European Economic and CRE Outlook - 1Q 2025

Highlights

·??????? Economic outlook still positive

·??????? Monetary policy easing

·??????? Market fundamentals holding up

·??????? Capital markets showing notable improvement

·??????? Investment returns already increasing

Welcome back readers to our newsletter - The Chief Economist - delivering meaningful and timely insights on the #CRE topics that matter the most to you. I'm Ryan Severino, CFA and we're hopping across the pond to examine the state of economic affairs in Europe. Let's get right to it!

The European economy underwent an important transition during 2024. Inflation across the region slowed considerably since peaking during 2022. That enabled the major central banks, the European Central Bank (ECB) and the Bank of England (BOE) to begin cutting interest rates. That followed a period of aggressive rate hiking. While that helped to alleviate some pressure on the economy, real interest rates at year end remained positive, restraining economic activity. Consequently, growth for 2024 improved compared to the prior year, but remained tepid. However, these changes position the region well for better economic performance and consequently a better backdrop for the commercial real estate (CRE) market in 2025.??

Economic Overview And Outlook

The outlook for this year looks brighter, even with some uncertainty looming over the broader environment. The ECB and the BOE should continue to cut interest rates, further lessening a key restraint on economic growth. The labor market should remain tight with an ongoing labor shortage, providing consumers with real wage growth and spending power after a period when wage growth lagged inflation. Declining interest rates should also serve as a catalyst for investment in the economy. That not only provides a current boost to growth but also supports future growth due to the strong empirical relationship between investment and productivity. Productivity improvement should begin slowly but underpin firmer growth as it not only increases economic output but also helps to lower inflation. This combination of real consumer spending plus rebounding investment is providing the economy with important drivers. But one key uncertainty looms large – the potential for a global trade war stemming from US trade policy. If the region can avoid the direst of global trade scenarios, the European economy looks poised for another year of improvement in 2025.

The regional European economy should strengthen as the year progresses. That not only sets 2024 as a year of positive growth but should bring solid momentum heading into 2025 and 2026. This should occur not only on a regional level, but across all major constituent economies. We project generally stronger sequential growth, as the economy moves past the worst of the economic disruptions stemming from exogenous events like the pandemic and war. Moreover, real economic growth across the entire region should get a powerful boost from the combination of lower inflation and lower interest rates. Inflation should continue to slow as the reverberations from exogenous disruptions fade. The ECB should continue to cut rates during the latter half of the year while the BOE gradually shifts toward loosening monetary policy.

Property Market Overview And Outlook

The broad perspective for CRE in the region looks increasingly favorable. Generally, market fundamentals across property types and geographies have performed well until challenging economic conditions during the past few years. Yet, despite these challenges, vacancy rates remain generally low while rents continue to increase. On the capital markets side, where pain in CRE has been felt most acutely, the environment began to shift notably last year once the BOE and the ECB began cutting interest rates. Rather quickly, CRE returns showed notable improvement. While much will depend on the path forward for interest rates and monetary policy, the outlook for returns across the region over the next few years looks more favorable (on a durable basis) than it has since before the pandemic.

Logistics

The logistics market concluded another positive year in 2024. Demand for space slowed but stabilized near healthy pre-pandemic levels. While increasing certainty resulted in longer timelines to complete deals and sign leases, it did not derail activity. Meanwhile, with construction across the region remaining rather limited, the market remained in a favorable position. Vacancy rates remained fairly stable, maintaining a tight market environment for space. Consequently, rental growth across the region remained robust, even with some variation by market. This momentum should be maintained in 2025. Occupiers will focus on two general strategies. The most successful firms will continue to place quality of space above all else and remain willing to pay for the highest-quality space, which remains relatively scare and more expensive. Meanwhile, firms that focus on the bottom line will seek to improve margins and efficiency, through the use of less expensive but potentially better-located space. But a stabilizing economic backdrop, including improved business confidence, should sustain demand for space. Development activity should slow further. And the combination of the two should maintain relatively low vacancy rates and relatively high rent growth, especially in markets where land for development remains exceedingly scarce.

Investment volume during 2024 appeared to have stabilized, showing little quarter-to-quarter variation. While demand for assets remains high, relatively few properties came to market for sale during the year. But toward the end of the year, a notable change was occurring. As central banks cut rates, reducing the cost of capital, greater clarity and agreement on pricing began to occur. That is slowly starting to catalyze the market. With further rate reductions likely ahead, the wall of capital seeking to enter the market should find relatively more opportunity in 2025 than in 2024. Amidst a relatively unchanging market environment, yields remained steady. During the year the market experience little quarter-to-quarter variation, leaving yields at the end of 2024 in roughly the same place as they were at the end of 2023. But yields look set to compress again in 2025, albeit modestly, as volume increases and enthusiasm for assets finds more targets.

Office

Office leasing volume across Europe increased marginally versus 2023 levels, but momentum appears to be building heading into 2025. Importantly, increased activity occurred on a widespread basis, with more than half of the major markets across the region seeing an uptick in volume. In what represents the continuing an entrenched trend, Class A increasingly dominates leasing activity, now accounting for the majority of leasing activity. Despite this, Class A vacancy rates continued to increase across the region, including many key markets, will supply growth outpacing demand. That should reverse in the coming quarters as supply growth slows and demand slowly increases. For all other classes, future prospects remain more challenging. Although supply growth beneath Class A remains rather limited, so does demand, which is increasingly losing ground to the Class A segment of the market.? Similarly, rent growth remains healthy, well in excess of inflation, but this is increasingly driven by the Class A segment of the market where tenants are willing to pay a premium for high-quality space. Rent growth should slow a bit this year but we forecast that real rent growth should remain positive, particularly in key markets.

Transaction volume during 2024 declined further, following pullbacks in the wake of the ECB and the BOE tightening interest rates, beginning in 2022. Despite this lower volume, pricing appears to be stabilizing, with office yields across the region remaining largely unchanged during 2024. We anticipate that the transaction volume should slowly increase over the next 12-24 months as lower interest rates and borrowing costs, coupled with a more conducive economic backdrop, combine to provide a healthier investment environment. Correspondingly, we anticipate that office yields should slowly begin to compress over the same time horizon, albeit marginally.

Residential

Like many parts of the world, the residential market in Europe remained strong in 2024. Demand remained resilient, driven by powerful demographic drivers including growing populations and households (particularly among younger households) while increased life expectancies and health outcomes underpinned durable demand. Moreover, the shift in preference toward professionalized rental product is also proceeding apace, generating demand for high-quality apartments. At the same time, supply remains incredibly scare across the region, particularly in key markets where developable land remains limited. Moreover, relatively expensive construction costs, even following a slowdown in inflation, are also restraining new development. This combination of forces is keeping vacancy rates across the region among the lowest in the world and driving positive real rent growth across a large number of markets.

The environment for residential investment shifted notably midway through the year once the ECB and BOE began cutting rates. The combination of strong fundamentals and declining interest rates and the cost of capital propelled returns, beginning during the second quarter and accelerating in the latter half of the year. With interest rates set to decline further and supply remaining scarce for the foreseeable future, the investment outlook for residential across the regions remains positive over the medium term.

Retail

The European retail market has held up quite well under challenging circumstances. After taking a hit due to high inflation and high interest rates, consumer confidence continues to recover across the region. Consumer spending is increasingly supported by real wage growth, with nominal wages now growing in excess of inflation, which has cooled considerably over the last few years. And a tight, undersupplied housing market provides a modest boost via the wealth effect. Tourism, important for Europe’s retail market, has finally returned to pre-pandemic levels. All of this has boosted market fundamentals. Vacancy rates across the region remain healthy, generally in the mid-single-digit range. Correspondingly, rent growth has also remained healthy, and now it is growing in excess of inflation. That rental growth momentum will be difficult to maintain in 2025, but that does not mean deterioration. Quite the contrary – the sector should remain tight for the balance of the year.

Although once overlooked, the retail investment market continues to gather more interest from investors. Historically, investment volume has lagged that of other major property sectors. But, the sector’s attractive yields, on an absolute and relative basis, are increasingly being noticed. Investment across different subtypes and formats, from shopping centers to high-street retail, is increasing on a widespread, if not uniform basis. High-quality assets, particularly those that are well located, continue to generate substantial rent and yield premia. Assets of inferior quality or location should continue to trail their higher-quality peers by investor interest, transaction volume, yield, and total return.

Life Sciences

For the life sciences sector, the winds of change began shifting during 2024. The sector came under pressure from higher interest rates in recent years because in two critical ways. First, like most property types, higher rates raise the cost of capital, limits investment, and pressures valuations and yields. All of that certainly occurred. But additionally, the higher rate environment pressures the venture capital industry which frequently provides the funding for the kinds of firms that generate a significant percentage of the demand for life sciences space. Thankfully, construction volume has remained rather limited, with high costs helping to keep a lid on new completions. With looser financial conditions ahead, that bodes well for both funding for life sciences firms and for investment into the sector itself. Moreover, the sector’s bright outlook stems from two durable factors. First, the aging demographic profile of the region, and developed economies overall, suggests strong future demand for pharmaceutical products. Second, ongoing policy support for the life sciences industry across the region also suggests a conductive environment ahead for the industry. Together, these factors suggest a continued favorable outlook for the property sector in the medium term.

Data Centers

Demand for data centers in Europe has shifted into a higher gear with the advent of the artificial intelligence revolution that is now well underway. Additionally, cloud storage continues to represent an important and growing component of data centers. Demand (including preleasing activity) during 2024 remained quite healthy. With limited availability in key markets, the forward supply remains robust but is increasingly shifting away from core markets toward secondary and tertiary markets. While some of this stems from lack of physical space, much of it stems from ample energy resources needed to power the most modern data centers.? With multiple demand drivers entrenched, supply should struggle to keep pace with demand over the medium term. That should help to keep availability low and rental rates high and growing. Consequently, that portends well for investment into the sector, especially for the newest centers. As investors increasingly seek to diversify portfolios away from traditional property sectors, data center investment should remain at healthy enough levels and provide attractive total return potential.

Summary And Risks

A trade war now stands as the main risk to the region’s economic outlook. Because the major developed economies of Europe rely more heavily on international trade for growth than the US or the major Asian economies, it puts them in a more precarious position. Additionally, the hot war on the eastern side of the continent continues to pose an unpredictable risk even if its impact on the economy remains less direct.

For the CRE market, much will hinge on how the broader economic landscape impacts interest rates because of the asset class’s well-known sensitivity. Rates should continue to decline, which should continue to support attractive total returns. And market fundamentals, and consequently income returns, should continue to remain healthy. But the specific path forward for CRE remains clouded by exogenous factors.

That's all from me, but I hope you appreciate the approach we've taken to give you a read from my team's research desk on how we see the real estate markets unfolding across Europe. Please leave your thoughts and comments below. Thanks and see you next week!

Ryan S.

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