Yield determination in European office markets: how does pricing respond to bond yields and market activity?

Real estate yields are thought to reflect risk free rates of return, a risk premium and expected growth in cash flows. Modelling of real estate yields can then be conducted using proxies for each of these factors. A common proxy for risk free rate is nominal government bond yields, but these compensate investors for expected inflation and inflation risk, whereas real government bond yields should track changes in the underlying real risk free rate. This paper examines whether real bond yields provide more explanation than nominal bond yields of real estate yields for a panel of 20 office markets in five European countries over 1997-2016. Past bond yields, disequilibrium in rents and levels of investment activity are also used to explain real estate yields. The initial results suggest that the use of real bond yields does not improve empirical models much for this sample of data. However, past bond yields and lagged transaction volumes exhibit statistically significant relationships with office yields, raising questions as to how investors adjust target rates of return and required yields in the face of changing macroeconomic and real estate market conditions.