Spotlight: European Office Value Analysis

Low eurozone inflation forecasts will maintain low sovereign bond yields and cheap debt levels

Lower rates for longer

Economic Overview

Eurozone inflation fell into negative territory during August 2020 for the first time in four years due to weak demand, as eurozone retail sales fell for the second consecutive month indicating the hopes for a V-shaped recovery are fading. The growing realisation of a second wave of coronavirus has knocked consumer confidence, in which the European Central Bank (ECB) must act to avoid a deflationary spiral.

Given previously weak inflation levels, the US Fed and Bank of England have adopted average inflation targeting since the Covid-19 outbreak, to ensure that market expectations of future inflation do not become detached from reality. Economists are now anticipating that the ECB could follow suit and wait for inflation to rise above the 2% target rate in the short/ medium term, in order to compensate for underachieving inflation targets in previous years.

The ECB’s additional €1.3 trillion of asset purchases as part of the Pandemic Emergency Purchase Programme (PEPP) will add further liquidity in order to increase inflation levels and boost demand. A number of developed European economies are seeing government debt to GDP ratios increase by circa 20% and are expected to see this exceed 100% of national GDP by the end of 2020 as a result of the Covid pandemic, and growing debt burdens are likely to drag on the economic recovery into 2021/22.

The impact of this indicates that interest rates will remain lower for longer which is likely to maintain property yields at historic low levels. Focus Economics anticipates the eurozone weighted ten-year government bond yield to remain below 1.5% until at least end 2024 (see chart below).

With many European government bond yields now in negative territory, our analysis shows that the current average yield spread between European prime offices and eurozone government bonds is 325 basis points (bps), over 100 bps above the historic average of 223 bps.

The true health of Europe’s economy will, however, remain a blur until there is more labour market visibility, although Focus Economics indicate GDP growth will fall -8.2% during 2020, above previous months' growth expectations. The eurozone’s July unemployment rate has increased to 7.8%, although once furlough schemes are gradually removed throughout H2 2020, Capital Economics forecast that the unemployment rate will peak at c.10% by the middle of 2021. In Italy’s case, a number of unemployed workers have dropped out of the labour force and are now inactive, reducing the number of unemployed workers although we are now observing an increase in the overall rate.

Several southern European countries are forecast to see higher levels of unemployment increases due to exposure to the tourism sector and a higher proportion of workers on short-term contracts. European office-based employment is forecast to rise by 3.1 million over the next five years, reflecting 0.7% growth per annum.

Many questions are still yet to be answered regarding the long-term behavioural changes emerging from Covid-19 and how this will affect demand for office space. One thing that we can expect is that the historic relationship between office-based employment growth and office demand is likely to change tack as we observe a rise in flexible working post-Covid.

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