DTZ Insight Impact of Europe s austerity measures Most exposed markets offer highest returns

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1 DTZ Insight Impact of Europe s austerity measures Most exposed markets offer highest returns 13 September 2011 Contents Introduction 2 Methodology 2 Criteria 1 Sovereign debt 3 Criteria 2 Economic performance 5 Criteria 3 Office employment trends 6 Country grouping 10 Impact on office markets 11 Appendix 13 Authors Kasia Sielewicz Forecasting & Strategy Research +44 (0) Matthew Hall Forecasting & Strategy Research +44 (0) Contacts Magali Marton Head of CEMEA Research Martin Davis Head of UK Research +44 (0) Tony McGough Global Head of Forecasting +44 (0) Hans Vrensen Global Head of Research +44 (0) Our analysis confirms the limited risk appetite in European office markets (Figure 1). Total returns in markets most exposed to austerity measures related to the evolving sovereign debt crisis are forecast at 8.4% pa for This is higher than those in the least exposed markets (6.7% pa). These returns are mostly driven by higher income returns, as investors demand higher yields to invest in the most exposed markets. There is a spread of over 100bp between the most and least exposed markets. Along with higher income returns, we expect some yield compression, as we expect the most exposed markets government bond yields to tighten and return towards their lower long-term averages. This is in contrast to the least exposed markets where government bond yields are expected to rise, triggering negative yield impact. Despite strong total returns, rental growth is forecast to be extremely subdued throughout the next five years in the most exposed markets. Austerity measures are dictating significant public sector job cuts in many markets, acting as a drag on rents, by feeding through to overall economic growth. Secondary office locations are more dependent on public sector employment than city centres increasing exposure to job cuts and thus having greater impact on office space demand. Overall, the impact of austerity measures on office markets is currently limited to handful of countries at the heart of the crisis. The majority of key office markets are classified as marginally or least exposed. Figure 1 Components of total returns by criteria Source: DTZ Research 8.4% Average total return Most exposed Marginally exposed Least exposed Capital Value Growth 7.8% Initial Yield 6.7% 1

2 Introduction Introduction Historically high levels of national debt, combined with falling GDP levels have left some European economies exposed to sovereign debt concerns. Reducing national debt through austerity measures is the only option for many countries. As part of these austerity measures, we expect job cuts. Cutting public sector spending through job reduction will have a significant impact on the property sector in some markets. We attempt to quantify the impact of public sector job cuts across European countries and property markets in this report. We have attempted to highlight countries that are most at risk and why, and then demonstrate how office market performance will be affected over the next five years. The approach we have taken represents an assessment across three criteria; if the proportion of national debt relative to GDP is high, whether GDP growth is expected to be weak over the next five years and lastly if proposed public sector job cuts are substantial relative to total office employment. We then group countries depending on how many criteria they meet. Results suggest that countries that meet two or more criteria can expect relatively flat rental growth over the next five years, with rents edging upwards only at the end of Our analysis also indicates that investors have generally already priced in the risk for holding office assets in these markets as yields are substantially higher than in countries that meet one or none of the criteria. Methodology We undertook following steps to assess the impact of austerity measures on office market performance in Europe: Step 1: Criteria setting As a starting point we have formulated three criteria against which each country has been assessed: Proportion of public debt to GDP Annual GDP growth over Change in public administration employment relative to total office employment, Step 2: Country grouping For each of the criteria we have set a threshold to assess how many of the criteria are met by each country. Countries that meet more than two criteria are viewed as most exposed and were classified as Most exposed. Countries that meet one criteria were classified as Marginally exposed and none of criteria as Least exposed. Step 3: Impact on office markets We have then assessed the outlook for office market for each group of countries over the next five years. Real estate performance indicators in our analysis included: Rental performance Yield movement Total return Furthermore, it is clear that although this analysis is focused on country level performance, there is a significant difference in exposure by regions and cities. Some regions such as East Germany, Southern Italy and Northern Scandinavia - have high levels of exposure to public sector employment highlighting their vulnerability. We note that many of these more remote regions do not have major office markets, as part of our regular market coverage. The economic and employment data used in this report is sourced from IMF and Oxford Economics. The property indicators and forecast are based on in-house data and models. Total office employment comprises of public sector administration, also referred to as the public sector, and employment in finance and business services (F&BS) sector. 2

3 Sovereign Debt Step1: Criteria setting Criteria 1: Sovereign debt Where is the debt? In the years leading up to the financial crisis, national debt levels in many European countries maintained an upward trend, as high GDP growth expectations provided justification for government spending growth. However, high levels of debt (Figure 2) alone do not necessarily mean that countries are over-stretched or likely to default - as long as economic growth continues and budget deficits (Figure 3 horizontal axis) remain under control. Nevertheless, the aftermath of the financial crisis led to European recession as consumption fell and exports collapsed. Weak economic performance subsequently exposed some countries in Europe s periphery, in particular where unsustainable public spending led to large budget deficits and hence dramatic increases in national debt. This consequently led to falling confidence in many country s finances, causing their cost of debt in the government bond market to soar. To ascertain how indebted a country is we have looked at national debt relative to its economic output. In Europe, Greece and Ireland have some of the highest ratios at 152% and 114% respectively, hinting why these are at the heart of the current sovereign debt crisis (Figure 2). Although debt in Italy is second highest, both in absolute terms ( 1.9trn) and as a proportion of GDP (12), its budget deficit has been relatively stable until now. Spain s economy is less leveraged, at 64% of GDP. However, concerns are growing over potential growth in debt through falling GDP (Criteria 2). Spain s economic growth was driven by a highly cyclical construction boom, leaving the economy vulnerable to a downturn. Should GDP fall too severely, the budget deficit will rise as tax receipts fall (increasing borrowing requirements to replace lost tax revenue), driving up national debt. Furthermore, as GDP falls, the ratio of national debt to GDP rises, generating even further concern. Although Spain is currently outside the most effected markets, it is simple to illustrate how easily this can change. In absolute terms, Germany has the largest debt, just over 2trn. Despite this, the proportion of debt to GDP is only 8. As its economy is continuing to grow and the budget deficit is stable, at a manageable level so investors consider Germany a safe bet. The UK has the fourth largest national debt in absolute terms but as a proportion of GDP equates to 77%, below the European average. However, concern was mounting over the expanding budget deficit amid sluggish growth, prompting the UK government to make aggressive cuts in public sector spending over the next five years. Fiscal finances are in much better shape in the Nordic countries where prudent politics and downsizing of the public sector started to take place before the financial crisis. As such, they have typically low public debt and are expected to show sustainable deficits, or even surpluses, in Figure 2 Government gross debt as % of GDP, year-end 2011 Figure 3 Government gross debt in bn and % of GDP vs. budget deficit, forecast Source: IMF, DTZ Research Weighted average 88% Gross goverment debt amount (% GDP), year-end Finland 97 Belgium Italy 1,916 Portugal 355 France Germany 156 1,761 Austria 2, Spain 693 Netherlands 211 Denmark Poland Romania Turkey Czech Republic Russia Greece 116 2% 4% 6% 8% 1 12% Source: IMF, DTZ Research 345 Budget deficit (% GDP), year-end 2011 UK 1,438 Ireland 177 NB: Hungary, Norway, Switzerland and Sweden are not represented in the chart as these economies are expected to have no deficit in The debt to GDP ratio is forecast to equate to 77% in Hungary, 54% in Norway, 37% in Sweden and 53% in Switzerland as of year-end

4 Sovereign Debt Debt maturity drives loss of confidence Outstanding debt alone is not the only issue, the maturity profile of that debt can undermine investor confidence, as seen in Greece. Our analysis shows that over 4 of Greece s debt is set to mature between 2011 and 2015 (Figure 4) N.B. this was close to 6 prior to recent renegotiation. As servicing its debt became a pressing matter, Eurozone policy makers recently agreed to a second bailout. This time round the 109bn rescue package was accompanied by the lengthening of loan repayments and lower interest rates on bail-out loans. In addition, private bond holders were also urged to chip in by voluntarily participating in debt exchanges and rollovers. The second bail-out released some immediate pressures and lowered the cost of debt, but did little to address the outstanding value. Conversely, UK debt maturities are more spread out and tend to be on longer dated bonds, following issuance of 30 year bonds between 2008 and In the next four years 3 of debt principal is to be repaid to UK debt holders, which is well below the European average. Risk of contagion elevated In addition to Greece s rescue package, Portugal and Ireland have also had loan maturities extended and interest rates reduced. This prevented a meltdown but ultimately failed to convince investors that the underlying problem has been resolved. This was reflected in Italian and Spanish government bond yields which edged upwards. To prevent spreading of the crisis, the ECB intervened by purchasing Spanish and Italian bonds on the secondary market. Bond yield movements indicate the level of risk investors attribute to government debt and as such, it is a good indicator of a country s creditworthiness. Bond yields in Ireland and Greece remain elevated albeit reduced after the Eurozone response (Figure 5). On the other hand German bund yields fell amid investors retrenchment to safe assets and general risk aversion. Spread of debt crisis would be disastrous A spillover of the sovereign debt crisis to Italy and Spain or even to France would have a much more profound impact on the Eurozone and subsequently on Europe as a whole. It would require more sizeable bail-out. Combined outstanding debt in France, Spain and Italy is six and a half times the combined debt of Greece, Portugal and Ireland. It would also impact the credibility of the region, triggering a financial crisis and credit squeeze on a par or worse than that seen in 2008 (Figure 6). Figure 4 Government debt maturity profile % of outstanding debt to mature Source: Bloomberg, DTZ Research Figure 5 Debt maturity period UK Greece European average 10 year government bond yields Italy Ireland Spain Greece Germany Portugal Source: Bloomberg, DTZ Research Figure 6 Government debt and size of bailout packages bn Italy France Spain Greece Ireland Portugal EU-IMF bailout package Source: Oxford Economics, DTZ Research 67% 57% 54% Government debt (Maastricht measure) 4

5 Economic Performance Criteria 2: Economic Performance GDP growth closely linked with ability to service debt The overall debt position does not necessarily imply that the economy is at risk. As long as output is growing, ability to service the debt is viewed positively. There is therefore a close link between the country s ability to repay debt and its economic performance. GDP is also a driver for office demand, as economic expansion generally leads to higher employment levels and thus demand for office space. GDP growth forecast are therefore key to assessment of real estate performance. European economic performance diverges Figure 7 GDP y-o-y growth (%), Banded by debt to GDP ratio in % < % 2% 1% -1% -2% -3% -4% - -6% > 9 The aftermath of the financial crises and the subsequent debt crisis in the Eurozone has led to a divergence in terms of Europe s economic performance (Figure 7). On one side we have peripheral Europe headed by Greece, where GDP growth is expected to continue to contract or remain fragile as economies cut their excess debt levels through various austerity programmes. Conversely, the best performing economies include the more volatile Central Eastern European countries. These economies are maturing, export driven and have favourable demographics which support domestic demand. Nordic countries are also expected to perform well backed by positive sentiment among consumers and companies. These typically have lower ratios of debt to GDP (below 6). Most of these countries are also not members of the Euro. Having their own currency enabled more effective monetary policy intervention. Elsewhere, economic growth is expected to be relatively muted. This group is dominated by Eurozone countries, where production is slowing while investment is hampered by corporate deleveraging and wider economic uncertainty. Although these economies are less leveraged, with debt to GDP ratios ranging between 6 and 9, economic growth is slowing. Germany s output was forecast to increase 3.3% in 2011, but slowing in France is struggling to generate strong growth with GDP in the region of 1.9% in 2011 and 1.6% in The same applies for the UK where limited GDP growth is forecast amid a slowing Eurozone, UK s main export market, and deep cuts in public finances at home. Source: Oxford Economics Tough austerity measures ahead Given fragile economic performance and large budget deficits, governments in exposed countries are now less able to respond and stimulate growth. However, for many the only option is to reduce national debt to more sustainable levels and to shrink deficits. Tough austerity measures are being planned, and some already implemented, in countries at the heart of the sovereign debt crisis. Amongst means adopted are tax increases, disposals of state owned assets, job cuts and pay freezes in the public sector workforce (Box 1). Box 1: Cost saving measures what is the plan*? Greece: 150,000 job cuts in the public sector, tax increases, 50bn sale of state owned assets by 2015 Spain: 14bn in sale of state owned assets (National Lottery, 49% share in Aena), cuts of 13,000 public sector workers and wage freezes for all public sectors. Portugal: asset sales, reduction of civil servant jobs in central and local government by 2% annually Italy: cuts over three years in public sector workforces, replacing only one employee for every five who leave. Three-year freeze on public sector pay rises. Ireland: 5bn sale programme (stakes ESB, Bord Gais, Air Lingus and National Stud). Public servant s pay cut at least and social welfare reduced. UK: Fiscal tightening of 113bn during Cuts of 490,000 jobs in the public sector. *Outlines some of the austerity measures planned or undertaken by governments across Europe. Source: DTZ Research 5

6 Office Employment Trends Criteria 3: Office employment trends Aggressive cuts to public sector employment amid fiscal tightening Austerity measures adopted in peripheral Europe and the UK point to a large reduction in public sector employment. This in turn will have a knock on effect on property markets by reducing demand and increasing supply of offices. Additionally, lower employment levels will reduce consumption and thus retail spend. The most vulnerable property markets will be those in countries with a high debt to GDP ratio, expected weak economic performance and where public sector job cuts will be significant as a proportion to total office employment. The ultimate impact on these office locations will however depend on how fast and how aggressive the cuts will be undertaken. High percentage of public jobs highlights areas at risk Our analysis shows that in addition to high debt and weak economic performance, Greece also has the highest proportion of public sector jobs of all European countries. Almost half of its office based workforce is employed in public administration. This is closely followed by Portugal with 42%. High dependence on public sector employment further highlights the vulnerability of some of the countries at the centre of sovereign debt crisis (Figure 8). Figure 8 Public administration employment (% of total office) by country, 2011 The CEE 1, led by Poland, has a high ratio of public sector jobs driven by EU accession. In contrast to the European trend of decline, the pool of government workers in the CEE is expected to expand further. Over the next two-three years as their economies grow and the previously underweight administration sector (associated with the European Union) expands. At the bottom of the ranking are Switzerland and the UK. These countries have prominent financial and business service sectors dominating office occupation. These have the lowest proportion of public sector workers at 19% and 18% respectively. Some regional office markets dependent on public administration jobs Dependence on the public sector is less evident in city centres than in secondary locations. This indicates greater downside risks outside CBD s, in regional office markets (Map 1). Following on from Map 1 in the 2010 DTZ Public Administration Employment report highlighting exposure throughout the UK, the UK is demonstrated to be in a relatively stable position when compared to some regions of Europe. East Germany, Southern Italy, most of France and Northern Scandinavian demonstrate some of the highest exposure to public sector employment. Some of the second tier European regions have public administration employment share as high as 7 (Figure 9). Most of these regions have relatively small F&BS sectors with much of their employment in agriculture and manufacturing. Figure 9 Public administration employment (% of total office) in selected European regions (NUTS2), 2011 Greece Portugal Hungary Poland Spain France Finland Belgium Norway Czech Republic Europe average Austria Germany Ireland Italy Romania Denmark Sweden Netherlands Switzerland United Kingdom 36% 32% 32% 31% 3 29% 28% 28% 27% 26% 26% 21% 19% 18% 46% 42% 41% 41% Severozapaden (Bulgaria) Alentejo (Portugal) Thessalia (Greece) Extremadura (Spain) Podlaskie (Poland) Lubelskie (Poland) Castilla-La Mancha (Spain) Prov. Luxembourg (Belgium) Itä-Suomi (Finland) Nord-Norge (Norway) Limousin (France) Franche-Comté (France) Highlands and Islands (UK) Mecklenburg-Vorpommern (Germany) West Wales (UK) Molise (Italy) Europe average 28% % 6 56% % 47% 46% 46% 43% 41% 41% 4 39% Source: Oxford Economics, DTZ Research Source: Oxford Economics, DTZ Research 1 CEE covers Czech Republic, Poland and Hungary 6

7 Office Employment Trends Map 1 Density of public administration, 2011 Public administration share of total office employment in 2011 (NUTS2) 51% % % 21% - 29% 1-2 Countries not covered Public administration employment per country in 2011 Thousands Helsinki Oslo 1,000 Stockholm 500 Edinburgh Copenhagen Dublin Berlin Amsterdam Warsaw London Brussels Prague Frankfurt Vienna Paris Budapest Zurich Geneva Lyon Milan Bucharest Marseille Rome Madrid Barcelona Lisbon Athens Source: Oxford Economics, ESRI, DTZ Research 7

8 Office Employment Trends Wave of public sector job cuts yet to come Data suggests that cuts in public administration employment have already begun in most countries, but the wave of job losses is expected to intensify (Figure 10). By 2013, the UK public administration workforce is expected to have reduced by 12% from the peak in In Europe s periphery, Portugal and Ireland have already endured most of their planned cuts during 2010, but further lower level reductions are still anticipated. A second round of austerity measures in Greece points to a significant reduction in public administration jobs, however, Greece was still expanding its public workforce in The depth of cuts varies across country s regions with some more exposed than others. Deep cuts are expected across all UK regions (Appendix, Map 2). Job creation in finance and business services sector to offset public sector layoffs in Europe Overall employment in Europe is forecast to stay relatively flat in the coming years. As austerity measures are implemented, cuts to public sector jobs will gain pace. However, Europe s office employment is dominated by finance and business services (F&BS), comprising 72% of all office based employment. After a fall in 2009, F&BS has returned to growth and is expected to increase by 2. per annum over the next five years, outweighing falls in public sector employment. However, given the considerable uncertainty about the strength of broader economic recovery, downside risks to F&BS employment outlook remain (Figure 11). Office job growth trend diverges with Nordics and CEE leading growth Economic disparity and austerity measures discussed earlier are reflected in office job growth trends across Europe. Nordic 2 countries are expected to record robust increases in the coming years while the CEE is forecast to maintain momentum on the back of strong economic growth (Figure 12). No major changes are expected in France and Germany where growth in office employment is forecast to remain relatively stable on a national level, but this does not rule out the possibility of future cuts. However, in the UK and PIIGS 3 cuts to the public sector are significant while job creation in F&BS is weak, and skewed to particular locations, resulting in negative office job growth in Beyond 2012, growth in the F&BS sector is forecast to offset job losses in public administration. Weak employment statistics suggest that demand for office space will remain subdued in many office markets for some time (Appendix, Map 3). 2 Nordics covers Denmark, Finland, Norway and Sweden 3 PIIGS covers Portugal, Ireland, Italy, Greece and Spain Figure 10 Change in public administration employment, % -1% -2% -3% -4% - -6% -7% Portugal Ireland Spain UK Italy Greece Source: Oxford Economics, DTZ Research Figure 11 Change in Europe office employment by sector, Public administration as % of total office employment: 28% Other office employment sectors: 72% 6% 4% 3% 2% 1% -1% -2% Public administration employment Total office employment Source: Oxford Economics, DTZ Research Figure 12 Finance and business services employment (F&BS) Change in total office employment, CEE Germany France Nordics UK PIIGS Source: Oxford Economics, DTZ Research 8

9 Office Employment Trends Government key employer in some cities Public sector jobs account for up to one third of office personnel in some major European cities. Brussels and Budapest are cities with the highest concentrations of public sector employees. However they are not undergoing the same level of fiscal retrenchment as others. Brussels is the headquarters of the EU which boosts the ratio significantly. Greece s capital Athens is also near the top, mirroring the country rankings with more than one third of office workforce employed in public sector administration. Here exposure to public sector employment is more of a problem. What is further highlighted by city level data is the lower exposure seen in the major capital cities across Europe. Although there are notable exceptions, such as Brussels, the general pattern is of reduced exposure to public administration in the major markets. The most prominent reason for this comes from the dominance of F&BS employment in locations such as: Central London, Milan and Frankfurt (Figure 13). In these cities, downside risks will be dominated by the global economic recovery. Although employment is forecast to grow, it will be at a low rate Figure 13 Public administration employment (as % of total) vs. change in total office employment, major markets Public administration as % of total office employment, Dublin Barcelona Paris Brussels Lisbon Madrid Rome Zurich Athens Oslo Berlin Forecast average Edinburgh Milan Lyon Helsinki Warsaw Prague Stockholm Amsterdam Frankfurt Budapest Historical average ( ) Central London Bucharest Source: Oxford Economics, DTZ Research Figure 14 Change in total office employmentper annum, % share of public sector in total take-up, selected cities 2 Although the previous section identifies local markets where total employment is dominated by the public sector, this does not necessarily translate into activity. Although loss of employment will undoubtedly have an impact on the wider market, the level of public sector employment rarely translates directly into letting activity. The reason for this comes from differing occupier patterns around Europe. Generally, government occupation portfolios across Europe comprise of 2 leasehold and 8 freehold tenures. This obviously creates a disconnect between government employment and letting activity. 1 1 Source: DTZ Research City average (11%) As can be seen in Figure 14, the actual proportion of take-up by the public sector is well below the actual share of employment. As well as the fact that European governments are far more likely to own the building that they occupy. Public sector leases have traditionally been much longer than in the private sector. 9

10 Country grouping Step 2: Country grouping Majority of markets are marginally exposed To highlight the impact of austerity measures on office markets in Europe, we have grouped countries based on three criteria; ratio of public debt to GDP, by forecast GDP growth and lastly by contribution of public sector job cuts to overall office employment. We then looked at these variables and classified countries vulnerability depending on how many criteria they meet; Most exposed, Marginally exposed and Least exposed (Table 1). This analysis highlights which group of countries is likely to be more vulnerable to the impact of austerity measures and fiscal tightening. It is no surprise that meeting all three criteria places countries at the heart of the debt crisis, i.e. Greece. The Marginally exposed group lists some of the larger countries such as Germany, the UK and Spain with the majority qualifying due to more aggressive cutting of public sector jobs or high debt. The Least exposed group lists a mix of Nordic and Eastern European countries, generally the ones outside the Eurozone except for France and the Netherlands. This group of countries either had more intact fiscal finances and less public debt or are not members of the Euro (enabling more effective monetary policy response).these groupings are based on current information and any country can easily move. For example, France finds itself in the least exposed group, by the thinnest of margins, with borderline debt and GDP growth and has still to fully announce its cut programme. Spain is also a marginal case where the smallest downgrade to GDP will see it move to the Most exposed category. Table 1 Grouping by criteria selection Country Criteria 1 Criteria 2 Criteria 3 Exposure grouping Debt as % of GDP 4 > 88% GDP growth 5 < 1. pa ( ) Public sector job cuts relative to total office employment 6 <-1.6% Most exposed Greece 152% 1.1% -5. Yes Italy % -1.2% Yes Ireland 114% 2.9% -1.7% Yes Portugal 91% 0.7% -3.6% Yes Marginally exposed Belgium 97% 2.1% -0.1% Yes UK 83% 2.6% -2.8% Yes Germany % Yes Austria % Yes Spain 64% 1.6% -4. Yes Finland 51% 2.9% -2. Yes Least exposed France 88% % Yes Hungary 77% 3.4% -0.4% Yes Netherlands 66% 1.9% -1.4% Yes Poland 57% Yes Norway 54% 2.4% -0.9% Yes Switzerland 53% % Yes Denmark 46% 2.2% -1. Yes Czech Republic 42% 3.1% -1.6% Yes Romania 38% 5.2% 2. Yes Sweden 37% 2.2% -1.1% Yes Threshold 88% % Source: Oxford Economics, IMF, DTZ Research Number of office markets covered by DTZ 3 markets 23 markets 17 markets 4 Thresholds for criteria 1 is based on weighted European average of debt to GDP ratio in Countries with ratio higher than 88% have been classified as meeting this criteria. 5 Threshold for criteria 2 is based on average annual GDP growth in Europe between 2011 and GDP growth lower than 1. pa have been classified as meeting this criteria. 6 Threshold for criteria 3 is based on how extensive cuts to public administration employment between 2010 and 2015 are relative to the total office employment in a given country. Cuts larger than 1.6% of office employment (European average) have been classified as meeting this criteria. 10

11 Impact on office markets Step 3: Impact on office markets Rental outlook muted As would be expected, rental growth performance in the markets matching two or more of the austerity criteria is decidedly weak. Ireland and Italy lead the way in this sector with weak rental performance stemming from limited economic stimulus and subdued demand acting as a drag on performance. Markets matching two or more criteria only begin to display signs of recovery towards the end of the forecast period as debt problems are worked through and job growth returns (Figure 15). The performance of markets matching none of the austerity criteria produces an interesting forecast profile. Rental growth is subdued, despite a lack of imposed austerity measures. This can be attributed firstly to weaker economic growth throughout the Eurozone and secondly, and perhaps most importantly, to the fact that most of the markets within this category have traditionally been the less volatile. This is highlighted by the way the least effected markets miss both the peaks and the troughs of the marginally effected markets. Upward pressure on yields in core markets Upward pressure on core market yields is expected to grow towards the end of the forecast period as bond markets and risk perceptions normalise. Yields in markets without any debt issues have remained lower and are forecast to continue being so throughout the next five years (Figure 16). The yield spread between the groups is driven by risk perceptions. With the most obvious spread between the least and most exposed (around 100bp) clearly demonstrating investor sentiment. Both the least and marginally exposed groups are expecting to experience negative yield impact during the next five years. The recent flight to quality has created significant downward pressure on yields. As the sovereign debt crisis resolves, yields are forecast to normalise as risk perceptions converge. What is significant is the fact that the currently underperforming and most exposed markets are forecast to experience positive yield impact throughout the next five years, given if they continue to manage their economic transition in the current manor. Our analysis is based on 43 prime office markets in Europe. The grouping of markets by exposure is represented in Table 2. Figure 15 Weighted rental index by exposure, Index 2005 = Source: DTZ Research Figure Most exposed Marginally exposed Least exposed Weighted office yield by exposure, % 6.6% 6.4% 6.2% % 5.6% 5.4% 5.2% 5. Source: DTZ Research Table Most exposed Marginally exposed Least exposed List of office markets by exposure Most exposed Marginally exposed Least exposed Dublin Rome Milan Antwerp Barcelona Berlin Birmingham Bristol Brussels Cardiff Dusseldorf Edinburgh Frankfurt Glasgow Hamburg Helsinki Leeds London City London West End London Docklands London Midtown Madrid Manchester Newcastle Nottingham Munich Amsterdam Bucharest Budapest Copenhagen Geneva Gothenburg Lyon Malmo Marseille Source: DTZ Research Oslo Paris La Defence Paris Western Crescent Paris CBD Prague Stockholm The Hague 11

12 Impact on office markets Box 2: Negative yield gap more risky to invest in Irish government bonds than in Dublin s prime office assets The attractiveness of property compared to other asset classes is often measured by comparing the property yield with the 10 year government bond yield. The latter is assumed to be equivalent to a risk free rate under normal market conditions, i.e. the return on an investment with no risk of loss. Until the recent debt crisis unravelled in Europe, government bonds typically offered a lower yield than the investment in real estate assets. Nevertheless, as the risk of insolvency spread to other vulnerable countries in Europe s periphery, investors priced in this uncertainty requiring higher compensation of holding sovereign debt. As a result government bond yields rose to record highs - notably in Italy, Ireland and Spain. In the case of Ireland this has consequently created the so called negative yield gap. This means that at present investors attach more risk to holding an Irish government bond than investing in prime office property in Dublin (Figure 17). Government bond yields are expected to normalise over the medium term with the most exposed markets expecting yield compression, while core markets expecting upward movement. Figure 17 Gap between prime office yield as of Q and 10 year local government bond yield* 1 9% 8% 7% 6% 4% 3% 2% 1% Moscow Dublin Warsaw Milan Madrid London (City) Prime office yield as of Q *Local government bond yields are as of 12 September 2011 Source: Bloomberg, DTZ Research Frankfurt Stockholm Paris (20 districts) 10 year local government bond Total returns highest in most exposed markets Despite extremely weak rental growth performance throughout the forecast period, total returns are expected to be strongest in the most exposed markets over the next five years with 8.4% pa (Figure 18). High income returns are the principle factor behind this as investors demand higher yields to invest in these locations given the associated level of risk. Figure 18 Components of total returns by criteria Average total return % 7.8% % In addition to higher income returns, a normalising government bond market towards the end of the forecast period is expected to drive positive yield impact in the most exposed markets. Where the flight to quality has left government bonds in core markets at an extremely low level and with little room for further compression, risk levels in the most exposed markets are forecast to fall over the next five years and government bond markets are expected to normalise. - Source: DTZ Research Most exposed Marginally exposed Least exposed Capital Value Growth Initial Yield 12

13 Impact on office markets Map 2 Change in public administration employment Change in public administration employment per annum (NUTS2) -5.6% % % -1.2% % % % Countries not covered Public administration employment per country in 2011 Thousands Helsinki Oslo 1,000 Stockholm 500 Edinburgh Copenhagen Dublin Berlin Amsterdam Warsaw London Brussels Prague Frankfurt Vienna Paris Budapest Zurich Geneva Lyon Milan Bucharest Marseille Rome Madrid Barcelona Lisbon Athens Source: Oxford Economics, ESRI, DTZ Research 13

14 Impact on office markets Map 3 Change in total office employment Change in total office employment per annum (NUTS2) -4.4% % -0.2% % - 1.9% % 3.3% - 6.1% Countries not covered Total office employment per country in 2011 Helsinki Oslo Thousands Stockholm 10,000 Copenhagen 5,000 Edinburgh Dublin 1,000 Berlin Amsterdam Warsaw London 500 Brussels Frankfurt Prague Vienna Paris Budapest Zurich Lyon Milan Bucharest Marseille Madrid Rome Barcelona Lisbon Athens Source: Oxford Economics, ESRI, DTZ Research 14

15 Disclaimer This report should not be relied upon as a basis for entering into transactions without seeking specific, qualified, professional advice. Whilst facts have been rigorously checked, DTZ can take no responsibility for any damage or loss suffered as a result of any inadvertent inaccuracy within this report. Information contained herein should not, in whole or part, be published, reproduced or referred to without prior approval. Any such reproduction should be credited to DTZ. DTZ 2011

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