Early End to QE Would Hit Office Hard

LOS ANGELES-Jitters over a spike in interest rates have had the industry watching the Federal Reserve's every move for some time, looking for clues to the Fed's timetable for winding down its third round of quantitative easing. However, a report from DTZ says CRE in the US and overseas could face another side effect of an early withdrawal from QE3 and similar programs now in effect from European central banks:a negative impact on office pricing.

DTZ looked at the effects on office asset pricing in 10 US markets (New York City; Los Angeles; San Francisco; Chicago; Washington, DC; Boston; Dallas; Houston; Atlanta; and Seattle) and 10 European ones (London City; London West End; Paris, Berlin; Stockholm; Brussels; Frankfurt; Madrid; Amsterdam; and Milan). It considered both a "base" scenario of the status quo and an "early withdrawal" in which central banks end their programs sooner than expected.

“With central banks considering how and when they will withdraw QE support, we wanted to look at the impact on the commercial property market,” says Fergus Hicks, DTZ's global head of forecasting. “Our base case is for an orderly withdrawal of QE, under which we see current pricing in most key US and European office markets as attractive. However, under our early withdrawal scenario all of the 20 office markets we looked at show a deterioration in pricing due to lower expected returns.”

Under the base case forecast, the Fed starts to taper asset purchases in the fall, stops making purchases altogether in mid-2014 and begins to unwind QE by starting to reduce assets held in 2015. The scenario also assumes the Bank of England holding QE at its current level of £375 billion until 2016, when it begins to reduce its assets held.

Although the report notes that early withdrawal—which is not likely to occur, especially as it assumes a faster economic recovery than we're now seeing—could generate an unexpected short-term surge in the economy next year, it also would mean that central banks would then be likely to withdraw from QE more quickly. This would lead to bond yields rising more sharply and see economic growth begin to slow, with the US entering recession in '16.

“Current office valuations become much less attractive under this scenario,” the report states. “The combination of weaker rental growth prospects and higher yields in 2017 hits total returns. Indeed, all of the 20 office markets covered in this report became less underpriced/more overpriced.”

On the basis of DTZ's Fair Value analysis, 16 of the office markets covered in the report look attractively priced under the base case forecast, while under the early withdrawal scenario only 13 look attractive, and all of them would see a deterioration in pricing. In particular, the early withdrawal scenario sees four markets move from the “Hot” (undervalued) to 'Warm' category, and three markets move from the “Warm” to “Cold” (overvalued) category.

The only market that would remain “Hot” under this scenario, here or in Europe? Dallas.