European Property Markets

European Markets at H1 2022

A pivotal year that will transform risk reassessment

2022 is shaping up to be a transformative year for real estate markets in Europe. Macroeconomic events prompted realization that elevated inflation will continue far longer than originally anticipated. For the asset markets, it means more uncertainty in interest rates plus early closure of most unorthodox policies like QE. The outcome is an accelerated process of normalisation of monetary policy that will dial the clock back to before the GFC. For real estate, this represents not a price correction but a reset that will establish new market norms. Consequently, the market is entering a “grey” period of pricing uncertainty over H2 2022 where buyer expectations are not meeting those of sellers. The outcome for real estate investment is quite clear: slowdown in transaction volumes over the remainder of 2022 and maybe into early 2023. Total investment in Europe was €115.2 billion in H1 2022, +2% up on H1 2021. The first quarter witnessed strongest expansion at €63.3 billion nearing the pre-pandemic highs. The second quarter (at €52.1 billion) shows signs of slowdown. This is not surprising given the development in the macroeconomic environment. Total investment is slowing in all the major markets though the sectors are not all responding in the same way. On a rolling year basis, office investment (-6% vs Q1 2022) is slowing the fastest, followed by logistics (-4%), while hotels investment and retail volumes are stable. This may reflect cyclical positions of each and their market fundamentals.

Yield decompression now inevitable

The uncertainty in the financial environment represents an element of unpredictability that has re-entered asset pricing. In a more aggressive interest rate environment, the previous model of real estate pricing is no longer sustainable. It means that yields prevailing across Europe are not compatible with debt servicing and the level of rental growth likely to occur cannot support existing price levels. The inevitable outcome is yield decompression across the three main sectors until a new equilibrium is attain. This is not a factor of lack of demand, this clearly is still there; it is the parameters that make investment profitable that are changing. Currently, yields are in their “pause and adjust” phase so as of Q2 2022 are stable. The European composite yields for retail and logistics stood at 3.4% and 3.5% respectively, unchanged over H2. The composite office yield for Europe stood at 3.2% for the 16 top markets. It is likely that by end of 2023 European office yields may have expanded by between 25 to 50 basis points.

Office demand continues to grow albeit selectively

Prime office yields are likely to be the most enduring with modern units in CBDs as they hold the most promising prospects. In Q2 2022 yields in markets like Brussels (-50 bps), Prague (-25 bps), Madrid (-25 bps) and Milan (-20 bps), are lower on annual basis. In markets like London, they are flat and Berlin has posted decompression of 5 bps. Historical data notwithstanding, yield compression has clearly ended. Investment on an annual basis still 4% up on H1 2021 at €46.7 billion though Q2 witness a sharp slowdown in activity.

Occupational demand in contrast continues to expand. It is no longer accurate to talk about office markets in recovery a Europe attained that in Q4 2021. Transactions of around 4.669 million sqm occurred over H1 in the 17 main European markets, up 39% compared to last year. H1 2022 activity surpassed the 10-year, over same period, average by 7%. Most markets showed significant improvements in volumes, including Dublin (+346%), Central London (+122%), Warsaw (+95%), Munich (+67%) and Luxembourg (+53%). Demand is unambiguously expanding across the major cities though it is a bifurcated market as demand focuses on the best quality unit. Rental patterns are following this dynamic, as is vacancy. The overall vacancy rate in Europe stood at 7.1% at the end of Q2 (stable vs. Q2 2021). Cities like London, Berlin and Paris all witnessed 30 basis points expansion in vacancy in H2 2022 mostly due to lower take-up of poorer quality units. Low availability in central submarkets and in new buildings, and much higher vacancy rates in peripheral office districts, continues to characterise cities.

We think there will be a short-term push to office rents from inflation that will result in growth for prime units in Europe. Many secondary buildings may not benefit from inflation uplift. The gas crisis is renewing focus on operational costs and the interest of occupiers this year has concentrated on energy efficient buildings. This can only grow going forward and will widen the gap of modern and secondary.

“Total investment is slowing in all the major markets though the sectors are not all responding in the same way”

The retail sector has a longer road to recovery

Investment in retail picked up over 2022 to €19.1 billion (18.9% on H1 2021) with more interest especially in shopping centres. Yet the macroeconomic changes mean full restoration of the retail sector as an attractive investment now has much longer recovery period. Although the pandemic is behind us, positive rental growth is still some distance off, although 2022 may see the floor for rental decline. Inflation and the implications for more selective consumer spend will focus the minds of retailer on cost control: they will be less keen on taking expensive units without clear revenue improvement. City centres have high percentage of tourist sales. As the tourism sector is now very active, it is likely to result in better revenue and aid rental recovery from 2023. Logistics rental growth is strong

European logistics investment is also slowing. Activity at €25.2 billion for H1 2022 is 10% down on the same period year so is healthy. The momentum is little slower and yield decompression is already popping up in markets such as Germany, France and the Netherlands.

Take-up in the 6 leading countries rose by 13% to 14.9 million sqm in H1. Like investment, logistics occupational is showing signs of selective slowdown with weaker demand in places like the Netherlands and UK. This is a complex situation due to a combination of slightly weaker demand and problems securing suitable space. Vacancy in the logistics sector continues to operate at historic lows with the European average below 4%. There are few speculative developments in any country. The supply issue inhibits the sort of strong take-up seen previously and prompts two responses: innovation in delivery operation and rental increases for available units. Prime rents increased by 12.2% over the last 12 months in Europe, notably in the UK where growth of around 25% occurred in London and Birmingham. Rental growth is receiving an indirect boost from materials inflation associated with construction.

Samuel Duah, PhD, Head of Real Estate Economics at BNP Paribas Real Estate