The year 2022 marked a turning point for office values both in Spain and in Europe as a whole, as interest rates rose after a prolonged period in which they stood at close to 0%. Although occupational markets held up well and in some submarkets, particularly CBD (Central Business District) and City Center, there was modest rent growth, the impact of rising borrowing costs and the corresponding rise in bond yields was more than enough to push down pressure on securities.
The correlation between real estate and government bond returns is well known, with real estate yields typically higher than those on fixed income to reflect both the illiquidity of real estate assets compared to bonds, and the fact that risks are part of the real estate sector and should be rewarded with higher yields.
Prime office yields in the Eurozone rose 38 bps last year, but with bond rates rising by 279 bps over the same period, it has not been enough to stop the fall in the office yield premium from 423 bps at the beginning of the year to just 182 bps at the end of the year. This is leading some to suggest that office returns have much more to go up.
Taking Eurozone offices as an example, prime yields have enjoyed a premium of an average of 3.6% over the past five years and up to 4% in the fourth quarter of 2021. However, at the end of 2022, the premium was only 1.7%, its lowest level since 2008.
However, we are no longer in an environment of ultra-low interest rates: taking an average of five or even 10 years that includes this period of monetary history can be misleading. If we recall the behavior of the market before the financial crisis of 2008-2012 (GFC), when interest rates were higher, the profitability premiums of real estate assets were much lower: only 225 bps for offices in the Eurozone, for example. What's more, the gap has already stabilized and may rise again to be closer to pre-GFC averages in the coming months with only a modest additional increase in housing yields and a stabilization in bond rates. Therefore, we may be closer to reaching a new equilibrium in office profitability than many suspect.
While this interpretation offers a somewhat positive outlook for the European office investment market as we move into 2023, it is important to differentiate between well-located prime offices, which meet occupant demand in the post-coronavirus world, and secondary assets (by location, quality, and services, among others), which are projected to lag behind. An increasingly bifurcated investment and leasing market is expected for the foreseeable future, as the price gap between well-connected, highly sustainable high-quality assets and offices deficient in these issues will continue to grow. Therefore, it may be true that prime office yields have already experienced much of the correction brought about by the new interest rate environment we find ourselves in, but this is not necessarily the case for all offices in all submarkets.