French yield under pressure
As elsewhere in Europe, offices is the asset class that has suffered most in the real estate market in France. However, when one speaks of French offices, it is acknowledged that the country has two distinct institutional office markets: the very large and diverse Paris market and the provinces sub-markets. It should be stressed that in periods of troughs, provincial offices have on average traditionally outperformed Parisian offices. For example according to Immostat, prime office rents in La Défense are 35% below their 2000 peak (-17% in Paris central business (CBD) district). More recently, prime rents in the major provincial office markets show a relative stability (4% down from the 2000 peak).
However, recent positive signals have been observed: vacancy has peaked in first quarter of 2004, and remains way below the peak that was reached during the 1990’s crisis. Take-up has started to recover since the second quarter of 2003, even if net absorption remains slightly negative. In this context, rents in recent transactions have still been slipping, but at a much more moderate pace.
The most worrying factor is the employment market. More than 40,000 office jobs have been closed in the Paris region during 2003. What is more, the employment market does not show any clear sign of recovery despite stronger macroeconomic figures. This has considerably dampened our rental prospect for the Paris office market, and we do not expect any significant rental growth before 2006.
Another striking feature of the French real estate market is the disconnect between rental market fundamentals and capital market flows and pricing. The phenomenon is of course similar to that observed in the US and many other major European markets. The so-called ‘excess liquidity’ recorded for the case of the most secured assets, has driven cap rates down and limited the slide in capital values, despite rental declines. The question of over-pricing in the French market is then truly an issue today.
To understand the mechanics of what is happening today, one has to turn to the ‘real estate risk premium’, ie, the current cap rate net of the real risk free interest rate. Our analysis shows that today’s risk premium in France is at a historical high (400 basis points), clearly above its long-term average (160 basis points over the last 15 years). Given the fact that we probably are on the verge of improving real estate fundamentals, this ‘comfortable’ spread makes real estate investment very attractive, even when one factors in a probable increase in interest rates.
Many investors believe that the timing is now ripe for a move from ‘defensive’ to ‘growth’ stocks with more development and letting risk, particularly for the Paris office market given its cyclical behaviour. As for the provincial market, the investors should still find opportunities for yield compression since those markets still exhibit the highest office cap rates in Europe (8.0% in Lyon and Marseille and 8.5% in Lille).
The Paris region logistics market has quickly adjusted to the fall in demand observed in 2003: speculative development has drastically dropped from 1,000,000m2 to 25,000m2 in this region from end 2002 to end 2003. Consequently, rents have slightly slipped (-5.0-6.0%) during that period. Demand should pick up based on sustained consumption spending in France (which remains the main growth engine). Investment opportunities should relocate from mainstream transportation axis to European ‘entry points’ located in France, such as the ports in Marseille and Le Havre.
According our analysis, there is still room for yield compression as these are still amongst the highest in Europe, in a market that is becoming more and more institutionalised.
Mahdi Mokrane is head of research and strategy, IXIS AEW Europe in Paris