Real Estate Research
Paris offices – Fluctuat nec mergitur
“Fluctuat nec mergitur” has been the official Latin motto of Paris since the 14th century. In English it translates into “The ship is tossed by the waves, but does not sink”. Clearly, Paris has been “tossed by the waves” in recent years and of course in a dramatic and utterly shocking way in January and November last year. It has, however, not sunk and the outlook is steadily improving.
This article addresses the topic of where the Paris office market is in the cycle and where we see opportunities as real estate investors. While the occupational market has been through a thin couple of years, there are signs of a recovery and the balance between demand and supply varies considerably across different parts of the city. We believe that the spirit of “Fluctuat nec mergitur” can also be seen in the Paris office market.
Strong demand from both French and international investors drove down the yield on prime offices in the central business district of Paris by a further 0.5% in 2015 to between 3.25 – 3.50% (source PMA). As a result, prime office yields in Paris are now back to, or even slightly below their pre-crisis low and prime office capital values have risen by approximately 30% in the last two years, even though office rents have been flat, or falling.
As figure 2 illustrates, the recent compression in prime office yields is not peculiar to Paris. Prime office yields in most major European cities are back to 2006 – 2007 levels. The key questions now facing investors is will Paris office yields stay low, or will there be a repeat of the damaging increase seen in 2007 – 2009?
We think that Paris office yields are likely to remain low over the next couple of years for two main reasons. First, although Paris office yields are low in absolute terms, they look high in relative terms set against 10 year French government bond yields, which now stand at 1%, compared with 4.0 – 4.5% in 2006 – 2007. Indeed, one of the main reasons why Eurozone real estate yields have fallen over the last two years is that bond investors have become increasingly keen to find other assets which offer a decent yield.
Of course, there is a possibility that French government bond yields could jump in 2016 – 2017 and put upward pressure on office yields. However, we think that is unlikely because inflation in France and the rest of the Eurozone is forecast to remain subdued at 0.5% – 1.25% and Schroders expects the ECB to wait until the end of 2017 before raising interest rates. Furthermore, the current gap of 2.25 – 2.50% between Paris prime office yields and French 10 year government bond yields is wide by historical standards. Over the last 15 years the gap has averaged 1.4%. That suggests a bit of leeway and that if 10 year French government bonds were to rise to 1.5 – 1.75%, then Paris office yields wouldn’t necessarily react.
The second main reason why we think Paris office yields will stay low is that office rents are likely to recover from 2016 onwards, prompting investors to raise their expectations for future income growth. Average grade office rents in Paris fell by 10% between 2008 – 2014, mainly because of an increase in new supply in La Défense and the area west of the CBD. This pushed up the vacancy rate from 5.5% to 7.6%. Total office employment was broadly stable over the same period, although the aggregate masked a fall in government jobs, which was offset by growth in professional services.
Over 2015 however, office employment in Paris rose modestly, as business confidence improved and some companies started to execute their real estate strategies or switched into expansion mode. This increase in occupier demand, coupled with a slowdown in new development, was sufficient to lead to a small fall in vacancy and put a floor under office rents. Looking forward, we expect the recovery in private sector office employment to accelerate through 2016 – 2018, as low interest rates, low energy prices, stronger domestic demand and exports to Germany, the UK and US boost corporate investment and profits. The “Tax credit for encouraging competitiveness and jobs” (CICE) recently announced by the French government should also help profits. Moreover, new office development is likely to remain subdued over the next few years. As a result, we expect the vacancy rate to fall steadily to 6% by end-2018 and average grade office rents to increase by 2 – 3% per annum.
A final reason why prime office yields in Paris tend to be lower than in other European cities is because investors are generally willing to pay a premium for liquidity. €10.5 billion of Paris office investment deals were completed in the first nine months of 2015, an increase of ca. 15% on the corresponding period of 2014 (source RCA). While the value of London office deals in the first nine months of 2015 was almost double that in Paris, Paris was far ahead of other major European office markets such as Munich, Frankfurt and Madrid.
To some extent the liquidity of the Paris investment market is simply a matter of scale. The greater Paris region of Ile-de-France has a total office stock of 52 million square metres and is home not just to major French companies (e.g. AXA, BNP Paribas, L’Oreal, LVMH, Renault, EDF, Sanofi-Aventis), but is a European headquarters location for several US multi-nationals (e.g. Disney, GE Capital, Microsoft). In addition, the French investment market is highly transparent, ranking fifth in JLL’s Global Transparency Index. And France has been an early adopter of strict environmental standards, so that there is a significant stock of “green” buildings, that not only appeal to corporate occupiers given the fit with CSR policies, but often also have lower operating costs.
Paris not “one” market – Conditions vary hugely by submarket
While looking at aggregate data certainly helps to understand high-level trends, the size of the Paris office market makes it essential to analyse individual submarkets. Arguably, there is no such thing as “the Paris market” as the ca. 15 submarkets of Greater Paris office market have different occupier and investment market characteristics and supply/demand profiles and tend to behave slightly different. The most important and most high profile are of course the CBD and La Defense, but they only account for 20% of the office stock in the wider Ile-de-France region.
The differences between the submarkets become clear when looking at vacancy. While vacancy rates in the submarkets of central Paris (the 20 arrondissements) are currently between ca. 2.0 – 6.5%, vacancy in La Defense is close to 12% following some large developments in 2013 – 2014. And in the Peri-Defense, the vacancy rate is over 15%.
A good way to get an indication of which submarkets could offer upside is to look at the current level of vacancy in comparison to the average annual volume of take-up in the last 10 years (“Years of take-up”) as in the chart below. Here, the submarket of the 18/19/20th arrondissement stands out with a comparably low balance, while prime yields are much higher than in the CBD at 4.75%. There are ca. 70,000 sq m of office space under construction at the moment. But ca. 60% is of this is already pre-let or for owner-occupation. Another interesting area is the Paris 3/4/10/11th arrondissement, where prime yields are at ca. 4.00%. However vacancy is low at around 5% and with just around 20,000 sq m of space under construction – though all speculative – supply is under control.
But also submarkets that currently look oversupplied can offer interesting opportunities at yields of 150 – 200 bps over the CBD. Vacancy in La Defense has increased significantly in recent quarters, which has put rents under pressure. However, going forward, supply is low with only ca. 50,000 sq m to be added to this 3.4 million sq m market and non of the supply is speculative. In addition, La Defense remains a major international business location with excellent accessibility and the recent developments have provided a high amount of modern, high-quality stock and larger floor plans. The Northern Bend is in a similar position. Though vacancy is one of the highest in the overall market and accessibility has to be carefully evaluated, the availability of larger floor plans at significant discounts to rents in central parts of Paris can be appealing to corporate occupiers. With only ca. 35,000 sq m of space under construction and all of it pre-let, supply should also reduce albeit slowly.
In addition to a through analysis of key indicators, investors should however always familiarise themselves with local areas to understand the characteristics of a submarket and its interaction with other areas in order to accurately judge the market risk.
Grand Paris is progressing
An interesting opportunity for investors and occupiers alike comes in the form of the “Grand Paris” project, a multi-billion € infrastructure plan that will significantly enlarge and enhance public transport in the wider Paris areas. In a way, Paris is shrinking and expanding at the same time. The first areas to benefit will probably be St. Denis and St. Quen as well as the corridor between the southern end of the 13th district and Orly airport. Progress is also made elsewhere, with an agreement now reached on the finance for the extension of line 11 in the east. However, while Grand Paris has started to capture peoples’ imagination, it should not be forgotten that the full project will take 15 – 20 years to complete and that it will therefore be some time before there are any tangible benefits.
Fair winds and a following sea
It looks very much as if the Paris office market is sailing into calmer waters supported by a strengthening of the general economic environment. We maintain our conviction that the market offers a range of opportunities, despite the very low yield levels now recorded in the CBD, as the recovery in occupier demand lifts rents over the next few years. Investing outside of the CBD is of course a step up the risk curve and it is critical to understand the submarket and the location. Good connectivity by public transport and a range of amenities are also paramount in our view. And while these kind of investments require a more thorough and in-depth underwriting, the rewards can be higher yields and returns.
The views and opinions contained herein are those of Oliver Kummerfeldt, European Real Estate Analyst and may not necessarily represent views expressed or reflected in other Schroders communications, strategies or funds. Past performance is not a guide to future performance and may not be repeated. The value of investments and the income from them can go down as well as up and investors may not get back the amount originally invested. This document is intended to be for information purposes only and it is not intended as promotional material in any respect. The material is not intended as an offer or solicitation for the purchase or sale of any financial instrument. The material is not intended to provide, and should not be relied on for, accounting, legal or tax advice, or investment recommendations. Information herein is believed to be reliable but Schroder Investment Management Ltd (Schroders) does not warrant its completeness or accuracy. No responsibility can be accepted for errors of fact or opinion. This does not exclude or restrict any duty or liability that Schroders has to its customers under the Financial Services and Markets Act 2000 (as amended from time to time) or any other regulatory system. Schroders has expressed its own views and opinions in this document and these may change. Reliance should not be placed on the views and information in the document when taking individual investment and/or strategic decisions. Issued by Schroder Real Estate Investment Management Limited, 31 Gresham Street, London, EC2V 7QA. Registration No. 1188240 England. Authorised and regulated by the Financial Conduct Authority. For your security, communications may be taped or monitored.