Despite muted economic growth in Europe a lot of commercial property has become expensive; particularly prime property and particularly office and industrial properties. Other things are going on in retail.
After peaking at 6.15% in mid-2009, prime office yields for a basket of large cities in the Euro area1
fell to just 3.72% at the end of 2018. This was their lowest ever level, at the time sparking discussion about how low they could go and were they nearing their limit. Since then, they have fallen another 200 bps. The debate continues.
From an investor perspective, a key consideration for pricing is the return on alternative assets. Particularly alternative risk-free assets such as medium-dated government bonds (bonds). Property, even prime property, however, is not a bond. For one there are costs to be paid. These include things like capex, depreciation and management costs. These should put a natural floor under yields even before considered things like risk premia. With capex and/or depreciation and other non-recoverable costs together arguably accounting for around 150-200 bps, however, yields could still fall some way before they hit that floor.
Nor is property, even prime property, a risk-free asset. We need to consider the required reward for taking the investment risk, investor expectations of future capital growth or losses, the uncertainty regarding future income, and how the weight of capital looking to deploy in property can affect yields. Taking everything together and comparing property yields with bond yields we get an interesting phenomenon. Although prime office yields have fallen, they have not fallen as much as bond yields and the spread between the two is now practically as big as it has ever been and it is far higher than the pre-2013 norm.
The two things that we know are that falling bond yields have been the primary driver of falling property yields and that prime property markets, with retail a possible exception, are not in bad shape. This suggests that the widening property-bond yield spread is driven by the dynamics of the relationship between property yields and bond yields. When bond yields fall, prime property yields do not react in full immediately and the spread increases. We think this is partly because of investors’ decision lags and partly because it takes time for investors to be convinced that the fall in bond yields is permanent. After all, property is a medium-to-long-term investment and, from a risk-free alternative perspective it is not just the current level of bond yields that matter2
This has important implications. If bond yields stay at their current very low levels, there is scope for yields to fall much further. What is less obvious is that even if bond yields bounce back from their current low levels, property yields could still fall in the near-term and their longer-term increase could be quite muted. This is because property yields are still adjusting to the new normal of low bond yields and even if bond yields rise from their current lows, they are still likely to be very low by historical standards and property still has some catching up to do.
Chart 2 shows the recently released CBRE forecasts for prime office yields in the Euro Area together with the CBRE view on bond yields. The view on bond yields is that they will stay low for a while as global economic growth and inflation remain subdued and as QE adds further downwards pressure. Growth will eventually recover, and inflation will more than likely bounce back even if it remans low by historical standards. This will see bond yields rise to around 1.9% in the Euro Area by the end of 2025. This might look like a steep rise from their current levels, but it would still leave them at historically very low levels and consistent with a “lower for longer” view of the world where low bond yields are a consequence of an on-going global investment-savings imbalance.
There are two major implications for property. One is that there is scope for further modest falls in yields even though bond yields are increasing. In our new forecast, prime office yields for our basket of Euro area markets will not bottom out until the end of 2022, three years after the low point in bond yields. The fall is modest (13 bps) but it is a fall nevertheless. The second implications are that the subsequent rise will be very gradual. Even by the end of 2025 office yields are still forecast to be lower than in early 2019. Another way of saying this is that time will allow prime office yields to catch up with bond yields and that eventually the spread will be much closer to historic levels than it is now.
Does this mean that investors can sit back and stop worrying about yields moving out? What is really means is that they need worry less about the impact of rising bond yields but recessions always impose a threat. The steep rise in property yields in 2008-9 was driven by the recession not rising bond yields. Painful as they are though they are though, recessions are transitory. Once recovery sets in yields fall back and will once again be guided by lower for longer bond yields.
1 The focus here is on the Euro area. Yield shave also fallen in Central Europe and the UK for many of the same reasons though the story there is complicated by convergence in the case of Central Europe and Brexit in the case of the UK.
2 We have focussed on the risk-free aspect of the property- bond yield relationship. bond yields are also closely related to other long-term interest rates and may also affect yields through thee impact on borrowing costs. This may have a rather quicker impact, but the data clearly show that there are considerable lags between changes in bond yields and property yields.