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Bubble or no bubble? The case of the Paris Real Estate Market

Paris, 7July 2014 - The prime Paris yield has fallen by an estimated 50 basis points over the past 12 months, from 4.50-5.00% to 4.00-4.5% and current transactions are being seen at even lower yields. At this level, yields are close to the 2006-2007 low-point from before the subprime crisis. Given the flat economic climate and the difficult rental market, legitimate questions are being asked as to whether yields at this level are sustainable or if we are seeing a real estate bubble.

A real estate bubble forms when there is a rapid increase in prices with no link to the fundamentals of asset value. The formation of a bubble is often due to the combination of a number of factors: excessively optimistic expectations, planned short-term ownership while speculating on rapid capital gains, etc. Another bubble characteristic is that after having inflated, it bursts (crash) or deflates leading to a fall in prices with a lesser or greater degree of severity and over a varying period of time.

Is there a bubble or not in 2014? To answer, let’s consider the facts from 2007 and 2014:
No reversal in the spread between real estate yields and the French risk-free rate (OAT) in 2014 - quite the opposite. Historically, real estate has always presented a risk premium over the 10-year OAT
(150-250 points for the prime references). “Between 2006 and 2007, the investment market moved away from this historic rule with a "negative risk premium” or reverse yield gap for prime Parisian assets - which had yields below that of the OAT”, explains Virginie Houzé, Research Director. Since then, the difference
has been restored and the French OAT has fallen to a very low level; this has maintained a comfortable level of risk premium for investors, currently at around 200 basis points.
Recent ECB decisions are unlikely to reverse this trend in the short term.
No speculation on financing. In 2006-2007, the abundance of debt and commercial mortgage-backed securities (CMBS) contributed to the market overheating, whereas investors’ recourse to financial leverage is now limited. “In recent years, 80% of investments in the Greater Paris Region for assets over €30 million were not subject to financing and LTV levels remain reasonable (at an average of 63% in 2013)” adds Virginie Houzé. Whilst the availability of debt in the market is very high, a significant number of investors (sovereign wealth funds, insurance companies) invest almost exclusively using their own equity and therefore bring a higher level of stability to the market. “It’s also worth noting that real estate markets only account for a small fraction of market liquidity and that the annual investment volume for the French market is not even equivalent to a week's activity on the Paris stock exchange” adds Stephan von Barczy, Head of French Capital Markets Group for JLL.

Investors remain selective. Unlike the 2006-2007 period with its abundance of capital and debt, the current situation has not (yet) attracted unexperienced investors in the French market. Investors active in the French market are experienced and remain highly selective with rigorous internal processes and little inclination for excess – either in terms of asset choice or prices. “This is also illustrated by the fact that ‘not everything sells’ and that some marketing programmes are unsuccessful either due to the asset’s characteristics, location or the price expected by the vendor. Market segmentation remains a reality", states Stephan von Barczy.

The starting point and expectations are not the same, for both the economy and the rental market.
Micro and macro-economic elements used by investors to determine cash flows are not the same as in 2006-2007. In fact, in terms of macro-economics, annual GDP stood at 2.5% in 2006-2007 whereas French GDP is currently struggling to rise significantly above 0%. "In terms of real estate, it's also worth noting that the current prime office rent stands at €735/sq m whereas it was €860/sq m in 2007 when expectations of up to €1,000/sq m were being used for cash flow forecasts” commented Virginie Houzé.

For these reasons, the overall landscape in 2014 is quite different to that seen in 2006-2007. The level of prices and market values in particular are currently lower than those recorded pre-crisis. However, there is one common structural element to both periods: investor appetite remains strong and demand is outstripping supply across virtually all segments. “Given this context, it’s interesting to note that investors who were ‘net vendors’ in 2007 and seeking capital gains, are now positioning themselves as purchasers seeking cash flows as part of longer-term ownership strategies (the case of life insurance companies for example)”, adds Stephan von Barczy.

In conclusion (and without denying the cyclical nature of financial and real estate markets) according to us, real estate is not showing the same risk factors as in 2007 and still appears to offer growth opportunities for investors.