Commercial Property Yield Re-rating
A re-rating of commercial property yields is likely, given current conditions and alternatives.
Australian property yields just three months ago were considered tight, and for most markets, at or over their peaks. With two recent cuts to the ‘official cash rate’ and the prospect of more to come, increasing global trade tensions and tumbling returns on bonds and equities, property is starting to look like a bright light in a sea of investment gloominess.
Discussion is mounting as to whether current conditions are now conducive to a re-rating of property investment yields with several arguments prominent. To form an opinion on this the m3property Research team has conducted analysis around the
key arguments listed below:
Yields more attractive now than last year
When looking at current yields for property the expectation is that they would be less attractive now than a year ago as tightening continued for the office and industrial sectors. However, this is not the case on an inflation-adjusted basis.
The chart below shows inflation-adjusted investment yields last year compared to now, across the major property sectors and compares this to inflation-adjusted yields for Bonds and Equities/Shares (two major competing asset classes). This shows that all sectors and asset classes except 10-year bonds are actually delivering higher returns now than they were 12-months ago. Sub Regional and Neighbourhood retail centre yields show the highest available yields on an inflation-adjusted basis, followed by industrial property.
Property compared to other asset classes
The current situation of 10-year treasury bonds showing a negative inflation-adjusted yield means that if you purchase a 10-year bond today and hold it until maturity the investment will lose money. The closest alternative asset class to Bonds in terms of risk and liquidity is cash. According to Canstar, the best available rate for cash in the form of a term deposit, as at 15 August, was 2.2% for a $500,000 investment, indicating a slightly positive inflation-adjusted return on investment.
Shares are another alternative as they have the benefit of high average returns and liquidity. However, this asset class has the disadvantage of higher levels of volatility or risk and at current, average yields for shares on the All Ordinaries Index are decreasing and are generally below property yields nationally.
There is also likely to be more falls in shares in the short-term with the US share market expected to fall further as markets are spooked by the inversion in the US Treasuries (with 10-year bonds falling below 2-year bonds), which in the past has tended to be a precursor to an economic downturn.
The buying power of A-REITs and property firms in Australia is increasing with the average cost of debt reducing from 4.5% as at June 2018 to an average of 4.1% as at June 2019 across a basket of listed A-REITs and property firms. Anecdotally, it is now possible to get debt for the purchase of commercial property at levels of around 3%. This is contributing to a reduction in the weighted average cost of capital, which translates to these entities being able to acquire properties on lower yields and for it to still be accretive.
Property investments are becoming an attractive alternative, with the highest returns available, at current, out of the major asset classes and with the weighted average cost of capital reducing, property assets at the tightest end of the yield spectrum can be accretive to earnings.
The lower Australian dollar effect
The Australian dollar (AUD) has remained below 70 cents against the US dollar (USD) since July 2019 (at 13 August it was just 67.64 cents). The amount that overseas investors (exchanging for US dollars) have to pay for Australian assets is, therefore, lower, all other things being equal. It is, therefore, expected that demand from foreign investors should continue to rise in the short-term. The stopping of quantitative tightening by the US Federal Reserve in August is expected to see further falls in the AUD and Australian 10-year bonds in the short-term.
In looking at the correlation between the change in the volume of purchases by overseas investors against the exchange rate (to the USD) it was found, as expected, that a negative correlation existed for the period from end January 2013 to the end of July 2019. A negative correlation indicates that as the AUD rises against the USD, sales to foreign investors decrease; and as the AUD falls against the USD, sales to overseas investors increase. The correlation, however, was not as strong as expected (-0.1289). Over 0.70 (positive or negative) would be considered a strong relationship.
It was suspected that the widening base of foreign investors may be a factor in the lack of strength in the relationship between the exchange rate A$1=USD and change in sales volume purchased by foreign investors, as other currencies may be rising when the USD was falling, or vice versa. This was, therefore, also tested by looking at the correlation to a commercial property investment-weighted Currency Index (based on the country of origin of purchasers over the period from 2013 to current as recorded by m3property). While the relationship was stronger, it was still weak at just -0.1399.
The m3property Commercial Property Investment-weighted Currency Index is based on the weightings listed below:
Hedging of currencies is likely to be the key reason behind the lack of strength in the relationship between exchange rates and foreign investment purchases of Australian commercial property and would suggest that foreign investors are now acting more on market expectations rather than currency risk. Currency is, therefore, unlikely to be a key driver of a yield re-rating.
Relationship between 10-year bonds and IRRs
Historically, there has been a positive relationship between 10-year bonds and commercial property IRRs and therefore yields.
The chart below illustrates this relationship, as well as the divergence in the relationship since December quarter 2018. Since December 2018 prime IRRs have increased by eight basis points (bp) for shopping centres and fallen for industrial (-22bp) and CBD offices (-4bp) whereas 10-year bonds have reduced by 105bp resulting in a differential of 550bp to property. This is close to the maximum differential over the past six years.
The table above indicates there is a strong positive relationship between 10-year bond yields and prime IRRs in the major property sectors. This means that as 10-year bond yields fall, prime IRRs should also fall. When a lag of three-months is included the relationship strengthens for prime CBD offices and shopping centres. When a six-month lag is factored-in the relationship continues to strengthen for the prime CBD office but weakens for prime shopping centres and prime industrial (albeit remaining strong and positive). While dependence cannot be determined it can be argued that the falling 10-year bond yield is usually associated with a tightening in commercial property IRRs and that tightening in IRRs historically can come through with a lag to the change in bonds, particularly for prime CBD office.
The historical relationship between 10-year bonds and IRRs suggests a property yield re-rating is possible.
National Director - Research
While it was found that the relationship between a lower AUD and investment into commercial property has not been significant since 2013 and is, therefore, unlikely to be a driver of a yield re-rating, other factors are likely to positively influence the flow of investment into commercial property and increase the scope for an adjustment.
The current forecasts for inflation-adjusted returns are shown below with a scenario of yield re-rating based on the increased attractiveness of property compared to other asset classes.
Under a re-rating scenario, inflation-adjusted office yields could show yield tightening moving out to March 2020, before rising at a reduced rate compared to baseline modelling.
Despite inflation-adjusted yields currently softening for retail property, under a re-rating scenario, yields could, instead of flattening, show a tightening moving out to March 2020, before rising again at a reduced rate compared to baseline modelling. The differential between retail inflation-adjusted yields and the other property types is expected to reduce slightly over the next two years.
Under a re-rating scenario, inflation-adjusted industrial yields could show tightening moving out to March 2020, before rising marginally and at a reduced rate compared to baseline modelling.
Given the current economic and market conditions (and assuming that there is not a major economic downturn) there is scope for a re-rating of property yields. This is supported by property yields being significantly more attractive than some of the other major asset classes, which could result in investors gravitating towards property-related investments resulting in yield compression. The relationship between IRRs and 10-year bonds also suggests a fall in IRRs is likely, which in turn would result in a tightening of yields.