Investors seeking yields in property.
With recent interest rate cuts,we will continue to witness capital piling into higher yielding asset classes, property included, as people seek arbitrage opportunities to try and obtain a real return on their money.
Cash rates at 2.00% means that monies on deposit are going backwards in real terms (after inflation) and thus it is no surprise that the market continues to seek out alternative investment destinations, property in particular.
Over the last few years, property yields have chased the interest rate curve down. This has seen prices for property increase significantly in an environment where the broader property fundamentals are either benign or negative.
Yields following the interest rate curve is not a new phenomenon, however the extent to which it has occurred over the last two years has meant that broader property prices are starting to look expensive. In particular:
- Recent transactions in the Melbourne CBD for B grade assets have occurred on yields in the 5% range and at per square metre rates of between $6000-8000m2 (and in one case, almost $10,000m2 ).
- Industrial transactions are occurring on yields of 7-8% which historically is very tight, particularly in an environment where the ability to supply new industrial stock is plentiful. Pricing reversion is particularly relevant in industrial given the typically long term lease nature of the leases.
We have seen numerous arguments that the current pricing of property is reasonable given that the risk premium (the return obtained over and above the risk free, or cash, rate) has largely been preserved.
Typically, property has sought to provide a return over the risk free rate (or 10 year bond rate) of circa 400-500 basis points (4-5%). Given the current 10 year Government Bond rate is 2.8%, property yields are close to this range.
Whilst on this basis it can be argued the property sector is step with market expectations, it assumes that property investing is based solely with reference to the risk free rate.
If this was the case, property yields would have softened slightly over the last few months as the 10 year bond rate has inched upwards. On the contrary, property prices have continued to tighten and there is talk about the tightening in property yields representing a structural change.
We have heard all of this before. Consider the following excerpt from an ANZ Economics report issued in June 2007, just prior to the start of the GFC: “Marked falls in commercial property yields have led many analysts to believe that recent capital appreciation has been excessive and that current valuations appear stretched. However, whilst investment yields on commercial property have firmed significantly in recent years, at an aggregate level, much of this can be justified alone by a structural fall in the ‘risk free’ benchmark”.
This ANZ report also spoke about the impact the “weight of money” was having in compressing yields. Do these statements not sound very similar to today? Well, we know what happened next……
It can be a dangerous game to invest on a relative basis to other metrics – property pricing should be a function of property fundamentals, not a function of interest rates (or relative pricing to other investment sectors).
Relative investing in property was what drove the sector pre GFC. Money flowed into property chasing yield, and the resultant growth was a boon for all involved. However, it went too far and after a while the only thing supporting the market was momentum – the market had fundamentally surpassed the traditional metrics which represented sound pricing.
As the commentary above indicates, the other argument supporting the tightening in pricing is the weight of money coming from offshore, in particular, Asia. As the ANZ report highlights, this was the same argument mounted pre GFC off the back of foreign institutional capital flowing in.
Much like the Japanese foray into Queensland in the 80’s, such capital inflows only distort markets beyond their fundamental pricing. Eventually property prices revert to the mean but the necessary rationalisation of the sector hurts many.
As was pointed out earlier in this article, yield compression is certainly justifiable if market conditions are such that there is a strong likelihood of significant improvement in rental market conditions, that is falling vacancies, tightening incentives and improving net effective rents.
However, looking across the Australian property markets such conditions are not present. Leasing markets remain quite soft; vacancies and incentives have actually been inching up and generally rental growth is either subdued or non existent over the short to medium term.
Will we be right in our commentary on the market? Only time will tell. However based on experience, many property sectors are starting to look expensive and we felt it was worth sharing with you some of what we are seeing in the marketplace.
Ultimately, over the long term markets follow particular investment based outcomes. And based on the pricing we are seeing emanate from the market at the present time there is potential for significant downside risk.
When acquiring income producing property on tight pricing, you are reliant on interest rates to remain where they are in order to preserve margins.
Given your cash flow is generally fixed for a predetermined period, any increase in interest rates will slash investment margins and therefore result in a concomitant softening in yields, a fall in values and arguably a significant change in sentiment.
This is not to say that good opportunities won’t present, however the market appears to have moved a little too far away from core fundamentals which increases the likelihood of a negative shift in asset pricing.
Beware of relative pricing – it might seem attractive in the short term, but long term it can be your downfall.