European office market faces biggest test since financial crisis

Europe’s office market faces the toughest conditions since the financial crisis, experts have warned, as rising interest rates and a surge in building costs threaten to choke off its recovery from the pandemic.

Higher interest rates and a broader tightening in financial conditions have driven the cost for office owners of servicing their debt above the rental income they receive for the first time since 2007, according to an analysis by Bank of America.

That is already cooling investment into the sector and could cause distress for highly leveraged office companies.

Rising base rates have added to office owners’ debt servicing costs. But that is merely the tip of the iceberg, according to Marc Mozzi, a real estate analyst at BofA.

“When people are talking about interest rates, that represents only about a quarter of the cost of borrowing for European real estate companies. The credit spread is the hidden part of the iceberg,” said Mozzi, referring to a measure of how much more a company has to pay to borrow compared with a sovereign issuer.

Over the past 12 months, credit spreads have doubled for UK-listed real estate companies and almost tripled for European groups, calculations from BofA show, indicating that bond investors are increasingly anxious about the companies’ creditworthiness.

The deteriorating outlook comes after the Bank of England earlier this month delivered the biggest rise in its key interest rate in more than a quarter of a century, as it steps up the fight against inflation.

The office market had a buoyant start to the year but has sunk since. In London, the value of deals completed in the first quarter of the year was 105 per cent above the 10-year average; but in the second quarter it was 27 per cent below that level, according to Mark Ridley, boss of estate agency Savills.

Executives say the challenge could get tougher when buyers have to refinance the debt they used to buy buildings.

“Look at the financial crisis and what happened: the pinch points were the refinancing moments, that’s where the squeeze can come,” said Adam Goldin, head of the UK business for CC Land, the Chinese developer that owns London’s Leadenhall Building, known as the “Cheesegrater” skyscraper.

“If you simply don’t have the money to refinance then you don’t have the money . . . There are plenty of organisations out there, [such as] funds that are closed-ended and can’t put more money in, so their one direction is to sell. We will then find out how much capital is there to buy,” he added.

A recent survey by the Royal Institution of Chartered Surveyors, a leading body for the property industry, found that roughly half of the estate agents, surveyors and consultants from across Europe and the US who responded “view the market as having slipped into the downturn phase of the property cycle”.

Office landlords are also contending with a jump in the cost of building materials, the persistence of hybrid working and the additional costs required to meet environmental regulations.

Nevertheless, they point out that the level of leverage in the sector today is far lower than it was before the financial crisis, and that other investors and buyers will step in once prices for offices fall further.

But Mozzi is sceptical. “Why would anyone buy something that returns less than they are paying for it?” he said.