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Are Milan offices safer than Italian Government Bonds?

by | Oct 4, 2018

Italian government bond yields are fast approaching Milan office yields. Why does the usual theory of property yield determination not appear to apply to Milan?

On Friday (September 28), the yield on Italian 10-year government bonds reached 3% following  news that the coalition government’s proposed budget for 2019 implies a deficit equal to 2.4% of GDP. While this is within the EU’s 3% borrowing limit, it will push Italian debt-to-GDP ratio up while the EU’s target is to bring it down.

Friday was not the first time in recent months that the Italian government 10-year bonds yields had reached 3%. It has flirted with 3%, or even passed it on occasion, ever since the coalition government was formed in the Spring as markets worried about the consequences of increasing government debt. Compare that with German and French 10-year bond yields of 0.47 and 0.81% respectively at the time of writing.

This isn’t the place to go in to the Italian government’s motivations, but it is very pertinent to explore the relationship between Italian government bond yields and property pricing – particularly the yield on prime offices in Milan.

To start with, some theory. It is generally argued, by ourselves amongst others, that there is a direct link between prime property yields and the yield on government bonds. Furthermore, in times of low inflation, property yields are likely to be higher than government bond yields. The spread represents a premium because property is considered a riskier asset. The risk premium can be reduced if investors expect future real rental growth, but the spread is still likely to be positive.

In Q3 2018, Milan prime offices yields were stable at 3.4% while the yield on 10-year Italian government bonds averaged 2.84%. That’s still a positive spread of 56bps – but a narrow one compared to the Eurozone average of 259bps. And this is not the first time recently that this spread has fallen to very low levels.  It practically disappeared in 2007-08 and it actually went negative at the height of the European Sovereign Debt Crisis in 2011-12.

There are two reasons why the spread can shrink or even go negative. These are mainly periods of high inflation; or when substantial real rental growth is expected. Neither of these appears to apply now (although Milan’s prime office rental growth record compares favourably with than of many other major European cities). It just looks like markets sometimes have almost as much or even more confidence in Milan prime offices than they do in Italian government debt.

When we attempt to build an econometric model of Milan office yields we find only a small and very slow reaction of yields to change in Italian government bond yields. Interestingly, if we substitute the yield on German government bonds for Italian government bond yields we get a much stronger relationship. The same is not the case for Milan retail or industrials. Can it be that markets value Milan offices more like a German than an Italian asset?

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