Fraser Watson (Savills): Hedging costs on Czech income could slow the market

hedging

Robert McLean

#cee, #proptech, #development a #architecture

Do you find it odd that we’re going into the third year of a pandemic that’s thrown office workplace strategies into chaos…and yet yields have barely budged?

Yields are generally the reflection of demand and perception of value from buyers in the market. Office yields have gone up fractionally from 3.9% to 4.1%. However, if a super-prime office opportunity came around arguably it would still be sub-4%. You’re saying that the world seems to have imploded and that this is not normal.

But there’s an argument to say that volumes in 2017, 2018 and to some degree 2019 weren’t normal. We had a really good few years with strong office occupancy and falling vacancy. Interest rates were still very low, there was a high degree of all-round economic confidence, unemployment in the Czech Republic was going down, and there was a big fight to get the right people in to fill corporate positions. A focus came to Central Europe with more and more institutional funds willing to see the value of the region and simultaneously getting priced out of Western Europe. So, maybe it was the three or four years before 2020 that were abnormal.

Beginning around 2016, people would ask when the market would finally collapse. The answer was always “another 18 months or so.” By around 2018, people seemed to stop worrying.

Investors from the West were getting a decent yield spread, coupled with a perception of lower risk. You had a lot of international blue chip corporations anchoring office buildings here. You had Prague winning awards as the best ex-pat city to live in, the yield spread with the perception of actual risk reward — the risk on income security was overall pretty favorable.

hedging

From Savills’ Q3 2021 Office Market report

You were getting the same tenants, the same quality buildings with BREEAM and LEED certification for 100 or 150 bps cheaper (off a lower rent as well). Which means capital values per square meter are lower compared to Western markets. Inherently therefore, the real equity risk is lower because you have to spend less of it to get the same quality of building and the same tenants.

In 2018 going into 2019 when vacancy went to 4.5% there was a growing mood for seven-year leases (rather than five years) because tenants wanted to secure themselves in an office market that offers relatively few options to move to. Tenant incentives were being pushed down, so investors were getting excited about rental increases — that hadn’t happened in years. If you look at 2007 until now, rents have been broadly the same.

 

Prague’s a boring rental market compared to a city like Warsaw.

Exactly. So, the rental growth story and the increase in term in 2019 was quite a fundamental change for the market. It was driven by the genuine underlying demand/supply balance, coupled with the sense of strong market economics. And while Prague’s planning system is its Achilles’ heel in good times, it’s certainly playing a part in keeping the market afloat now. Because there’s just not that oversupply that you have in other markets.

hedging

From Savills’ Q3 2021 Office Market report

What’s the impact of rising Czech interest rates likely to be, since euro rates aren’t moving?There are four main things it does, or at least a mix of some of them. It pushes up the yields on Czech denominated income. It pushes down the returns for investors. It forces hedging or swap instruments, but the cost benefit of doing that on smaller deals probably isn’t there. Or else it reduces the transaction volume.

Why would volume fall because of hedging on smaller deals?

If you’re talking about, say, a €5 million deal (CZK 125 million) that’s usually going to be for a smaller, potentially riskier asset, potentially located in a smaller city. If it’s Czech denominated income and you borrow in euro, it means you have to hedge the income currency to pay your Euro loan. It’s a cost, it’s complex, so the question is if hedging is worth doing for smaller assets? These deals have typically been done by domestic investors more than internationals, where it’s a Czech domestic fund using retail money they’ve collected in Czech crowns to buy income in Czech crowns. The economy of scale with hedging is potentially going to mean those deals would get more difficult.

Sellers are going to have to adjust their expectations, or buyers will, or else the market could experience a bit of stagnation. So, it will be interesting to see what happens in terms of a repricing on Czech income. We might see a spread now in pricing between Czech crown and euro denominated incomes. And between euro and Czech-denominated investment deals.

Fraser Watson is Director of Investment Advisory at Savills in Prague

 

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