The uptick in government and corporate bond yields in Q4, coupled with the continued decline in property yields, resulted in a deterioration in the relative valuation of commercial property markets in Europe. That said, less than a third of all markets look overvalued. And given the recent financial market fallout caused by the COVID-19 outbreak, which has seen equity prices and government bond yields tumble, property valuations should improve in Q1.
- The uptick in government and corporate bond yields in Q4, coupled with the continued decline in property yields, resulted in a deterioration in the relative valuation of commercial property markets in Europe. (See Chart 1.) That said, less than a third of all markets look overvalued. And given the recent financial market fallout caused by the COVID-19 outbreak, which has seen equity prices and government bond yields tumble, property valuations should improve in Q1.
- The European all-property yield fell in Q4, reflecting a broad-based decline across the sectors. On an annual basis, the pace of yield compression was the fastest since Q2 2018.
- Markets breathed a sigh of relief as trade tensions abated and government bond yields ended the year higher. In contrast, the rally in equities resulted in equity dividend yields edging down.
- In turn, our property valuation scores deteriorated across the board. The proportion of overvalued markets rose from 22% in Q3 to 28% in Q4. However, this was still an improvement from Q4 2018’s 52%.
- At the sector level, most office markets appear overvalued, while 74% of retail markets are now in fair-value territory. The industrial valuation score, on the other hand, is back to its Q2 level.
- By region, except for Budapest offices, all CEE assets look fairly valued. In contrast, all the undervalued markets were concentrated in the euro-zone. The performance of the Scandinavian markets was mixed.
- A brief summary of our methodology is presented, for reference, on page 5. Further details can be found in our Focus, with an explanation of our updated weightings in this Update.
Chart 1: Composite Valuation Scores by Sector (%-pts)
Source: Capital Economics
Chart 2: Prime European yields finished 2019 at a historical low of 4%, down by 10bps on the year.
Chart 3: Much of the yield fall in Q4 was concentrated in the office sector, while only retail yields edged up.
Chart 4: Bond yields edged higher at the end of 2019 as policy rate expectations rose, but have since reversed
Chart 5: Prior to the COVID-19 related global market rout, dividend yields had trended lower.
Chart 6: While valuation scores deteriorated across the board, all sectors are still in fair-value territory.
Chart 7: The number of office markets that appeared overvalued rose in Q4, back to its Q1 2019 level.
Chart 8: Milan retail ended the year in fair-value territory, while Madrid continues to look undervalued.
Chart 9: Almost half of industrial markets now appear overvalued, with only Lisbon looking undervalued.
Sources: Refinitiv, Capital Economics
- The easing of tensions in response to US and China reaching a “phase-one” trade deal and positive signs on the economic outlook meant that bond yields in the euro-zone edged up at the end of 2019 (10). Since then, the outbreak of COVID-19 has sparked a rally in safe-haven assets, most notably government bonds in the euro-zone. In the rest of Europe, Russia and Turkey bucked the upward trend in bond yields, as both countries pressed on with their respective easing cycles (11).
- Meanwhile, in line with the movement in “risk-free” rates, corporate bond yields in Europe ticked up by 14bps in Q4 (12). And even though we no longer expect the ECB to increase the pace of its asset purchases, given our forecasts for further monetary easing this year, corporate bond yields are likely to remain low.
- Dividend yields generally fell in Europe, as equities rose towards the end of the year on the back of an easing in US-China trade tensions (13), (14). Overall, despite the decline in dividend yields, the rise in bond yields meant that the relative valuation of property deteriorated in Q4. Since then, bond yields have plummeted, and our expectation for government bond yields to remain low over the next two years should provide support to property valuations (15).
Chart 10: Euro-zone 10-Year Government Bond Yields (Change over quarter, Bps)
Chart 11: Non-euro-zone 10-Year Government Bond Yields (Local currency, Change over quarter, Bps)
Chart 12: European 7-10-Year BBB Corporate Bond Yields (Change over quarter, Bps)
Chart 13: Euro-zone Equity Dividend Yields
Chart 14: Non-euro-zone Equity Dividend Yields (Change over quarter, Bps)
Chart 15: Alternative Asset Yields (%)
Sources: Refinitiv, Capital Economics
- With both government and corporate bond yields ending the year a touch higher, and property yields continuing to trend lower, valuations generally worsened. Moreover, compared to their historical performance, office assets across Europe look overvalued (16).
- Office market valuations fared better when compared against government bond yields, with only Istanbul, Prague and Amsterdam looking overvalued (17). Moreover, substantial declines in dividend yields in Q4 meant that a few markets saw their valuations improve against equities (18). That said, most office markets still look overvalued against this asset class. Bringing all this together, the number of office markets that appeared overvalued on our composite measure doubled in Q4, with only Lisbon looking undervalued (19). Both Rome and Barcelona moved back into the fair value zone.
- In contrast to the office sector, given that the falls in European retail yields in Q4 were more muted than in the other sectors, there was a widespread improvement in retail valuation scores (20). Most markets are now firmly in fair value territory, with only Istanbul looking overvalued. In the industrial sector, on the other hand, most markets saw a deterioration in their valuation scores (21). Industrial assets in Germany and France recorded the largest declines.
Chart 16: Office Valuations vs. 10-Year Averages (%-pts)
Chart 17: Office Valuations vs Govt. Bond Yields (%-pts)
Chart 18: Office Valuations vs Dividend Yields (%-pts)
Chart 19: Composite Office Valuation Scores (%-pts)
Chart 20: Composite Retail Valuation Scores (%-pts)
Chart 21: Composite Industrial Valuation Scores (%-pts)
Source: Capital Economics
- Assessing value in property markets is not an easy task. But assessing the relative value of commercial property against a range of alternative asset classes – government bonds, corporate bonds and equities – and its own long-term history is a useful approach. We have formulated a composite valuation measure, based on historical data, for each of our 31 markets and across each of the three main sectors. This provides an objective rationale upon which we can rank markets according to their relative valuation scores.
- Our valuation measure focuses on the income yield of property and alternative asset class yields. Other property valuation measures tend to factor in expectations for rental growth. However, in our view, this risks falsely justifying aggressive market pricing, particularly near the peak of a cycle. Therefore, we base our analysis on the current income yield, which we believe provides a fair and prudent comparison.
- In order to reach a valuation score for each measure, we calculate the average quarterly yield gap between prime property and the alternative asset’s yield over the last 10 years. This long-term yield gap is then added to the current yield on the alternative asset to form a required yield or ‘fair value yield’. We then compare this required yield to the current property yield in that market to determine whether a market is undervalued, fair value or overvalued. Our fair value band is centred on zero, but has a 50bps range either side, with markets being undervalued or overvalued if their yields diverge by more than 50bps from their required yield. Our analysis aggregates valuation scores against different asset classes to provide a single valuation score for each property market and sector, but the weights attributed to each asset class comparison can vary, as shown in Table 1.
- We have back-tested the valuation measure to ensure that it will send the appropriate signals when property moves too far away from fair value. Chart 22 shows the back-tested measures for a small selection of office markets. This shows that the measure would have highlighted the overvaluation of Madrid offices in Q4 2006. At that time, historically low yields were justified by double-digit annual rental growth expectations and therefore, traditional models of fair value would have still shown the market to be reasonably well-valued. In the current cycle, there was a clear downward trend in valuations in the markets shown between Q4 2014 and Q4 2018. Since then, there has been an improvement in valuation scores in the last three quarters as alternative asset yields have fallen.
Weights This Quarter
In 2019 we made a significant change to our weightings for all three sectors, having removed any weighting to property’s score against its own long-term history. (See our Update.) Most of this weight has been re-allocated to government bonds. Despite investors’ focus on income yields, we have decided to err on the side of caution with respect to the equity weighting and keep it at a fairly high level of 0.35. This reflects the risks to economic growth and thus, income growth, as well as commercial property’s inherent upside potential.
Chart 22: Office Market Valuation Scores
Table 1: Weightings of Valuation Sub-Measures
Source: Capital Economics