Office Value Analysis

Methodology

An investor must be compensated for bearing the risk of investing in real estate over sovereign bonds, the 'risk-free' rate, factoring in future real rental growth and depreciation. Savills European Office Yield Analysis adopts the following methodology to assess prime ‘fundamental’ office pricing relative to market pricing across 23 European markets, covering London-City, Stockholm, London-WE, Manchester, Lisbon, Oslo, Berlin, Paris, Copenhagen, Dublin, Amsterdam, La Défense, Prague, Hamburg, Madrid, Barcelona, Helsinki, Munich, Warsaw, Brussels, Frankfurt, Milan and Bucharest.

Fundamental yield pricing > 50 bps above market pricing we consider underpriced

Fundamental yield pricing within 50 bps of market pricing we consider fairly priced

Fundamental yield pricing >50 bps below market pricing we consider fully priced

n.b. Savills European Office Value Analysis adopts a pan European view into the relative attractiveness of office pricing based on macro fundamentals and does not cover local market drivers e.g. vacancy rates.

The risk premium of investing in CBD offices against sovereign bond yields in a low return environment should be lower than that of the long-term average. For that reason, we have now adjusted our methodology to compare the five-year average risk premium, rather than the long term average risk premium.

Sovereign bonds

Ten-year government bond yields fell from an average of 0.6% pa to 0.4% pa during H1 2020 as long term economic outlook softened. Risk-free rates in Germany (-0.3% pa), Netherlands (-0.2% pa) remain negative, as French ten-year government bonds fell back into negative territory during Q3 2020. Falling government bond yields are widening the gap between prime office yields and fixed income, increasing property’s appeal.

Rents

Capital Economics’ five-year European office rental growth forecasts have fallen from an average of 1.9% pa to 1.4% pa in response to the coronavirus pandemic. Savills anticipate the strongest rental growth in London City over the next five years given modest future development and low vacancy levels, although we have revised our forecast down from 3.4% pa to 2.5% pa since Q1 2020.

Stockholm (2.4% pa), Amsterdam (+2.0% pa) and Copenhagen (+1.8% pa) are likewise forecast to observe among some of the strongest rental growth over the forecast period. This is partly underpinned by some of the fastest working-age population growth, exceeding 1% pa over the next ten years across several Nordic cities. Berlin’s sub 2% vacancy rate is also likely to generate positive rental growth of 1.9% pa according to Capital Economics, although this is below the levels we have observed in more recent years.

Inflation

More modest rental growth forecasts have been offset to some extent by lower inflation expectations. As a result of weaker demand in the economy, five-year eurozone inflation forecasts have reduced from 1.7% pa to 1.5% pa since Q1 2020, according to Oxford Economics.

We have held all other inputs constant, although, in some markets, we are observing landlords increasing internal CapEx in order to attract tenants at existing rental levels, which has effectively reduced net effective rents. Rent-free periods have remained stable over the past 12 months across we are observing some early signs of incentives increasing as we head into the final quarter.

Liquidity

Investors will be paying particular attention to the liquidity risk premium associated with each office market. Despite the constraints due to tighter lending criteria, liquidity of global capital remains high and is mostly in search of safe havens amidst the uncertainty caused by the pandemic. Core cities including London City, Paris CBD and Frankfurt stand out as the most transacted office markets over the last ten years, which will pique investor interest.

Since Q1 2020, the risk premium of investing in prime CBD offices over sovereign bonds has risen from 304 bps to 325 bps. This is partially reflective of some minor outward prime yield movement in Prague and Warsaw during H1 2020, although the majority of prime yields held firm during H1 2020, although the more significant driver has been the average ten-year eurozone bond yield falling a further 12 bps.

The other factor at play is the value of the euro against the US dollar which has risen by 12% since the start of the pandemic. However, this repositions the euro in line with the long term average, so is unlikely to have any major impact on cross border capital flows.

_{Read the articles within European Office Value Analysis below.}