urbanisation trends, is providing for an opportunity in “living” investments, that provide long term resilient cashflows. We have a particular focus on undersupplied affordable and mid-market rental housing segments. Careful consideration needs however to be given to local regulation adjusting to protect residential tenants from e.g., price increases. We also see opportunities in selective senior and student housing markets in the UK and across the Continent.
We remain cautious about the retail sector but have conviction that convenience and grocery-anchored formats providing inflation-linked cashflows will be most resilient. We also have a continued focus on other more operational segments, able to provide long-term resilient cashflows with outsized income growth potential, aligned with the success of tenant. We also see opportunities in selective parts of the hotel market with a preference for leased hotels in the main destination locations providing inflation-linked base rents and variable components capturing operating profit or further up the risk curve operating hotels where repositioning/ restructuring of operations and/or completion of stabilisation activities drive value creation.
The prevailing environment further reinforces our focus on operational excellence as we seek to drive long term, sustainable outperformance for our investments. We believe that all real estate has become operational in nature in that the financial outcomes for investments in assets are aligned with the success of tenants’ businesses in the assets. As such we manage every building as it if were a business by itself, improving services, ensuring efficient operations, and minimising CO₂ waste and use of scarce resources (including energy) to optimise net income and value over the investment horizon.
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