Overview: With the global recovery looking more assured, interest rates are set to rise more obviously over the next two to three years. This note examines real estate yields in the context of a rising bond yield environment. In our view, despite the improving growth outlook, most real estate markets already look fully priced and at risk of a correction if global bond yields are sustained above 3%.
The global recovery has continued to gain traction
There is increasing confidence in the global recovery. After a prolonged period of unconvincing growth, global activity looks to be gaining momentum. The immediate outlook for growth remains positive, notwithstanding heighted geo-political risks. Both consumer and business confidence have rebounded in response to the positive economic momentum and sustained employment growth. In addition, financial market risk spreads have fallen sharply and are now at their lowest levels since the peak of the last cycle (Chart 1).
Source: Federal Reserve, Grosvenor Research
This has been a long-time coming. By historical standards we are already at a relatively mature stage of the cycle. However, despite the prolonged length of the cycle, the pace of growth has been one of the weakest on record (Chart 2); cumulative growth since the trough in the US is currently just 16%, compared with average trough-to-peak growth of 25% through the post-war era. This slow pace of growth suggests that this cycle may turn out to be longer than average. Indeed, assuming continued growth of around 2% p.a., it would still take more than four years to reach the usual cumulative growth peak for an average cycle.
Source: IHS, NBER, Grosvenor Research
Global imbalances remain contained. The world economy appears to be entering a positive reflationary stage of the cycle, with few obvious signs of overheating in the short-term. Most of the “usual suspects” that might indicate a heightened recession risk remain relatively benign:
Credit cycles are generally at an early stage: The deep freeze in global credit markets from financial deleveraging looks to have finally thawed, with a broad-based improvement in bank lending now underway in most countries. Total household debt in advanced economies is now around 76% of GDP, still well below its pre-crisis peak of 86% of GDP. In addition, debt servicing costs remain low, reducing the risk of any imminent credit crunch. The main exception is China, which has seen total non-financial sector debt-to-GDP grow 73% over the past decade, increasing the risk of a potential correction.
Speculative construction activity remains limited: While construction activity is picking up, it remains below its pre-crisis levels in most advanced economies, particularly in the Eurozone (where construction is still 25% below its 2008 level). Even in countries like the US and the UK, which are at a more mature stage of the economic cycle, construction activity has only just recovered from its post-crisis downturn.
Inflationary pressures remain moderate: Despite indications of tightening labour markets in most countries, wage growth since the GFC has remained underwhelming. This is largely due to lingering underemployment and disappointing productivity growth. But both consumer prices and wages have been rising modestly since the second half of 2016, suggesting inflation is on course for a return to a target range of around 2% p.a..
What impact will higher interest rates have on property markets?
Rising interest rates will create challenges for asset pricing. While the continued improvement in growth prospects is welcome news, it also means that we are now entering a slow but steady interest rate tightening cycle, which will have important implications for global real estate investment. Global interest rates have remained at unprecedented lows for the past eight years. One of the most obvious consequences of this sustained period of ultra-low interest rates has been a significant appreciation in capital value across all asset classes, including real estate. As a result, asset prices are now highly sensitive to any upward movement in global interest rates.
Most property markets already look overvalued. Our analysis supports the view that global real estate markets are now fully priced, on both a historic and relative value basis, and moving into overvalued territory. Chart 3 shows the latest level of yield across 25 global cities, split between the office, retail and residential sectors. This highlights the broad-based decline in yields that has occurred across all geographies and sectors over the past eight years. The average yield across all markets is now just 4.5%, compared with a pre-crisis average of 6.2%. Yields are now below 4% in more than a third of these markets (35%), with less than a quarter of markets (23%) reporting yields above 5.5%. By comparison, in 2010 only 5% of markets had yields below 4%, with more than half reporting yields above 5.5%.
Source: CBRE, JLL, Grosvenor Research
Another way to assess relative value in real estate markets is to look at the number of markets where yields are simultaneously: (i) below their long-run average and (ii) where the property risk premium has narrowed excessively. Chart 4 shows how both the level of yields and risk spreads have compressed in global office markets. This analysis suggests that there are now few clear “buy” markets. Over half of these global office markets now have a combination of low yields and narrow risk spreads. This compares with just two markets in 2010 (Chart 4). Indeed, all Tier 1 office markets (London, New York, Paris, Tokyo, LA, HK, Shanghai) look to be in overvalued territory. By contrast, there are still a few selective Tier 2 cities (particularly in North America) that offer selected opportunities for investment.
Source: CBRE, JLL, RCA, Grosvenor Research
Note: Real bond yields have been calculated as nominal sovereign bond yields less current inflation. Bubbles are sized by average annual investment volumes from 2007-2016.
Beware of overpaying late in the cycle
This analysis suggests that despite the improving growth outlook, there is little room for further yield compression in global real estate markets. In effect, the compression in property yields that historically accompanies stronger rental growth has already been front-loaded and priced into real estate yields. Indeed, most real estate markets are now highly exposed to any sustained upward movement in global bond yields.
Although there is a relatively weak contemporaneous relationship between bond yields and real estate values, there is a clear long-run relationship between the global cost of capital and property yields (Chart 5). While market volatility can mask the relationship in any given year, we have estimated a structural econometric model to track the long-run equilibrium relationship between bonds and property yields. This econometric analysis suggests that every 100 bps increase in global bond yields raises property yields by around 50bp over the long-run.
Source: IHS, various brokers, Grosvenor Research
Given this relationship, the key question now facing property investors is how far and how fast will global bond yields rise? While economists remain divided on the outlook for real interest rates, we believe that the global equilibrium real interest rate is now permanently lower due to structural demographic headwinds. Consequently, we would expect long-term equilibrium bond yields to average around 3-3.5% over the next decade, significantly lower than their pre-crisis average of 4.5%.
With the Federal Reserve expected to continue to steadily raise rates over the next two years, we expect global bond yields to continue trending back towards 3%, most likely by 2019. Nonetheless, even if bond yields were to only rise to around 3% over the next five years, our econometric analysis suggests that property yields would still need to rise by around 100 bps to get back towards their new long-run equilibrium.
In this environment, investors should be wary of overpaying late in the cycle. This next phase of the cycle will create a challenging time for investors, where unfortunately there are no easy answers. Our analysis suggests that most of the returns from this cycle have already been banked and investors now face the difficult choice of whether to remain invested in low yield Tier-1 markets, look to move up the risk curve by chasing secondary markets at a mature stage of the cycle, or cash in their chips and look for better entry opportunities, knowing that the current slow cycle may still have several years to run.
At this stage in the cycle outperformance is more likely to come from market dispersion, rather than trend growth (i.e. from “alpha” rather than “beta”). The best returns will be driven by finding targeted opportunities in selected cities, rather than playing the macro cycle.
1. For simplicity we assume that “fair value “property risk premium of 350 bps above the real bond yield.
2. Grosvenor Group Research (January 2014) “New Evidence on Yield Movements”