y = i + p - r
The transaction volume in the German commercial and residential property investment totalled approximately €3.6bn in August. The rolling twelve-month volume stood at €74.3bn at the end of August, declining by 3.3% compared with the previous month.
The current yield on 10-year German government bonds is not only lower than ever but, more importantly, is also significantly negative (-0.7% on 01.09.2019). Consequently, the yield differential between office property and Bund yields is higher than ever before at 377 basis points (see Graph below). This record differential poses the question of whether real estate yields will fall further.
Based upon the capital asset pricing model (CAPM), initial yields on real estate can be represented as follows: the yield (y) is a result of the risk-free interest rate (i) plus the risk premium (p) minus expected rental growth (r). Hence, y = i + p - r. We have assumed that the 10-year Bund yield represents the risk-free rate in respect of long-term investments. Consequently, real estate yields are only likely to remain unchanged if the lower bond yields are offset by a rising risk premium and/or falling rental growth expectations.
In our view, there are no indications that estimations of the risk premium on office property have fundamentally changed over the last few months.
According to the latest economic data, Germany has slipped into a technical recession. In addition, the Ifo Business Climate Index for August posted the lowest figure since November 2012. Both of these factors are likely to have a negative impact on demand for office space in the medium term. Accordingly, we consider it probable that investors have revised their short to medium-term rental growth expectations downwards. This argues against further initial yield compression.
However, there are arguments that rents could increase further in an economic dip.
Firstly, it appears likely that companies would hold onto their personnel for as long as possible even in a weaker economy. Even during the crisis year of 2009, the unemployment rate only rose by 40 basis points despite the gross domestic product declining by 5.7%.
Secondly, quality requirements are increasing when it comes to office space, which could produce a trend towards higher rents on new lettings.
Thirdly, owing to the greater mobility of personnel between different office locations (multi-locality), there is a trend towards higher requirements for office space.
Fourthly, we are assuming that many offices in the top seven cities are currently over-crowded. Hence, it is unlikely that many occupiers will reduce their office space.
THE TEN LARGEST SINGLE-ASSET TRANSACTIONS IN AUGUST 2019*
Source: Savills / *only published transactions are shown
For further information, like transaction volumes and yield development, please see the PDF file.