By Robert Nystad, head of research. The Norwegian version of this article appeared in business journal Kapital on 13 October 2022.

The downturn is already with us, including in the unlisted market. Naturally, the big question is where the market will find its new equilibrium – in other words, how much yields will increase. Giving an answer is surprisingly difficult. A lot depends on interest rates, but this isn’t straightforward. We have nominal and real rates, with short and long tenors, spot and forward. In addition, interest rates have been extremely volatile from day to day this autumn.

At the time of writing,¹ the Norwegian 10-year swap rate is 3.46 per cent. The risk premium for the best office properties in Oslo has historically been around 1.50 percentage points, which indicates that prime yield ought to rise to about five per cent. But the historical difference between prime yield, which is a real return requirement, and the 10-year rate has emerged at a time with low and stable inflation. “Everyone” entered two or 2.5 per cent in their spreadsheets. Inflation has now shot up, and the real interest rate is record-low at the moment.

However, today’s real rate has little relevance. Most people expect it will rise a lot when inflation finally begins to fall. What we need is a good estimate of what the neutral real rate will be in the long term. By that, we mean the rate which stabilises the economy.

Unfortunately, we have no securities which can point the way here in Norway. But US treasury inflation-protected bonds (Tips) provide a good alternative. These bonds have varying tenors. By combining five- and 10-year tenors, we can calculate the market’s implicit pricing of five-year real rates five years from now. This gives a good indication of market expectations for a neutral real rate in the long term. These expectations have risen from -0.4 to 1.2 per cent since 1 January 2022 – in other words, no less than 1.6 percentage points. The real rate is nevertheless moderate in a historical context and 50 basis points higher than in 2008-20. During this period, the prime yield for offices in Oslo was 3.60 per cent.

In practice, both nominal and real interests undoubtedly play a part alongside credit spreads, the macro position and market sentiment. Over the longer term, the heaviest weight should be given to the real rate. We therefore believe the new market equilibrium (prime yield) is closer to four than five per cent. But this is definitely not the time to speak with firm conviction. We don’t know, for example, whether rates will rise further or overshoot and drop back a lot in coming quarters. A number of leading analysts are most inclined to believe the latter, and DNB Market’s forecast for the Norwegian 10-year swap rate in October 2023 is 2.75 per cent.

Will the rental market come to the rescue?

We must distinguish here between what has happened and what we think will happen. The rental market has undoubtedly been strong so far this year. Rents have risen about 10 per cent over the past year, which naturally helps to dampen some of the effect of rising yields.

However, we find it hard to believe that rents will continue to rise to any extent in 2023. All macroeconomic forecasts indicate stagnation, and perhaps recession, next year. The rental market is then unlikely to be healthy. Fortunately, both office vacancy and newbuilding are low, so it will take a lot for rents to fall.

A scenario where they possibly decline will probably coincide with falling (expectations for) interest rates. Quite a bit will thereby need to happen for the worst scenarios to be realised. Our main scenario is therefore that property values on a broad basis drop back 10-15 per cent from the peak at 1 January 2022 – perhaps nearer 15 than 10 per cent given the way things look right now. Much of the decline in value is probably being realised already, even though it will take time for this to show up in the valuations.