Will the Value of Office Buildings Fall off a Cliff?

Disaster on the Horizon? The Bull Market for Office Real Estate is Over.

Over the past decade, investors in the office market have seen yields (aka “cap rates” in real estate speak) just going one way: down. For instance, prime yields in the Amsterdam office market came down from around 6% in 2012 to just 3% in 2021. After riding the market wave for such a long time, it’s easy to forget that yields can also go up, and thus prices can also come down.

One of the main drivers behind declining yields has been the low, lower, lowest interest rate – the 10yr swap rate went from 2.4% to 0.4% over the 2012-2021 period. Alas, the golden era of almost free money is over, with the 10-year swap rate now back at 2.2%, and slated to rise some more as the ECB pares back its QE program and, yes, finally raises rates. The big question is: what are the implications of more expensive financing on the value of the commercial real estate?

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The economist view is quite sobering:

First, many “levered buyers” (i.e. those buyers that are relying, for a large part, on debt) have disappeared from the market, given that equity returns are no longer supported by cheap debt. Less demand for commercial real estate assets means, well, lower prices;

Second, pension funds, among the largest providers of capital in the real estate market, are pulling back slowly from illiquid assets, given the need for liquidity due to margin calls on interest rate swaps, and rapidly declining equity and bond portfolios. The latter has increased real estate allocations to levels that are significantly above target allocations, leading to less new capital flowing into real estate.

Third, the war in Ukraine, the higher cost of capital, and the scarcity of goods (i.e. inflation) are slowing down economic growth, with a recession likely to happen in the very near future. A recession means fewer jobs, less demand for space, and thus higher vacancy rates and lower office rents.

Fourth, the office market is still adjusting to the implications of COVID-19. Companies are calibrating their need for office space, and over the next couple of years, leases coming up for renewal will be carefully evaluated. Remember: small changes in demand can have large implications for the pricing of real estate. Recent research from Stijn van Nieuwerburgh at Columbia predicts a 28% drop in commercial office prices due to this factor alone!!

All of this will have significant implications for office yields. How large will the decline in office values be? Well, a simple, back-of-the-envelope calculation tells us that a 200bps increase in cap rates, from 400 to 600bps, will reduce prices by about a third (yes, price reductions of 30% or more!). That assumes “ceteris paribus,” or no changes to rents or supply. And given that the real economy may be affected by the lethal cocktail of monetary tightening and an ongoing war, the effects might be even larger.

Asking real estate market participants, like brokers, you would hear that, of course, “this time it’s different,” and that you should not fear…

Some argue that there are plenty of non-levered buyers around that sit on large swaths of cash. Indeed, plenty of money has been raised over the past years, and much of that money still needs to be deployed.

The market for space, which ultimately drives the cash flows of office buildings, is in pretty good shape. Despite COVID and its implications for the office market, the leasing market holds up pretty well (until now), with vacancy rates in Amsterdam at 3%, in Frankfurt at 8%, and similarly at 8% in London.

Inflation is high, and existing rent contracts can be raised, technically, by the consumer price index, That would bode well for rent growth, at levels of 8-9%. But of course, there is a big difference between can and will, given that some tenants may not be able to afford such a rent increase, and in other instances, space may already be overrented.

Looking at appraisers for guidance on the future development of commercial real estate values isn’t the solution: looking backward, at “comps” and lease deals achieved over the past months, does not tell us anything about the near future, let alone what may happen over the course of the next 12-24 months. One area of the market that may provide some more insight is the REIT market – listed real estate stocks tend to lead private equity real estate by about 24 months. Here, the news isn’t great:

Alstria (DE): -/- 39%

Demire (DE): -/- 25%

Gecina (FR): -/- 24%

Vornado (US): -/- 28%

So, REIT office pricing implies we should prepare for a 24-39% decrease in prices of commercial office property.

If you’ve ever been riding a wave, it feels like it never ends. But at some point, you either fall off or jump off the board, hitting the cold water. Office market investors are still on the board, but the wave has come to a standstill. Time to prepare for a careful landing…