European economic outlook

Activity

The Eurozone looks set to replicate the first quarter’s healthy but moderate growth over the coming quarters. Household consumption should grow solidly, with consumers benefiting from positive real earnings growth. Moreover, the European Central Bank’s (ECB) cutting cycle should help support growth into 2025. High-frequency activity data reflects this fairly bright outlook, though June’s flash Purchasing Managers’ Index (PMI) reading showed a moderation, especially within German manufacturing. Long-term structural headwinds persist, with geopolitical, industrial and demographic changes limiting European growth potential once positive cyclical tailwinds are exhausted.

Inflation

Energy, food, and core goods inflation have returned to normal levels and should stay there. However, we expect prices for services to undergo a far slower normalisation. Unit labour cost growth remains strong, as reflected by robust first-quarter nominal wage data, which is pushing up services inflation. Adding to these pressures, the first quarter’s labour cost was recently revised upwards. With unemployment coming in lower than expected, the Eurozone labour market is yet to roll over. This means the headwinds to disinflation posed by the services sector could keep headline inflation above 2% for the remainder of 2024. 

Policy

The ECB kicked off its easing cycle in June. However, we think the strength of domestically generated inflation and the tightness of the labour market mean that the data is incompatible with a further cut in July. Cuts are most likely at forecast-update meetings in September and December. In total, we expect two further reductions this year, though the risks of fewer are elevated. Cuts should continue into 2025, as the ECB normalises policy towards a still-suppressed equilibrium rate. The ECB is unlikely to intervene to stabilise volatile French markets, as it views re-pricing as consistent with economic fundamentals.

Key takeaway

Activity, inflation and policy are all on a gradual and bumpy path to normalisation for European real estate performance.

Eurozone economic forecasts

Source: abrdn June 2024 
Forecasts are a guide only and actual outcomes could be significantly different.

European real estate market overview

In the first quarter of 2024, INREV reported that Europe delivered its first positive quarterly return (0.41%) for seven consecutive quarters . Capital values were still down 0.6%, yet the pace of decline is notably slower and is now being offset by the highest income return in five years for the index. 

Gradually cooling inflation and the first rate cut by the ECB in five years have helped. However, arguably the main reason for real estate’s improving outlook is because it continues to perform very well from an operational standpoint. Aside from secondary offices, real estate remains in tight supply and rents are rising. According to data from MSCI, European rental values increased by 4.3% across all sectors over the 12 months to the first quarter of 2024. Rents for industrials increased by 6.8%, residential by 6.3%, offices by 2.8% and retail by 1.6%. Cumulatively, all property rents increased by 8.6% since the downturn began in June 2022. After the global financial crisis, all property rents fell by 8.5% before they stabilised two-and-a-half years into the downturn.

The strength of European real estate cashflows and their growth potential is attracting capital back to core assets. Prime yields jumped 140 basis points (bps) from a low of 4.3% in June 2022 to 5.7%, on average, in June 2024. Higher yields and the potential for income growth, in the wake of the strong correction in values, now present a compelling entry point for investors. In the latest INREV Confidence Indicator survey in June, sentiment towards core real estate jumped notably from -10% to 15% in one quarter. 

European real estate sector trends

Offices

The outlook for European offices remains mixed. Take-up reached 1.7 million square metres in the first quarter of 2024, up 2% from the first quarter of 2023. While it’s only a marginal increase, anecdotal evidence points to growing competition among tenants for the rapidly diminishing volume of office space available in many cities. The level of demand remains 11% below the five-year, pre-pandemic, first-quarter average. But structurally lower office demand is not unexpected, given the rise in flexible working. There was a small increase in the overall vacancy rate in March 2024, rising to 8.4% in Europe (+100 bps since June 2022). This is still relatively low compared with over 20% in the US. 

While vacancy rates increased steadily, prime rents continued their steep rise in most cities, highlighting the deep polarisation in the quality spectrum. In Paris, the vacancy rate increased to 8.4% in March 2024, yet prime rents climbed by 7.4% to another new record of €1,070 per square metre. A similar picture can be seen in other major markets, such as London, Amsterdam, Madrid and Berlin. Consolidation into centrally located, future-fit offices will dominate trends in the sector. The June 2024 Morgan Stanley Global Office survey showed that the major factor defining office requirements is a central location. This is reflected in the statistics in Paris where the central business district’s vacancy rate was most recently quoted at 2.3% in March 2024. 

Transaction activity is still muted, particularly for large lot sizes over €50 million. Total office investment recorded the lowest level on record, with just €34 billion closed. This reflects just 29% of all deals in the first quarter. Transaction yields are increasingly polarised by quality. Prime assets are trading at an average of 4.8% and secondary assets are trading at 9% – the widest spread on record. Weaker assets have a capital expenditure challenge to meet future-fit expectations. They will suffer much more substantial value losses while competition for prime offices is resurfacing. 

Logistics

The logistics occupational market has produced mixed signals. Take-up has been recovering and reached 6.2 million square metres in the first quarter of 2024, just 2.6% below the pre-pandemic, first-quarter average. The vacancy rate increased from 3.3% in 2022 to 5.9% in March 2024, yet the availability of best-in-class warehouses is scarce. The development pipeline suggests new supply will begin to fall back in the coming quarters. 

Logistics rents increased by 6.8% over the year to March 2024. 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 to avoid becoming stranded. 

Given the strong fundamentals and sharp correction in logistics values, sentiment is now clearly turning a corner ahead of most other sectors. Competition is returning for the right kind of logistics assets in good locations. Logistics investment in the first quarter of 2024 retained its 19% share of the total.

Retail

The retail sector has been out of favour for the past cycle. However, it 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. 

The vacancy rate for retail warehouses in Europe has fallen to 3.8%, on average, and as low as 2% in the UK. Shopping centres have a structural challenge, with vacancy rates increasing in the first quarter of 2024 to 13%. While retail warehousing represents our preferred retail segment, data from MSCI shows that net operating income per square metre has fallen since the pandemic. It remains a tenant’s market when it comes to rental negotiations, while weaker retail parks require substantial capital expenditure. 

Over the year to the first quarter of 2024, retail attracted 23% of total investment – yet another notable increase. Several large shopping centre deals (including the sale of Rome’s second-largest centre for over €200 million) and renewed interest from private investors in luxury high street retail have contributed to the sector’s resurgence. Retail yields have moved out a comparatively modest 120 bps since June 2022 and we expect resilience to continue. In our view, investors still need to be cautious of income risk in the sector, but selectively consider retail warehouse opportunities.

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 6.3% reported over the year to the first quarter of 2024. We estimate that open-market European residential rents are likely to grow at 3% per annum over the next three years. 

We remain focused on rental affordability as a key driver of performance and risk in the sector. With inflation dropping back, indexation pressure has cooled sharply to below the temporary caps introduced during the pandemic. This should support low churn rates and help to reduce operational costs. Very low levels of new supply across Europe further support the resilience of cashflows from the sector. 

In contrast to the commercial sectors, residential has generally been more resilient during the downturn. The impact on valuations has been offset by rental growth and links to the Consumer Price Index in many cases. We expect living sectors to show resilience, given the low supply, but investors must be wary of new rent and sustainability 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 5.9% over the year to June 2025, with three- and five-year annualised total returns of 9.1% and 9.2%, respectively. 

For the first time in two years, we no longer anticipate any further falls in prime European all property values. Secondary assets, particularly weak offices, have not repriced enough and will suffer further valuation declines. Stabilising yields and continued healthy levels of income growth should support a gradual recovery in values as the year progresses.

Now that interest rates are being gradually reduced, we believe the yield correction phase is almost over for good-quality assets. Logistics and residential values are stabilising and even seeing pockets of competition resurface. Offices are clearly lagging, particularly larger lot sizes but also weaker-quality offices and those that are poorly located. 

Having upgraded our forecasts, we believe that risks are evenly balanced to the upside and downside. The resilience demonstrated in economic fundamentals offers some upside potential over the next 12 months, while the French and US elections offer potential downside risks. 

We also believe that the market will offer strong opportunities to benefit from better entry prices for core and value-add assets. We favour overweight allocations to logistics, rented residential, student accommodation, modern retail warehousing, and alternative segments like data centres.