Naturally, covenant strength is of paramount importance for secure income returns, as occupiers across all real estate sectors have faced elevated operational costs over the last five years.
MSCI data indicates that income returns have accounted for over 80% of European offices’ total returns since 2001. Capital growth is also over five times more volatile than income returns for European offices, so why have investors become so fixated on capital growth to deliver their returns?
How does income risk vary across sectors?
Income Analytics’ INCANS Tenant Global Scores are international cross border scores that predict the likelihood that a company will seek credit relief or go out of business in the next 12 months. A higher score indicates a lower probability of failure or default. INCANS data indicates that across Western Europe, the projected probability of failure over a ten year term is lower in the office sector (2.2%), than in the retail (2.8%), or industrial (2.6%) sectors. Specifically for the UK, the trend is even more pronounced.
Looking at different office business sectors, insurance, legal, public administration and banks are among the occupier types with the lowest business failure probabilities.
Why is office income risk lower?
Lower office income risk can be explained by a number of reasons. For office occupiers, rent is generally a lower proportion of total costs than in other sectors - the real estate is not as central to the business’ profit margins as more operationally intensive sectors.
Likewise, the pure quantum of major office occupiers is significantly larger than that of other sectors. For example, in the logistics and hotels sectors, the top 10-12 occupiers have a higher share of the total market, whereas the office occupier base is more diversified.
One note of caution is that office occupiers have tended to seek new premises at the end of their lease, meaning that landlords have to refurbish the space and bring it back to market, whereas occupiers in retail and industrial are more likely to renew in their existing premises, according to MSCI data.
Looking forward, a weaker economic outlook will increase covenant risk, however a contributing factor to secure income returns is low vacancy rates, and prime CBD vacancy rates are generally hovering at 3-4% across Europe. Landlords holding prime office stock in cities with low vacancy rates are now finding footloose occupiers are being forced to stay, given the lack of alternative options. Low vacancy rates are also supporting office rental growth, which is currently outperforming both industrial and retail sectors in Europe.
Lower corporate failure ratings and more secure income returns in the office sector is justifying lower yields. Investors who are willing to move up the risk curve may begin to increase location risk, as long as covenant strength remains strong, in order to maximise their returns.
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