Around US$32 billion in office transactions were closed in the third quarter of this year, representing a near 59% decline in comparison with the same period last year. To give this some context, it was the weakest outturn since Q3 2009, when the global economy was in the midst of the GFC (albeit that Q3 2009 did not represent the lowest point of that year).

Institutions remain somewhat circumspect towards offices, accounting for less than 22% of transactions this year, however, this is only marginally down from a long-term average of 27%. Unfavourable market conditions – including high interest rates and a slowing global economy – favour a wait-and-see approach from investors, while uncertainty over the future viability of some offices is making it hard to plan some exit strategies. However, the global narrative is dominated by the somewhat bleak news coverage of the US market, and there remains plenty of nuance, both in the US and the rest of the world.

Prime yields continued to move outwards this quarter in Sydney (10 bps), London, Madrid, Paris, and Shanghai (all 25 bps), and Frankfurt (30 bps). Some markets will continue to see upward pressure in the coming months. However, with interest rates now peaking, the first pre-condition for stability has been met. Commercial real estate is slow-moving at the best of times, but nevertheless, some more certainty around interest rates and borrowing costs should help to facilitate a floor in pricing, and eventually a recovery in investment activity, particularly for those investors who can separate the art from the artist.

Transitory inflation Higher for longer

With transitory inflation now behind us, ‘higher for longer’ is the new slogan doing the rounds, summarising the outlook for the future path of policy rates. Central banks have gone to great lengths to convince markets that they are not cutting soon. Forward guidance has taken a hit in recent times, but this proves that central bankers still hold sway over the market (don’t bet against the Fed!). By convincing investors that rates will remain elevated, global bond yields have continued to rise in recent months, with the 10-year US Treasury briefly pushing past 5% in mid-October.

The question is whether higher for longer ultimately proves transitory (cue narrative klaxon!). History suggests it will; in the past 30+ years, the US Fed has typically held out for just six months before cutting rates again. Given they last raised rates in July, this would imply a rate cut at their first soirée next year. And yet, markets are currently pricing a 99% probability that the Fed Funds rate is at or above current levels following the January 2024 meeting.

Markets are nearly always wrong, but a fast about-turn is predicated on something going bang in the global economy, fundamentally shifting the narrative on growth and inflation. The proposition that the ‘Fed hikes until something breaks’ is grounded in fact; financial crises often follow rapid monetary policy tightening cycles. Investors want lower interest rates, but higher for longer is inextricably linked to a soft landing, so it’s a case of be careful what you wish for.

The good news then is that, in their recent forecast update, the IMF declared that the ‘likelihood of a soft landing has increased.’ Those expecting a more severe downturn in the global economy are using more intuition than fact to form their opinion; a soft landing in the global economy is the right call, conditioned on what we know today. Households, corporations, and the transparent parts of the financial system are generally in good financial health, able to weather the higher rate environment. Labour markets are showing few signs of rolling over, and real wage growth should support household consumption.

Tomorrow is another day

There are however plenty of vulnerabilities in the global economy right now; the property market in China, conflict in Ukraine and the Middle East, concerns over the US regional banking sector, etc. Given the historical context, we are perhaps embarking on a period of peak anxiety that makes it very difficult for investors to make long-term decisions. This is reflected in public markets, with the VIX index of equity market volatility in the US up from mid-year lows.

Follow my deed

Even a soft landing may not be the fillip that real estate investors want; a global economy that is ‘limping along’ in the words of the IMF does not provide much comfort. If investors follow the occupiers, then weak global demand is not an environment that will stimulate a strong recovery in office leasing and rents. In the US for example, some markets are now seeing a decline in office-based employment.

However, the soft landing is predicated on labour markets remaining relatively resilient, with only a limited rise in unemployment across most major economies. This should help to put a floor on occupational demand. ‘Wait and see’ is as relevant in the occupational market as it is in the capital market, but in many cases, occupiers do not have a choice. Much of the current office leasing activity is driven by non-discretionary activity, and this will continue to churn providing firms are not shedding jobs.

Furthermore, it is important not to generalise. There is plenty of nuance in the office market, much of which is now well-versed; most markets are seeing a bifurcation between the best quality buildings, which continue to attract tenants, and the older, poorly located stock. In Germany, while overall take-up in Q3 was down by nearly 29% on the year, average prime rents have risen by over 9% y/y across the top six markets.

In Seoul, where the vacancy rate remains well below 5%, prime rents are up by 7.1% y/y. The caveat is that concessions are rising in some markets, with landlords reluctant to reduce rents. But nevertheless, the right office, in the right location, will continue to deliver strong returns. Capital values are a function of both rents and yields, something that is often lost in the conversation about offices.

Key transactions

Methodology

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 logistics facility located in a prime location, fully let at the market rental value to a strong covenant tenant on a 10–15-year lease with open market rent reviews. 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.

_{Read the articles within Taking Stock: Capital Markets Quarterly – Q3 2023 below.}