Many argue that property yields are too low; that they should be at a risk margin over fixed interest and that they cannot fall below borrowing rates, let alone bond rates. This doesn’t make sense. Certainly, bonds and fixed interest are related, but there’s more going on here than just that. The main question is what will property yields do from here? And what does that mean for capital growth?
Property and bonds are quite different investment assets. Bonds are a fixed nominal [declining real] value asset with a fixed coupon, while property is a real asset with variable income. Why would you expect their yields to be closely related?
This is not the place to look at bond yields though, if I might say, I regard them as low – driven by US bond rates and then supported by Asian investment. And they could go up further from here.
But bond rates are not the only determinant of property yields. To the contrary, there are some classes of property where they have little influence. Yield formation in different markets is quite different. For me, yield as income is but a small component of total property returns. Over time, the majority of total returns comes from capital growth, driven by a combination of income growth and changing yields (as cap rates). But this can vary dramatically through the cycle from strong positive to strong negative contributions.
Over the years that we’ve been looking at yield formation, two major influences have dominated. The first is interest rates, the second is expectation of capital gain. But the influence of these factors can be quite different in different property markets.
Some would add ‘weight of money’ as a major influence. But I regard that more as the transmission mechanism for the more fundamental influences above. When investment conditions are favourable, the inflow of funds causes a firming of yields, and opposite when they aren’t.
Many believe that the amount of money going into superannuation funds has been a cause of and, implicitly, will continue to drive firming yields for property. My logic is that super funds are fickle and, in the process of chasing good returns, can move into and out of markets. When sentiment moves against property, property yields will soften.
Falling interest rates and a switch from fixed interest to property have driven a phase of extraordinary returns for retail and industrial property. Fixed interest-style investors relying on declining fixed interest income went hunting for secure cash flows in a real asset. They first found retail and then industrial property. This influence is confirmed in our regression analyses which identified a significant independent influence of interest rates, together with expectations of capital gain, on both retail and industrial yields.
But this isn’t the case for all sectors. We have never been able to identify a significant independent influence of interest rates on commercial property yields in any of the commercial property markets – and that’s not for lack of trying. I don’t think there is one. Office property prices are formed differently, determined primarily by expectations of capital gain, and independently of interest rates. Interestingly, this makes commercial property a good diversification from fixed interest.
What about the proposition that property yields can’t fall below the cost of funds? This idea comes both from property markets and from the investment community. The investment decision is much more straightforward when the investment ‘washes its face’. For owner occupiers, there is a strong cash flow incentive to invest when borrowing costs are below rental payments. For investors, secure rental streams allow them to gear up to improve return on equity. Hence, a few years ago, the focus was on security of income which allowed LPTs and syndicates to provide securitised assets. At that stage, capital growth was largely ignored. Significantly, the firming of yields and capital growth at the time did a lot more to boost total returns than gearing up on rental income.
Now, with a history of strong capital growth, investors are less focused on yields and more on total returns. And that’s as it should be.
So what happens next? There’s not much prospect of further interest rate declines leading to a firming of yields. To the contrary, the risk is all in the other direction. Either way, it won’t have much effect on commercial property.
But that doesn’t mean that property yields won’t firm any further. Over the next few years, the primary influence on property prices will come from strong demand driving rental growth, both directly by raising income and indirectly through the influence on expectations of capital gain; leading to a firming of yields from that source. Yields have further to fall.
This property cycle has further to run. And each sector needs to be evaluated on its own merits.
Dr Frank Gelber is Director and Chief Economist of BIS Shrapnel.