Uncertainty on office valuations sees investor shift away from sector

Recent data released by Real Capital Analytics (RCA) show a clear shift in European investor preferences away from offices and more towards residential and logistics - with Paris proving an exception, with demand for office assets remaining strong.

The RCA figures show a total investment volume in European property for the first quarter of €53.3bn - 32% down on the corresponding quarter last year. However, residential investment was up 36% to €16.1bn, while the senior living and care home sector jumped 10%. Offices are down 58% on last year, amounting to €14.5bn, with similar falls for hotels and retail. The in-favour logistics and industrial property sector was marginally down, but have gained market share vis-a-vis the pre-COVID years.

The share of investment in offices has plunged to 27%, representing a big shift away from the sector at least in the UK and Germany, Europe's largest markets. In the UK, investment volume in residential portfolios about equalled that for offices, a radical shift over the past couple of years from when residential portfolios played an insignificant role.

Notable also are the change in yields, as investors re-assess risk in all asset classes. Initial yields on urban logistic centres have seen their differentials to office, for example, fall from a difference of 150 basis points in 2017 to only about 30 bps now, as uncertainty hangs over the whole office sector in big cities like London and Germany's BIG 7.

The RCA figures are supported by the latest quarterly RICS Monitor survey results. Presenting the figures recently, RICS Deutschland's CEO Susanne Eickermann-Riepe highlighted how much the pandemic still has Europe firmly in its grip, and that the effects would be felt for at least the next three to four years.

The RICS survey respondents see retail rents falling further - for top locations, by 6%, while for secondary locations rent falls of up to 12% are expected over the coming twelve months. Logistics properties might see rents rising by up to 5% for the best locations, and 1.4% for secondary quality, said the RICS respondents.

The big uncertainty hangs over office space, where demand for office space is expected to fall by 8% over the next two years, with rents in secondary locations falling by about 3%. Top-quality buildings should be able to hold rents steady, perhaps even increase by 1%.

In this respect Germany compares well on an international basis, for although vacancies will rise, in Germany's biggest cities should remain under 6%, says the research team at Colliers Deutschland.

Despite what is expected to be a strong economic recovery, the effect of home-office working and new risk aversion by project developers to take on speculative new-build projects, is likely to see office demand fall by a good 5%, says Colliers. Frankfurt could have 10.5% vacancy by 2023, slipping back to old levels of over-capacity, they say.

In a recent note by Helge Scheunemann, JLL Deutschland's head of research, Germany's office market is viewed as being at a turning point, with landlords starting to offer generous incentives to tenants in order to sustain rent rates. He says the effective rents on a five-year lease agreement are now about 4% below the contracted rents, equivalent to about 2-3 rent-free months.

The low level of transactions means that price visibility is still a problem, with actual price developments likely to show up only later. At a recent presentation, Jens Tolckmitt, the head of the VdP, the association of Pfandbrief-issuing banks, mentioned falling demand for office investment but no evidence that prices could fall significantly. He said he expected a sideways movement for a while pending the recovery of the economy, and thereafter further modest growth.

All the signals that we're picking up here at REFIRE strongly support the view that offices in major European cities will be increasingly subject to polarisation, with less desirable, older properties struggling to maintain rent levels, while newer developments will see rents hold up well. Evidence of this is likely to become more abundant as economies start to recover after the pandemic.