One factor overshadowing interest rates is the gradual discontinuation of Quantitative Easing in the eurozone. A first concrete step was made at the beginning of 2018 as the institution already halved (to €30bn) its purchases of public and private securities. Further, the outcome of the last ECB meeting on June 14 was in this direction, with the end of QE being announced for end-2018 if the data confirm an increase in inflation, in the meantime keeping rates at rock bottom until summer 2019. The institution is thereby taking precautions, acting gradually and gently, which is bound to reassure financial markets.
There are several pushbacks to this potential increase in interest rates that are even set to last in the long term. There is the abundance and progression of global liquidity, particularly due to the accumulation of foreign currency reserves. Purchases of central bank bonds will remain considerable, even in the absence of QE. Inflation also remains fairly moderate in the eurozone, below the ECB’s 2% target, and is showing fairly little reaction to the health of the economy, commodity price trends, or even liquidity injections, even though these were largely made to push up the prices of goods and services. Moreover, the potential growth of the eurozone as a whole is now weaker, notably due to the less buoyant demographic trend and the overall debt levels of its countries. Lastly, it must be acknowledged that risk aversion could increase, with geopolitical tensions still present and doubt cast by protectionist intentions, as in the US. Such an environment could keep interest rates down for some time.
Companies of all sizes are taking advantage of global growth to increase sales and expand, leasing new spaces, often in the best locations. Net absorption is very positive in most European markets, leading to falls in supply despite fresh completions. Investors are keener than ever on prime assets in particular, both in Paris and certain French cities, as well as throughout Europe. The flight to quality attributed to bond markets could quite easily refer to real estate market of the main European business districts. Their remuneration is actually very attractive against the current interest rate backdrop. The construction of the initial real estate yield required by the investor may be seen as a sum between the risk-free rate and a risk premium.
The commonly applied risk-free rate is the long-term government bond yield, i.e. usually the 10-year OAT for France. In reality, calling government borrowing 'risk-free' is increasingly theoretical since the recent European sovereign debt crises. With respect to the initial real estate yield, if we take the prime office yield of the Paris Central Business District (CBD) as a benchmark, which currently stands at around 3%, the risk premium is around 230 basis points. This is historically high compared to its average of 150 bp for the last 15 years. This must mean that the prime yield of Paris CBD has a high resistance margin, of at least 80 bp, against a potential rise in bond yields. This resistance margin can be seen as a minimum as investment conditions in Paris CBD are very favourable at present, with an extremely low vacancy rate (2.4% vs. a 10-year average of 4.8%), and still relatively moderate rents.
The risk premium currently offers bright prospects to landlords seeking security, liquidity and yield. Furthermore, robust economic conditions and the generally healthy fundamentals of occupier markets mean that rental increases can be forecast for years to come, both for market and indexed rents, which was not the case a few years ago. Against a backdrop of weaker prime yields, rents therefore offer a source of growth to underpin increases in capital values. The confidence of investors in the French economy has rarely been as high as it is today. Monetary policies should create a financial environment that enables institutional investors to build their positions in commercial and residential real estate in the coming years. These allocations should thereby see European markets like France and Germany rise in the rankings among the world leaders of commercial real estate investment, which is becoming an increasingly globalised asset category, like those of debt and interest rates.
Nicolas Tarnaud, PhD, Frics, is an economist, head of the International Real Estate MBA at the Financia Business School in Paris, and a researcher at Larefi Université Bordeaux IV.
Richard Malle, PhD, Mrics, is Global head of research for BNP Paribas Real Estate and a lecturer at the Conservatoire des Arts et Métiers (CNAM) in Paris.