Eurozone inflation fell to 0.5% in March, the lowest since November 2009, and prompting fears of deflation. Deflation is not our central forecast, but presents a serious risk to European commercial property.
Deflation is not bad per se, but there are certain costs associated with it, such as it increases the value of debt outstanding in real terms. However, deflation caused by weak demand would have a negative impact on the economy and property market.
We look at a Eurozone deflation scenario which sees the economy return to recession, occupier demand fall and headline office rents drop. By contrast our base case sees the recovery gain momentum, unemployment plateau in 2014 and inflation gradually rise. Office rents show modest increases under the base case.
The deflation scenario sees higher real interest rates and the property risk premium increase due to uncertainty over the economic environment. These factors push office yields higher than under our base case, and capital values drop 24% in real terms over the next five years. By contrast they rise 2% under our base case.
Unsurprisingly, the deflation scenario makes all 9 of the Eurozone office markets analysed look overvalued on current pricing, by 27% on average. However, the likelihood of the deflation scenario playing out is relatively small, estimated at just 15%.
The weak Eurozone economy under the scenario precipitates slower growth and mild deflation in the UK. London office rents and capital values are hit as a result, making current prices look 10% overvalued.
Source : DTZ (Groupe UGL)