We expect investment activity to remain subdued in Europe until the second half of the year when the economy will slowly start to pick up. We anticipate total European real estate investment volumes for 2023 to range between €330bn and €340bn, a decrease of 17–20% YoY
A market in flux
The European Commission expects a modest expansion of real GDP in 2023 (0.8%) and 2024 (1.6%), as the continent anticipates an economic recovery from summer 2023 onwards. February 2023’s PMI activity points to an expansion in economic output, particularly across southern European economies and driven by the service sector. The disbursement of EU funds will also support activity. At the same time, a less supportive global economy will weigh on the external sector, and still-elevated inflation, higher interest rates, and lower savings will hit consumer spending. Moreover, large public debts and energy price swings pose downside risks to these forecasts.
Capital Economics predicts that fuel inflation, which rose from 11.3% in December to 12.2% in January, will fall below zero in March, provided oil prices do not surge. Nonetheless, the International Energy Agency's forecast of record oil demand this year may complicate matters, given China's reopening and a boost in international travel.
The prime European office all-in-debt costs have surged from an average of 150 bps at the end of 2021 to 450 bps at the end of 2022
Lydia Brissy, Director, European Research
On the other hand, the rising core price pressure remains a growing concern for the economy and policymakers. Core inflation is forecast to be 6.4% in 2023 as European workers campaign for higher wages. This has stirred the European Central Bank to press on with significant further rate hikes, with several economists anticipating interest rates to move out further to 3.5% from 3.0% expected by the end of April.
Bond markets' volatility is expected to persist until interest rates stabilise. Despite the significant speed at which prices adjusted during the latter half of the previous year – recording an annual average increase of 56 bps for prime offices across Europe – this remains far below the surge in borrowing costs, which has been a nearly +300 bps on average in EU 27. This financial equation is simply not viable. The prime European office all-in-debt costs have surged from an average of 150 bps at the end of 2021 to 450 bps at the end of 2022. Thus, investors face significant financial challenges and must navigate a treacherous economic landscape to succeed.
Drop in investment volumes in the first quarter of 2023
Preliminary results suggest that the total investment volume for the year’s first quarter will reach approximately €36bn, a record low since the years following the global financial crisis (GFC) and approximately 59% YoY compared to Q1 last year. Whilst this is a big hit, it comes as no surprise given the slowing down of investment activity that was already felt since the second half of last year. Both the range of market players and suitable assets narrowed significantly over the course of the past 12 months, restraining the number of deals. Investors that typically require leverage have been gradually leaving the European investment scene, whilst equity-rich investors target long-term income growth assets with a strong appetite for discounts.
Looking ahead, occupier markets are anticipated to come under pressure, with demand for space expected to plateau or decrease across all asset types. Particularly vulnerable sectors like retail and offices are expected to be hit the hardest. Nevertheless, the scale of this downturn is unlikely to match that of the years after the GFC, when many markets overflowed with new developments. Indeed, construction costs, which have outpaced CPI inflation, made any new developments inviable as yields move out and rents trend downwards, hence maintaining vacancy rates low.
Given historically high valuations, even moderate loan-to-values (LTVs) of less than 60% could result in covenant breaches. Consequently, we anticipate some distressed sales along the way, but with an abundance of capital available to take advantage of opportunities, a total collapse in pricing should be avoided. Investors seeking to remain on a steady course should focus on strategies for income-driven assets, as well as the most appealing locations and sectors in Europe. These should be chosen based on long-term trends, offering greater stability and resilience in market fluctuations.
All in all, we expect the investment activity to remain subdued until the second half of the year, when the economy will start slowly picking up. We expect the annual investment volume in Europe to range between €330bn and €340bn by the end of the year, representing a yearly decrease of 17% to 20%. This would make it the lowest level since 2015.
Beds and sheds will remain the preferred asset classes as both sectors benefit from a structural supply and demand imbalance. However, none of the property sectors will be immune to the downturn. High inflation puts cost pressure on residential operators, including multifamily, PBSA and senior living. Logistics will have to rely more on demand from the manufacturing sector as distribution needs are likely to reduce due to lower retail sales.
High financing costs to trigger outward yield shifts across real estate sectors
With financing costs on the rise, the ability to achieve desirable yields on investments is increasingly complex, with refinancings facing negative leverage across almost all sectors. In light of these challenges, we anticipate that the property market will experience further yield shifts as sellers are likely to become more willing to sell at higher yields in order to offload their properties.
For both CBD offices and logistics, in 62% of the jurisdictions we cover, we expect further outward prime yields movement ranging from 26 and 50 bps. On average, across Europe, the prime CBD yield was at 4.2% (+56 bps YoY) in Q4 2022, and the prime logistics yield was at 4.7% (+37 bps YoY).
For retail properties, in 52% of the locations we survey, we expect prime yields to move out by 26 and 50 bps, and in 44% of the locations, we expect prime yields to move out from 0 and 10 bps. The average prime shopping centre yield was 5.7% (+31 bps YoY) in Q4 2022, and the prime high street yield was 3.9% (+25 bps YoY).
Regarding the living sector, on half of the jurisdictions we cover, we expect prime yields to move out from 26 and 50 bps, whilst for the other half, we expect the prime yield to remain stable or move out slightly (10 bps). The prime multifamily yield was at 3.7% (+39 bps YoY) on average across Europe in Q4 2022.
Opportunity-led cross border investors enticed by the prospect of pricing adjustments
The amount of cross border capital invested in Europe totalled approximately €114bn last year. Whilst this is down by nearly a quarter on the previous year's volumes, as a proportion of total investment, cross border flows actually registered a small 4.00% rise on 2021 (47% in 2022, 43% in 2021).
The withdrawal of European investors from the European cross border market is the leading cause of this decline. Last year, intra-European investment totalled €36.6bn (-28% compared to the average previous past five-year), accounting for 32% of the total cross border volume, on par with the share of capital from North America.
For the remainder of the year, we anticipate that the share of cross border investment will continue growing as a variety of cross border investors seek to capitalise on increasingly attractive pricing levels across different European jurisdictions and asset classes.