Occupational office markets remain robust, but prices and transaction volumes are falling, with a likely quiet quarter ahead
The outlook for global office markets has continued to deteriorate in the third quarter. Capital markets are very subdued, with many investors either choosing, or being forced by the arithmetic of high debt costs, to sit back and see out current volatility.
Inevitably, with fewer active participants in the market, investors scaled back their ambitions in the quarter; nearly US$62 billion was transacted globally in the office sector in Q3, representing a 42% decline on the same period in 2021. With the completion of deals agreed earlier in the year, there is little new activity in the market, suggesting the final quarter will also be quiet.
The good news is that inflation is probably close to peaking, and by implication, so too are market-based interest rates. But it is not enough for interest rates to simply peak, they need to also come down to avoid a larger correction in pricing. There will likely be some distress along the way, but there is still plenty of capital out there poised to take advantage, which should prevent a total free fall in pricing.
Betting on the pivot
With inflation running at multi-decade highs, central banks are scrambling to restore their credibility. Forward guidance appears back in vogue, and the message is clear; inflation must come down, no matter the cost. The good news is that global inflation is close to peaking, and there are plenty of reasons to be optimistic that it will abate next year. The risk is that central banks ignore these signals and push the global economy into a deep recession by raising rates too far. It takes time for monetary policy to fully feed through to the real economy, but it requires a steadfast central bank to let these dynamics play out in this environment.
A more likely scenario is that rate hikes persist for the remainder of this year, allowing for a period of reflection in early 2023. But regardless, it’s difficult to see longer-dated interest rates rise much further from current levels. Long-term interest rates are broadly determined by the expected path of short-term rates. If higher rates today imply more economic pain, then central banks will need to cut rates further in the future. This dynamic is reflected by the recent flattening of yield curves across North America, Europe, and some parts of Asia; rising short-term rates are increasingly having little impact on long-term rates.
A challenging environment
Peak inflation and peak interest rates will bring some relief to investors; borrowing costs are benchmarked to long-term interest rates, given the typical investment horizon is over five years. But it is not enough for interest rates simply to reach a peak. At current levels, institutions that typically require leverage have effectively been priced out of markets. Tokyo is an exception, attracting greater investor interest, although accessibility and supply constraints make it difficult for international investors to gain a foothold. In traditional gateway cities such as London and New York, cash-on-cash returns are pitiful. Pure equity investors are still active, however, particularly those with a buy-to-hold philosophy, attracted by some of the existing discounts already on offer.
Nevertheless, transaction volumes are down sharply, and those deals that are happening are taking longer. In Europe, we have pushed out our benchmark prime yields by 10–25 bps this quarter, while in the US, the New York prime yield rises by 50 bps to 5%. But pricing remains sticky in comparison with borrowing; half of the markets tracked in this report have seen the cost of debt rise by more than 200 bps since the first quarter, and so we see the potential for some further upward pressure on yields in the next 12 months across most markets.
The fact that pricing is slow to adjust won’t come as a shock; commercial real estate is a slow-moving beast. Indeed many of the old guard at Savills have been surprised by the relative speed of adjustment in comparison with previous cycles. But the arithmetic simply does not work when considering the surge in borrowing costs; in the US for example, the prime yield would need to rise by another 140 bps to make debt-financing viable to lenders, assuming they require a typical low-risk interest coverage ratio of 1.5. In South Korea, the equivalent adjustment in yields would imply a decline in values of 35% from current levels.
Deals still happening
More of a surprise perhaps is that deals do continue to happen. Even pure equity investors need to be cognisant of the prevailing cost of debt when evaluating a potential purchase, not least because in many markets, the yield to maturity on the ‘risk-free’ asset is broadly comparable, or in some cases higher, to the equivalent initial return on core office space.
In the absence of a material decline in debt costs, income growth is crucial in justifying current valuations…and the best buildings remain hugely under supplied in many marketsOliver Salmon, Global Capital Markets, World Research
One explanation might be that investors expect (or hope) that interest rates will soon return to more manageable levels, assuming that the current period of flux is, dare we say, ‘transitory.’ At some point, central banks will have to cut rates. Economists generally agree that current central bank policy rates (ignoring inflation) are well above the theoretical long-run‘ neutral rate’ i.e., the level consistent with a low and stable inflation rate. For financial markets, this remains the key narrative arc for 2023, with daily swings in equities often attributed to changing expectations on the timing of the central bank pivot.
For commercial property investors, this dynamic will be key in determining the scale of the downturn. In markets where the spread between the total cost of debt and the property yield is highest – including the US, South Korea, and the UK – refinancing existing debt will be difficult unless investors can increase their equity stakes. More distressed sales are likely, which will mark the market at a much lower level.
The other justification for ongoing liquidity in the market is that investors continue to believe in the fundamentals. Indeed, many markets remain buoyed by robust leasing activity, particularly for best-in-class offices; vacancy rates are broadly unchanged across EMEA and Asia Pacific markets this year. In the absence of a material decline in debt costs, income growth is crucial in justifying current valuations. The weak economic outlook will challenge this narrative, but as we’ve highlighted before, the best buildings remain hugely under-supplied in many markets, which should help to put a floor on price declines.
Europe, Middle East, and Africa (EMEA)
Europe remains at the forefront of the global growth slowdown; the recent S&P PMI activity data suggests both the UK and euro area economies are probably in recession already. Occupational markets have continued to perform well, particularly in London, but this narrative will be challenged by the deteriorating economic outlook. Meanwhile, the cost of debt continues to rise, underpinned by a major upward revision in expectations for the ECB policy rate over the course of the quarter.
Given where yields began the year, core office markets in the euro area were always vulnerable to a price correction. In Paris, for example, the prime yield was just 2.6% in Q1, leaving little room to accommodate even small changes in the cost of debt. So it is no surprise to see pricing move across all markets again this quarter, with the prime yield rising by 10 bps in Frankfurt, 25 bps in Paris, and 35 bps in Madrid.
However, similar to trends elsewhere, this is modest in comparison with the rise in borrowing costs, which pushed past 4% in each market. This makes it very difficult for investors to secure debt financing; in Paris again, the rental income on a Grade A office would not be enough to cover the interest payments on the loan, assuming a 55% LTV. Investment volumes continue to decline as a consequence, with just €11.9 billion (US$11.7 billion) transacted across the euro area in Q3, down 31% on the year.
In the UK, markets are still taking stock after a tumultuous few weeks following the Government’s (swiftly abandoned) ‘mini-budget.’ This quarter, we raised the London City prime benchmark by another 25 bps to 4.25%, implying a near 12% decline in values since the beginning of the year. But the outlook suggests further pain is likely.
In Dubai, the dynamics are very different to Europe. Regional growth is being supported by high oil prices, which are well above the fiscal breakeven level, providing a windfall to governments across the region. The occupational market is very strong, supporting positive rental growth, and there is very little supply of Grade A stock in the pipeline.
In the current environment, there appears to be little appetite amongst investors for offices in major US cities. Cost of debt pressures certainly play into this narrative. An acceleration in the pace of policy tightening from the US Fed has pushed borrowing costs above 7% this quarter. This is squeezing cash-on-cash returns, although this is probably academic; the very low interest coverage ratio would make it difficult for prospective investors to secure debt to finance the purchase of a Grade A office at current yields.
In the current environment, there appears to be little appetite amongst investors for offices in major US citiesOliver Salmon, Global Capital Markets, World Research
The fundamental outlook for the US office market is perhaps more concerning, however. Firstly, US workers have embraced hybrid working, resisting the repeated efforts of their employers to coax them back to the office. A deterioration in the labour market may see more people returning, concerned about job security, but it would unlikely compensate for a decline in aggregate office-based employment.
More importantly, though, is the prevalence of empty floor space. The availability rate in Los Angeles rose to 25.4% in Q3 for example, an all-time high, as leasing activity continues to underperform pre-pandemic trends. This is putting downward pressure on rents, particularly across lower-quality assets. The outlook is a little better in New York, where the availability rate is at 18% and moving in the right direction. But the deeply inverted yield curve; a negative sign in the US, suggests a high probability that the economy will also fall into recession within the next 12 months.
With very little of note transacted in New York or Los Angeles in Q3, it is difficult to benchmark valuations. Nevertheless, we have moved the New York prime yield out by 50 bps to 5% this quarter, in line with the yield in Los Angeles. But with rumours circulating that distressed properties will soon hit the market, a series of heavily discounted sales could lead to a revision in mark-to-market pricing.
Across the Asia Pacific region, yields remained broadly stable in comparison with the second quarter, although most markets are likely to see outward movement in the next 12 months. Investment volumes were sharply down on the year, however, falling by 45% in US$ terms, although currency movements are like to exaggerate this decline.
Shanghai remains in a state of limbo amid large discrepancies between buyer and seller expectations on pricing. Indeed, end users are the only active buyers presently. Rents are falling and vacancy rates are high, with net take-up down by 67% year on year in Q3. Core markets in Shanghai are displaying more resilience – justifying a stable prime yield of 4.25% this quarter – but the price of non-core assets is adjusting fast, with sellers under pressure to exit investments.
In South Korea, cash-on-cash returns for a debt-financed purchase have been completely eroded. This has underpinned a large decline in investment volumes, down by nearly 70% on the year, with some sales being withdrawn from the market due to a lack of interest. Prices are expected to move out over the next 12 months, however tight supply across the three major business districts will help put a floor on valuations; the vacancy rate of 3.2% is the lowest across our sample of major office markets.
The Japanese market stands alone in the region as the only place where investors can take on debt to leverage their returns, owing to the Bank of Japan’s steadfast commitment to retaining an ultra-loose monetary policyOliver Salmon, Global Capital Markets, World Research
The arithmetic is also difficult for institutional investors in Singapore, and most of the investment activity is limited to smaller lot sizes, attracting a sub-set of investors that don’t need leverage, including family offices, high net-worth individuals, and boutique private equity houses, as well as larger ‘scarce’ assets. Rental growth remains strong given a limited stock of Grade A buildings, although leasing activity is limited to renewals rather than expansion activity.
The Japanese market stands alone in the region as the only place where investors can take on debt to leverage their returns, owing to the Bank of Japan’s steadfast commitment to retaining an ultra-loose monetary policy. A typical LTV of 65% is also high when benchmarked across regional peers, meaning that investors can expect a healthy 5.8% cash-on-cash return on a prime office asset in Tokyo.
The good news extends to the occupational market, where rents and vacancy levels are levelling off, particularly for assets in the best locations. Domestic investors remain cautious against the wider backdrop, but the combination of attractive relative returns and the precipitous decline in the yen is piquing the interest of overseas investors.
Uncertainty actually is the friend of the buyer of long-term valuesWarren Buffet
I would struggle today to find an investor who would counter the notion that there is a great deal of uncertainty in the markets right now, so are we seeing fair long-term value? On a daily basis, it is our job to help investors understand whether it is the right time to buy, wait/hold or sell. The reality is there is never going to be a single right answer. This is what makes markets – differing views, pressures and motivations.
However, in periods of uncertainty investor attitudes tend to become more clustered in the middle ground of wait/hold. Vendors do not want to undersell their assets and buyers do not want to overpay or catch a falling knife.
Since our last publication in August 2022, we are starting to see more groups wanting or needing to sell, accepting that they are unlikely to achieve the same pricing as they would have done in 2021, certainly in the short term. Varying degrees of pressure are determining how far vendors are willing to go to affect trades right now.
On the buy side, more investors are starting to increase their conviction that there is ‘value’ in the market, albeit there is a huge divergence of what constitutes ‘value’. For the most scarce assets, their simple availability is enough to prompt bids, absent any demonstrable discount, from investors with a long-term view.
Right now, those that can most easily take advantage of pricing are groups that are equity-rich and who have the potential to hold assets long termRasheed Hassan, Head of Global Cross Border Investment
For some, particularly private investors who are US dollar denominated/pegged to the dollar, the benefit they are getting from currency overrides the need for a significant asset-level discount.
Income-focused buyers, who in recent years have used low-cost debt to compensate for compressed yields, are starting to consider and bid on some assets on an unlevered basis given price moves.
Opportunity funds are recognising value, but as a generalisation aren’t unequivocally rushing in, unless they are able to find very ‘special’ situations. Achieving target returns without debt requires very severe asset discounting and we aren’t quite there yet, unless the underwrite is for a sharp recompression of yields in the short term. This is hard to do for many as it is a market factor that is out of the buyer’s control and is unpredictable from a timing perspective. As most of these funds are closed-ended, this presents a challenge.
Right now, those that can most easily take advantage of pricing are groups that are equity-rich and who have the potential to hold assets long term. This plays into the hands of private capital and evergreen funds, in particular those who aren’t answerable to committees and even more so those who can factor in potential future currency gains.
Net initial yields are estimated by local Savills experts to represent the achievable yield, including transaction and non-recoverable costs, on a hypothetical Grade A building located in the CBD, over 50,000 sq ft in size, fully let to a single good profile tenant on a long lease. The typical LTV and cost of debt represent the anticipated competitive lending terms available in each market. Cash-on-cash returns illustrate the initial yield on equity, assuming the aforementioned LTV and debt costs. The risk premium is calculated by subtracting the end-of-period domestic ten-year government bond yield (as a proxy for the relevant risk-free rate of return) from the net initial yield. Data is end-of-quarter values.
For weekly updates, sign up to our Global Capital Markets Newsletter here.