Bank of America ‘bearish’ on offices as debt costs outstrip yields

Office asset prices will fall to adapt to borrowing costs that are now higher than investment yields, BofA Securities, the investment banking division of US financial group Bank of America, said in a research note on European real estate equities, adding that it believes “real estate’s glory days are numbered”.

In the note, published by BofA Global Research on 29 June, the investment bank said higher funding costs would bring to an end the past 12 years of continued yield compression, negatively affecting real estate prices – with offices feeling the greatest impact, where cap rates stand at sub-3 percent in Continental Europe and 3.5 percent in the UK.

“This is largely below current borrowing costs at [between] 4.3 percent [and] 4.8 percent for real estate bonds. Yield expansion looks inevitable to offset this negative carry,” the bank warned.

“Recession will likely lead to office occupancy and market rental values to decline and property prices to fall apart. Cap rates will have to expand simultaneously to catch up with funding costs that now largely surpass prime investment yields by about 210 basis points and 110 basis points in the UK,” said the bank.

As a result, Bank of America is forecasting capital values for the 12 office and diversified stocks under its coverage to decline by 12 percent over 2023 and 2024, driven by a 60bps yield expansion to 4.1 percent. It also foresees that rental growth will “fade to zero” in 2024 as inflation recedes and recessionary pressures bite.

“Rates and credit spreads are back to levels not seen in a decade and stagflation is looming amid spiralling inflation. The cost of borrowing is now solidly higher than investment yields – a situation not seen since 2007,” it said. “Prices will likely have to fall to adjust.”

Large asset sales for investments and deleveraging would be necessary, it predicted, and drive dividend cuts for British Land, Covivio and Icade. The report also highlighted that office stocks were not yet registering the end of the “ultra-low bond party”, with a fall in asset prices and a lack of earnings growth ahead.

However, it attached a buy rating to the British REIT Derwent London due to its “high quality” office assets, low leverage, low refinancing needs and cheaper sterling refinancing costs. It also believes the high percentage of EPC A/B rated assets in its portfolio would benefit its leasing prospects and rental levels.