Finding returns in a low-yield world

What impact will higher interest rates have on property markets? How far and how fast will global bond yields rise? 

5th May 2017

Continue to the other two articles of this addition of the Global Outlook....

Green shoots in the global recovery

Momentum in the global economy has remained surprisingly robust so far in 2017. Brian Biggs, CFA, Senior Research Analyst, Global, takes a look. Click here to read more.

What is being done to tackle poor air quality in cities? 

Combatting air pollution is a major challenge for cities across the globe. What does this mean for the real estate sector? Simon Chinn, Senior Research Analyst, Global, examines. Click here to read more. 

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). 

Chart-1.jpg

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.  

Chart-2.jpg

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%. 

Chart-3.jpg

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.  

Chart-4.jpg

Chart-4-1-(1).jpg

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.

Chart-5.jpg

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”

View all Grosvenor contacts

DISCLAIMER

Use of this Grosvenor Fund Management Limited (“GFM”) section of the grosvenor.com website (the “GFM Website”) is subject to the following terms and legal notices (“Conditions”).  You are being asked to agree to these Conditions because:  (a) you are accessing the GFM Website for the first time or (b) you are accessing the GFM Website from a different section of the grosvenor.com website. 

The information in the GFM Website was prepared by GFM only for, and is directed only at, the limited categories of persons described under “LEGAL NOTICES” below.  The information in this GFM Website is not intended for the use of and should not be relied on by any other person.

GFM is registered in England, with Company Number 04056191 and its registered office at 70 Grosvenor Street, London W1K 3JP.

This GFM Website contains general information about GFM and related entities and is intended for informational purposes only. The information contained on this GFM Website is not an offer to sell or a solicitation of an offer to purchase interests in any fund managed by GFM or a related entity, nor  is it intended to provide, and should not be relied on for, investment, tax, legal or financial advice.  Investors should seek applicable professional advice for their particular situation.  The information contained herein is a summary only, is not complete, and does not include certain material information, including potential conflicts of interest and risks associated with an investment with GFM and its related entities.

No representation, warranty or undertaking, express or implied, is given as to the accuracy or completeness of the information or opinions contained in the enclosed materials, including hyperlinks or references to other sites, by GFM or its related entities, and no liability is accepted by such persons for the accuracy or completeness of any such information or opinions, to the fullest extent permissible by applicable law.  Users are responsible for evaluating the adequacy, accuracy, reliability, merchantability, non-infringement, and/or completeness of any information or the content available on this GFM Website or fitness for any particular purpose with respect to this GFM Website or any of its content.  The estimates, strategies, and views expressed herein are based upon past or current market conditions and/or data and information provided by unaffiliated third parties (which has not been independently verified) and is subject to change without notice. An investment with GFM is speculative and contains significant risks, including the risk of loss of some or all of an investment, and is intended only for sophisticated investors who meet certain eligibility criteria.  Such investments are not deposits or obligations of, or guaranteed or endorsed by, any bank and are not insured or guaranteed by any government or any other agency.

LEGAL NOTICES

Information displayed on this GFM Website may contain material that is interpreted as a financial promotion for purposes of the Financial Services and Markets Act 2000 of the United Kingdom (the “FSMA”).  GFM is not an authorised person for purposes of the FSMA, and accordingly, the communication of information on this GFM Website is provided only for and is directed only at persons in the UK reasonably believed to be of a kind to whom such promotions may be communicated by an unauthorised person pursuant to an exemption under the FSMA (Financial Promotion) Order 2005 (the “FPO”).  Such persons include: (a) persons having professional experience in matters relating to investments (“Investment Professionals”) and (b) high net worth bodies corporate, partnerships, unincorporated associations, trusts, etc. falling within Article 49 of the FPO (“High Net Worth Businesses”). High Net Worth Businesses include: (i) a corporation which has called-up share capital or net assets of at least £5 million or is a member of a group in which includes a company with called-up share capital or net assets of at least £5 million (but where the corporation has more than 20 shareholders or it is a subsidiary of a company with more than 20 shareholders, the £5 million share capital / net assets requirement is reduced to £500,000); (ii) a partnership or unincorporated association with net assets of at least £5 million and (iii) a trustee of a trust which has had gross assets (i.e. total assets held before deduction of any liabilities) of at least £10 million at any time within the year preceding the promotion.  Any investment opportunities mentioned in this GFM Website are available only to such persons, and persons of any other description in the UK may not rely on the information in it.  Most of the protections provided by the UK regulatory system, and compensation under the UK Financial Services Compensation Scheme, will not be available.

GFM is established in the United Kingdom, which is a member state of the European Economic Area (the “EEA”).  Accordingly, this GFM Website is issued by GFM to the categories of persons described in the paragraph above that are both resident in and accessing this GFM Website from any member state of the EEA in reliance on its rights under the Directive on Electronic Commerce (2000/31/EC).  The member states of the EEA are:  Austria, Belgium, Bulgaria, Croatia, Cyprus, Czech Republic, Denmark, Estonia, Finland, France, Germany, Greece, Hungary, Iceland, Ireland, Italy, Latvia, Liechtenstein, Lithuania, Luxembourg, Malta, Netherlands, Norway, Poland, Portugal, Romania, Slovak Republic, Slovenia, Spain, Sweden and the United Kingdom.

If you are not resident in an EEA member state or you are viewing this GFM Website in a country that is not an EEA member state, information displayed on this GFM Website contains material that may be interpreted by the relevant authorities in the country from which you are viewing the GFM Website as a financial promotion or an offer to purchase securities. Accordingly, the information on this GFM Website is only intended to be viewed by persons who fall outside the scope of any law that seeks to regulate financial promotions in your country of residence or in the country in which the GFM Website is being viewed. Examples of such persons may be governmental agencies, persons sufficiently experienced in investment business to appreciate the risks associated with investment services promoted on this GFM Website, large corporations and trusts and high net worth individuals. These examples are not country specific, may not be relevant to the country in which the GFM Website is being viewed and are provided for illustration purposes only. If you are uncertain about your position under the laws of your country of residence or the country in which the GFM Website is being viewed then you should consult your legal adviser.

Notice to Persons in the United States:

With respect to U.S. investors, investments in funds managed by GFM or a related entity are restricted to institutional investors who meet certain eligibility requirements.  Any potential investor should satisfy him or herself that an investment in any product of GFM or a related entity is permissible under the rules and regulations of his or her domicile.  This GFM Website is not directed to any person in any jurisdiction where the publication or availability of this GFM Website is or would be prohibited.

PAST PERFORMANCE IS NOT INDICATIVE OF FUTURE RESULTS. YOU SHOULD CONSULT WITH YOUR LEGAL, TAX, FINANCIAL, AND OTHER ADVISORS PRIOR TO MAKING AN INVESTMENT WITH GROSVENOR.

The related entities of GFM include:

  • In the United Kingdom, Grosvenor Investment Management Limited, which is registered in England (Company Number 02774291) with its registered office at 70 Grosvenor Street, London W1K 3JP and which is authorised and regulated by the Financial Conduct Authority.
  • In the United States, Grosvenor Fund Management Inc., which is registered as an investment adviser with the U.S. Securities and Exchange Commission.
  • In Japan, Grosvenor Fund Management Japan Limited provides financial services and products under its Kanto Local Finance Bureau (Kinsyo) License No 1956 issued by The Financial Services Agency, the Japanese Government and real estate investment advice as authorised under its Discretionary Real Estate Investment Advisory Business, License No. Sogo 63 issued by the Ministry of Land, Infrastructure, Transport and Tourism. It is also authorised to transact real estate business under its Real Estate Transaction Business License No. Tokyo Governor (2) 87514 issued by the Tokyo Metropolitan Government.  

By clicking “I ACCEPT” below, you consent to the above Conditions and, in particular, you confirm that either:

(a)     you are resident in and accessing this GFM Website from one of the United Kingdom or another member state of the EEA and you qualify as an exempt category of person under the FPO (such as an Investment Professional or High Net Worth Business, as described under “LEGAL NOTICES” above); or

(b)    you fall outside the scope of any law that seeks to regulate financial promotions both in the country of your residence and in the country in which you are viewing this GFM Website, and therefore by accessing this GFM Website you will not contravene or cause Grosvenor to contravene any such law.