Recent rises in government bond yields do not change our view that office and industrial yields will edge down a bit further in the next year or two. In fact, we don’t expect broad-based upward pressure on property yields until after 2023.
- Recent rises in government bond yields do not change our view that office and industrial yields will edge down a bit further in the next year or two. In fact, we don’t expect broad-based upward pressure on property yields until after 2023.
- Following the trend seen in many advanced countries, European government bond yields have increased significantly in the last month or so. Although they have edged back a bit in recent days, German and Italian bond yields are still around 20bps and 10bps higher than at the start of the year. And similar upward shifts have occurred in other alternative assets yields, such as corporate bonds and equity dividends. However, we think these moves are unlikely to have material implications for property yields in Europe.
- For one, the recent rises in bond yields are expected to be temporary. In our view, they have been driven by fears of rising inflation, rather than an expectation that the ECB has become more hawkish. And since recent increases in inflation have been driven by temporary factors, while economic activity remains weak, this shift is not expected to be permanent. Added to this, ECB policymakers have expressed concerns about the recent rise in bond yields and would likely step up their asset purchases if the sell-off in bond markets were to resume. (See here.)
- Further, even with these increases, bond yields remain low by historic standards. As such, property remains attractive to investors. Indeed, even with the rise in bond yields, valuations continue to suggest that most office markets are still fairly or undervalued. (See Chart 1.) The exceptions are Prague, Athens, Oslo and Zurich. Of these, Oslo and Prague are markets where we think valuations are unlikely to improve from here, as we expect the central banks in Norway and the Czech Republic to start tightening interest rates in the second half of this year, keeping upward pressure on bond and property yields.
- Admittedly, we also now think that bond yields will start to trend up from next year, earlier than expected in our last Outlook. (See here.) But our prime office yield model does not suggest that any significant changes are needed to our forecasts as a result. (See Chart 2.) The rise in bond yields will come alongside an improvement in economic activity and expected rental growth, which will provide offsetting support to property yields. In fact, model estimates would be consistent with only small upwards moves in offices yields of around 5-10bps, but not until later in the forecast horizon.
- Therefore, we remain comfortable with our view that office and industrial yields will edge down this year and next. That said, these developments support our view that these falls will be relatively small. Further ahead, property yields are expected to stabilise, before they gradually edge up after 2023.
Chart 1: Office Valuations vs Govt. Bond Yields (%pts)*
Chart 2: Euro-zone Prime Office Yields (%)
Sources: Refinitiv, Capital Economics *Using 2020 Q4 office yields
Sources: Refinitiv, Capital Economics
Amy Wood, Property Economist, firstname.lastname@example.org