While rising interest rates pose concerns for property investors, a deflationary scenario could be worse. Fergus Hicks and Himanshu Wani explain
Euro-zone inflation fell to 0.5% in March 2014, the lowest since November 2009, and well below the European Central Bank target ceiling of 2%. This very low level of inflation has prompted fears of deflation, which could derail an already fragile recovery. Moreover, the International Monetary Fund has said that it is not just the euro-zone that is at risk, but the wider global economy, and that deflation could prove disastrous to the economic recovery. Additionally, consumer prices are already falling in some peripheral countries such as Spain and Ireland, as high unemployment puts downward pressure on wages and inflation.
DTZ Research has recently conducted a scenario analysis to quantify the impact that deflation might have on the commercial property market. We took nine major office markets within the euro-zone and forecast their performance in terms of yields and capital values in a deflationary environment. Our results indicate that in real terms, on average, capital values would fall 24% over our forecast period of 2014-18.
From a macroeconomic standpoint, deflation per se is not necessarily bad for the economy. Rather it is the cause of deflation that determines its impact. For example, deflation resulting from a new technology that increases productivity would be beneficial, while deflation as the result of a negative-demand shock would be detrimental. The latter is the reason behind deflation in our analysis.
Our deflation scenario sees euro-zone inflation decline in late-2014 and turn slightly negative for several years. The economy endures recession until the end of 2016, with GDP in 2018 remaining below its 2008 peak. In this environment unemployment continues to rise, reaching 25m, or 16.5% of the labour force by 2018. In Spain and Greece, the jobless rate rises to over 30% and to 22% in Portugal. The eurozone would suffer a ‘lost decade’ and the social costs would be enormous.
A worry for highly indebted euro-zone economies is that deflation would inflate the value of their debt in real terms and become more costly to service. Furthermore, these circumstances are often associated with a sharp fall in real asset values. If this degrades the value of collateral on which loans are secured, the effect of the initial shock is magnified as firms and households become more likely to default.
Unsurprisingly, commercial property performance would deteriorate; a deflationary episode caused by recession would lead to lower income growth prospects and push property valuations lower. On the occupier side, the euro-zone deflation scenario sees recession in the economy feed through to reduced occupier demand for office premises. Headline office rents decline across the euro-zone over the next five years as a result. Across the nine euro-zone markets covered, our base case sees annual real rental growth averaging 0.4% for 2014-18, while under the scenario real rent declines average 2.4%.
Although declines in real rents under the scenario may seem like good news for occupiers, they come against a backdrop of firms struggling to survive and profit margins being squeezed as the economy endures recession. We also looked at London West End rental growth forecasts. These are also scaled back as recession in the euro-zone causes the UK economy to slow.
Turning to the investor side of the market, as bond yields approach their zero bound-in recession-driven deflation, the rate of deflation determines real interest rates. The faster the pace of deflation, the higher real interest rates become. In the euro-zone real interest rates, which we define as the ECB refinancing rate less euro-zone inflation, have averaged 0.3% since the currency bloc was formed. This means that at the zero bound deflation of 2% per annum would push euro-zone real interest rates above their historic average. Combined with lower income growth prospects, this would exert upward pressure on property yields.
Office yields across the euro-zone drift out as recession hits occupier demand and income growth prospects are reduced. Uncertainty over the economic environment pushes up the property risk premium, particularly for foreign investors. Furthermore, since debt secured against real estate is fixed in money terms, under deflation its value increases in real terms. This could result in loan-to-value breaches, banks foreclosing on loans and distressed sales of commercial property, reducing the amount of leverage in the system.
The gradual outward shift in yields and declines in rents result in nominal capital values falling 24% by 2018 under the scenario, compared to rising 11% under the base case. After allowing for the impact of inflation/deflation, under the base case capital values rise 2% in real terms by 2018, while under the scenario they fall 24%.
Policymakers in Europe will be keen to avoid repeating the deflationary episode in Japan and have already expressed their determination to do so. Japan has endured falling prices for most of the past decade, and there is a sense that Japan is trapped in a deflationary mindset, partly as a result of a slow and ineffective response from policymakers.
The key message is that although we think the likelihood of deflation is low – at around 15% – from a risk management perspective it is important for investors to understand what deflation might mean for European property. Our analysis suggests that it would lead to significant capital value erosion.
Fergus Hicks is global head of forecasting and Himanshu Wani is senior analyst at DTZ Research
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