The low point of the cycle seems close at hand, a favorable environment for investing in the segment.
Interest rate rises have been strongly felt in European real estate markets over the past year. Prime yields reacted by rising by some 100 basis points (bps) to around 4.25%. This represents a negative impact on capital value of over 20% per annum.
Yields have slowed to around 10-15 basis points in the first quarter of 2023. We seem to be approaching the low point of the European real estate cycle, a favorable environment for investing in the segment.
The logistics sector has seen a downward adjustment of around 30% on an annual basis, even though fundamentals remain positive. Even the best ESG/STEM offices, multi-family buildings and grocery stores saw their value fall by 20% to 25% per annum.
By comparison, retail warehouses and shopping centers have fallen by only 5% to 10% a year, despite the headwinds of online retailing. Today, these formats generate returns of 5.5% to 6% a year.
Assuming that the peak of interest rate worries is behind us, real estate investment volumes should begin to recover later this year. However, the cost of debt is likely to remain high, and investors will have to work harder to achieve returns in the coming cycle. ESG will also play a crucial role for investors in extracting alpha and avoiding obsolescence.
The availability of real estate bank credit has become increasingly selective in terms of sector and asset quality. The 5-year EURIBOR swap remained stable at 2.8% in the first quarter. Margins on real estate debt have also stabilized at 150-200 basis points, implying a total CRE cost of debt of around 4.5% to 4.75%. Margins are higher in the UK, ranging from 175 to 250 basis points depending on the sector.
Office leasing activity in Europe held up remarkably well in 2022. Annual demand amounted to 11.9 million square meters (5% of total office stock), a high post-pandemic level and slightly above the ten-year average.
The European office vacancy rate has stabilized until 2022, rising only marginally to 7.8% and remaining below the long-term average of around 8.3%. The markets with above-average vacancy rates are London and Dublin, while the markets with below-average vacancy rates are Copenhagen, Vienna and Madrid.
In 2022, office construction in Europe represented 1.7% of the total office stock, which is below the obsolescence rate of around 2.5% per year, assuming a building life of 40 years. It is expected that 2023 will be the year with the highest construction volume since the global financial crisis (2.2% of the stock, still below the obsolescence rate), declining thereafter. Projects beyond 2023 could be delayed as higher development costs and lower capital values reduce developer profits.
The return to office space continues in Europe. Physical occupancy has improved from 43% to 55% since last summer. This compares with the pre-pandemic norm of around 70%. Across all markets, the improving trend is clear. Despite concerns, rents for high-quality office space have continued to rise strongly, by 6.7% per annum until March 2023. Rental prospects remain best for the highest ESG-rated offices. The shortage of this type of space is set to intensify in the years ahead. Prime Dutch and German offices have seen the most aggressive evolution in investment prices, with an increase of 125 to 150 basis points.
European retail sales remain negative, falling by 3% in the 12 months to February 2023. Consumer confidence remains low, albeit improving slightly. The consumer confidence indicator, at -19, is up from its September low of -29, but remains below the long-term average of -12.
The resilience of the labor market is a positive factor for nominal household incomes, but wage increases are currently below inflation. This translates into lower real purchasing power.
As expected, the retail recovery immediately after the pandemic proved short-lived, halted by falling real incomes. While e-commerce adoption rates were down on the pandemic years, they remain on a positive long-term trend. Retail rents have fallen by almost 3% over the last 12 months, with significant declines recorded in Germany, Finland and the Netherlands. The gradual downward pressure on rents is set to persist. The grocery sector remains a favorite, as food is a necessity and therefore largely immune to price rises.