INTEREST RATES AND PROPERTY YIELDS

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1 FOR PROFESSIONAL CLIENTS, FINANCIAL ADVISERS AND INSTITUTIONAL/QUALIFIED INVESTORS ONLY. NOT TO BE DISTRIBUTED TO, OR RELIED ON BY, RETAIL CLIENTS. INTEREST RATES AND PROPERTY YIELDS The outlook for global real estate in a world of rising bond yields Chris Urwin & Sandip Bhalsod

2 Overview Although real estate is starting to look expensive in historic terms, the recent rally it has enjoyed has generally failed to keep pace with the progress enjoyed by other asset types. Consequently, real-estate assets still offer good value relative to government bonds. Even so, economic and financial normalisation are bringing the prospect of rising government bond yields ever closer. Meanwhile, recent movements in the bond markets have reminded investors that yields can move significantly higher in a short space of time. This paper sets out to provide a framework for analysing the outlook for global real-estate assets in a world of rising bond yields. Chris Urwin Head of Global Real Estate Research Sandip Bhalsod Global Real Estate Analyst Chris leads Aviva Investors Real Estate Research Team, which develops investment views of markets and sectors for our direct, indirect and multimanager real-estate strategies. Prior to joining Aviva Investors, Chris was a senior commercial property market analyst at CBRE and an economist at the Institute of Public Policy Research. Chris holds an MA in Economic History and a BA (Econ) in Economics from the University of Manchester, and is a member of the Society of Property Researchers. Sandip undertakes analysis of global realestate markets with a primary focus on the Asia Pacific region. Prior to joining Aviva nvestors in 2014, Sandip was a junior analyst in the DTZ research team. He holds a BSc (Econ) degree from the London School of Economics and Political Science and is a member of the Society of Property Researchers. Executive summary After analysing the likely impact of higher bond yields on the valuation case for real estate we remain relatively sanguine on the outlook for the asset class as: The expectation that bond yields will rise gradually and peak at a lower rate than in previous cycles is very supportive of real-estate values. Bond yields are not the only driver of real-estate yields; income growth expectations and the risk premium are also important drivers. Hence, bond and real-estate yields are not directly correlated. Our analysis confirms that movements in bond yields are reflected in real-estate yields, but with a lag reflecting the illiquid nature of real-estate assets. Compared to history, current real-estate spreads are most generous in Europe and Australia. In most other Asian markets, the spread remains below the historic average. In the US, the spread is below the historic average for tier one and two markets, but tier three markets still offer some margin. Rising bond yields will weaken the valuation case for real estate but it remains compelling for most European markets and Australia. Markets in Asia and the US look most exposed. Rising interest rates are often associated with improving economic and occupier market prospects and this is the case now. Rental growth expectations partly offset rising bond yields, especially in the US. However, valuations remain stretched in most Asian markets even when rental expectations are included. Higher bond yields are likely to affect prime and secondary real estate differently. Secondary assets should fare better against a backdrop of rising bond yields. Although higher interest rates carry the potential to disrupt real-estate financing, our research suggests that this will be limited in the medium term. avivainvestors.com Interest rates and property yields 2

3 This time is different Rates to rise slowly and to lower peaks than in previous tightening cycles The global economy remains in the recovery phase following the financial crisis and global recession of However, as is common in the wake of a major financial crisis, the recovery remains weak. As a result, monetary policy remains extremely accommodative. With signs that economic weakness is easing, however, the prospect of higher rates is moving closer. Figure 1 Tightening more likely The global monetary policy outlook Source: Aviva Investors Real Estate Research Team Easing more likely The Aviva Investors house view is that policy rates will be raised first in those economies where the recovery is most advanced. The US and the UK are notable in this respect. But with a number of countries in the Asia Pacific (APAC) region pegging their currencies against the US dollar or a basket of currencies including the dollar, rate hikes may be necessary in some parts of this region too. Hong Kong and Singapore fall into this category. By contrast, extremely accommodative monetary conditions remain appropriate for the weaker parts of the global economy such as the euro zone and Japan. This view is largely supported by current market pricing for government bond yields. Chart 1 (below) shows the forward curves for a number of economies capturing current market expectations. It demonstrates that yields are generally expected to rise across the board in the coming years. In the near term, curves are steeper in the UK and US as these markets have started or are closer to hiking rates but over the next five years, bond yields are expected to rise in all major markets with the exception of China. In both our house view and current market pricing, two points stand out when looking at rate expectations: The first is that interest rates are expected to rise very slowly. The Federal Reserve (Fed) and Bank of England, have been very clear in communicating their desire to hike gradually. With consumer price inflation (CPI) at extremely low levels and ample spare capacity in the global economy, they see little need to endanger the recovery by tightening too quickly. The second, is that rates are expected to peak at lower levels than in previous cycles i.e. the equilibrium interest rate is believed to be lower now than before the global crisis. A number of reasons have been put forward for this expectation including fiscal headwinds, secular stagnation in the global economy and deteriorating demographics 1. While we are of the view that the rise in rates will be gentle and at a gradual pace, consensus forecasts place future yields at slightly higher levels than implied by the market. The latest consensus survey suggests that yields on tenyear treasury notes may reach 2.8 per cent by the end of November, compared to market expectations of 2.5 per cent 2. 1 For example, Don t just do something, stand there, speech by David Miles to the Resolution Foundation, 14 July Consensus Economics Inc. November 2015 Survey. Chart 1 Market-implied forward curves for ten-year government bonds Yield (%) Q Q4 Q4 Q4 Q4 Q4 Germany Australia Japan UK US Source: Bloomberg as at 24 November 2015 avivainvestors.com Interest rates and property yields 3

4 The theoretical relationship between bond yields and real estate The above observations are important when it comes to thinking about the outlook for real-estate yields. In conventional investment theory, sovereign bond yields are taken to represent the risk-free return available to investors while other asset classes are judged to require a higher return to reflect the greater risks inherent in investing in them. In the case of real estate, this relationship can be represented by the equation: The actual relationship between bond yields and real estate Given then that bond yields are not the only explanatory factor in this equation, we should by no means expect a 1:1 relationship between movements in bond yields and movement in property yields. This is illustrated in Chart 2 below. To address this, we looked at the correlations between real-estate yields and bond yields of different terms in major global markets. Required real-estate yield = Risk-free rate + risk premium expected net income growth We found that: This equation clearly shows that bond yields are an important driver of real-estate yields and illustrates how lower bond yields can help to produce lower real-estate yields. However, the equation also shows that bond yields are not the only driver of real-estate yields. The real-estate risk premium compensates investors for weaker property market efficiency relative to the bond market due to factors such as lower liquidity and higher transaction and management costs. Income growth expectations reflect the equity-like elements of real-estate returns and, all else being equal, the higher the expected growth in income from a real-estate investment, the lower its yield will be. Both of these elements reflect investor perceptions and expectations and, as such, vary from investor to investor and over time. Income growth expectations will, of course, be heavily influenced by views of the economic cycle. And, although some elements of the risk premium reflect the institutional features of a market and might be expected to change relatively slowly, some, for instance liquidity levels, can change very suddenly. Bond yields have a significant effect on property yields but that the two do not move in parallel. In particular, changes in bond yields show up in realestate yields with a lag. In most markets the correlation is strongest at a time lag of 18 to 24 months. This is unsurprising as real estate is a relatively illiquid asset class and it takes time for changes in bond yields to get priced into real estate. Yields on longer-dated bonds are more significant than on shorter bonds. As real estate is usually a long-term investment, we would expect it to be priced off the longer end of the rate curve. Likewise, although central bank policy rates also tend to be highly correlated to real-estate yields, the relationship in most markets is weaker than for longer bonds. Chart 2 Correlation of French retail real estate to government bonds of different maturities Correlation Lag (months) 1Y 3Y 5Y 10Y Source: Aviva Investors as at 30 November 2015 avivainvestors.com Interest rates and property yields 4

5 The real-estate markets most exposed to higher bond yields Given that bond yields globally are widely expected to move higher from here and that changes in bond yields tend to be reflected in property yields over time, higher bond yields clearly present a risk to real-estate values. By comparing current real-estate spreads over bond yields to their historic averages, we can formulate a list of those markets which currently appear most vulnerable to rising bond yields. Charts 3 and 4 below summarise our findings for the major global real-estate markets. Chart 3 Historic versus current global retail property spreads Spread (bps) Source: Aviva Investors as at 30 November 2015 Current (15Q3) Historical average Chart 4 Historic versus current global office property spreads Spread (bps) Source: Aviva Investors as at 30 November 2015 Current (15Q3) Historical average avivainvestors.com Interest rates and property yields 5

6 Charts 3 and 4 demonstrate that: Real-estate spreads in Europe are above their historic averages. The spreads are particularly generous in continental markets, especially those on the periphery. In the UK, spreads are also above average although to a lesser degree than on the continent. The picture is somewhat more mixed across the APAC region. In Australia, spreads are well above the historic average for both office and retail sectors. In Japan, Singapore and China yield spreads have fallen below their historic averages in both office and retail sectors. In Hong Kong, this is also true for retail yields while office spreads remain generous by historic standards. In the US, the picture varies a little by market type. Spreads in the larger Tier 1 and Tier 2 markets have fallen below their historic average while in Tier 3 markets there remains a small buffer. In analysing the current and historic average spreads for the office and retail sectors we also calculated how much bond yields would need to move to restore the historic average as well as the upside/downside risks to real-estate values should this happen. We assumed that the real-estate yield moves to a point where the yield spread returns to its historic average and the change in real-estate values implied by the move was calculated. Figure 2 illustrates our findings. The impact of factoring in current expectations for bond yields While looking at spreads versus historic averages can be instructive, investment is, by its nature, a forward-looking activity and pricing at any point in time is driven by investor expectations. And, as we saw earlier, expectations are that bond yields in most markets will rise in coming years. To incorporate these expectations into the analysis, we looked at yield curve pricing for the coming years. Table 1 in the appendix shows implied bond yields for the next five years 3. It also shows the implied real-estate yield for each market assuming the historic average spread is restored. From here, we then calculated implied upside or downside to current values. We found that: Unsurprisingly, given that bond yields are expected to rise in the coming years, this analysis implies that the valuation case for real estate will diminish in all markets over time. Nonetheless, in continental Europe and Australia, the valuation case for real estate remains robust over the five-year horizon. In the UK, the valuation case will have diminished by the end of this period. Downside risk remains concentrated in the APAC region and in the US. Figure 2 Office The risk to capital values if spreads return to historical norms GREATER UPSIDE Retail 3 The market by no means has perfect foresight and it does not necessarily reflect our house view. Indeed, market expectations have consistently misjudged the timing of bond yield rises for many years. Nonetheless, we still feel market pricing is a reasonable guide to understanding the likely trajectory of bond yields. Prime Italy Prime Spain Prime Sweden Prime Germany Prime France Average Australia Prime Australia Prime UK Prime Hong Kong US Tier 3 Average UK US Tier 2 Prime Singapore US Tier 1 Prime China Prime Japan Prime Germany Prime Spain Prime Italy Prime Sweden Prime Australia Prime France Average UK Average Australia Prime Singapore Prime UK US Tier 3 US Tier 1 Prime Japan US Tier 2 Prime China Prime Hong Kong GREATER DOWNSIDE avivainvestors.com Interest rates and property yields 6

7 How rental growth might protect real estate from higher bond yields Our analysis so far has looked only at expectations for bond yields. However, as we have highlighted, rental growth expectations are also a key determinant of realestate yields. In most cases, rate hikes are a response to a strengthening economy and so rental growth expectations tend to be robust at times when interest rates start to increase. As such, it s worth reminding ourselves where we are in the real-estate occupier cycle to see whether improving income prospects can provide an offset against the expectation of higher bond yields. In common with the wider economy, real-estate occupier markets remain somewhat under the shadow of the financial crisis and recession of Rents in most major markets declined sharply in response to the recession with particularly pronounced falls recorded in peripheral European markets such as Spain and in cyclical APAC markets such as Hong Kong and Singapore. In Australia, where the recession was relatively shallow, occupier markets held up well and overall rents tended not to decline. All major markets have since returned to rental growth although, in common with the broader economic picture, the strength of the recovery has been mixed. In general, rental expectations are relatively positive and rental growth should provide protection to real-estate prospects in the face of rising bond yields. More specifically, we found that: In Europe, the rental recovery in many markets has been slow to build reflecting the subdued economic backdrop. For most markets, rental performance should improve in the next couple of years before falling back towards trend. One exception is the UK where the rental recovery has been under way for longer particularly in Central London offices. Rental growth here is likely to tail off significantly in the period ahead. Another exception is Spain where rental recovery has been very slow to build. The next couple of years are expected to see very strong rental growth, particularly in the office sector, before easing in subsequent years. In the US, the cycle is generally more advanced than in continental Europe and rental performance is expected to moderate over the coming years. In the APAC region, although rental growth is expected for all major markets in the coming years, the best of the rental recovery is generally behind us. The exceptions are China and Australia where occupier markets are currently somewhat subdued. In both, rental growth is expected to firm a little in the next few years. Chart 5 The Asia Pacific rental growth cycle, rebased to Rental values (2007=100) Australia China Hong Kong Japan Singapore Source: Property Market Analysis/Aviva Investors as at 30 November 2015 avivainvestors.com Interest rates and property yields 7

8 Chart 6 The US and European rental growth cycle, rebased to Rental values (2007=100) France Germany Italy Spain UK Nordics US Source: Aviva Investors/CoStar as at 30 November 2015 Determining future market yields We took market expectations for bond yields (i.e. the riskfree rate) and our assumptions for risk premiums and rental growth for a variety of markets in an attempt to determine what the appropriate yield for each market will be over the coming years. Table 3 in the appendix summarises the results of our analysis for the office sector. We found that: In Europe, our analysis supports the robust valuation case for real estate, particularly for the continental markets. In Spain, the very strong rental growth expected in the near term suggests that real estate is currently very cheap although this argument fades as time progresses and rental growth moderates. In the UK, the valuation case fades also as bond yields rise and rental growth eases. In the US, robust rental growth bolsters the valuation case throughout the five-year forecast period. Again, the greatest risk appears to be concentrated in the APAC region with the exception of Australia. The prospects for prime and secondary assets Until now, our analysis has focused on the potential for rising bond yields to impact prime real-estate markets around the world. However, it s also well worth examining how higher bond yields will affect prime and secondary markets differently especially as prime and secondary assets have not moved in tandem during this cycle. In all regions, prime investment markets especially the major gateway centres, were the first to recover for a number of reasons including: The prevailing backdrop of uncertainty over the outlook for economic and financial conditions. The prominence of equity-rich investors (institutions, sovereign wealth funds, REITs) whose focus tends to be on prime assets. The growth of cross-border investors who also tend to focus on prime and major/gateway cities. By contrast, investors have generally been slow to expand their horizons to smaller markets and secondary assets. However, recent indications suggest that this may be changing driven by signs of economic normalisation, inadequate supply of prime assets and the increasingly keen pricing for prime. The UK s regional markets are already seeing increased investment volumes, for example, while in Europe s periphery there s been a pronounced pickup in activity in both Spain and Ireland. But so far, secondary pricing has failed to rally by as much as prime in any regional market. However, there are good reasons to think they might. Real estate has bond-like characteristics, notably its relatively high degree of income security. It also has equity-like characteristics, notably the potential for income growth due to higher rents and improving occupancy. avivainvestors.com Interest rates and property yields 8

9 Prime assets, by definition, possess a lot of certainty of income and so are more bond-like. As a result, investors are more likely to price prime with significant reference to bond yields although with the rise of international investment it may not always be domestic bond yields that matter most. A further caveat is that many buyers of prime assets are seeking wealth preservation over a very long-run horizon and may not be heavily influenced at all by trends in bond yields. Meanwhile, secondary real estate is more equity-like and stands to gain more from improving occupier markets. So, broadly speaking, we would expect secondary assets to fare better against a backdrop of rising bond yields given that: Higher bond yields reflect improving economic fundamentals. And Prime assets have already re-priced further than secondary assets. As a result, we expect to see a narrowing of the yield gap between prime and secondary as bond yields start to climb. Higher interest rates are unlikely to disrupt realestate financing So far our analysis has focused on the potential for higher bond yields to weaken the valuation case for real estate. But, higher bond yields and interest rates also carry the potential to disrupt the availability and cost of credit for realestate investment. In many ways, this may be thought of as part of the general risk of financial dislocation as rates finally rise after a prolonged period at such low levels. However, we are relatively sanguine about this risk to real estate for a number of reasons: This cycle has been far less credit dependent than the last one This cycle has been far less reliant on credit than the escalation we saw in values prior to the global financial crisis. In fact, recent years have seen a de-leveraging of real-estate investment in all regions. According to DTZ s Money Into Property publication, equity invested in real estate globally has been increasing strongly since 2009 while debt has increased far less significantly. As a result, all regions have seen debt decline in importance in the capital stack (see Chart 7). Debt is most prominent in the US and least important in the APAC region. The fact that the run-up in real-estate pricing has not been primarily driven by debt suggests that higher rates should not be significantly negative for real-estate values. Underwriting standards, while loosening, remain relatively conservative Another feature of the cycle in the run-up to 2008 was a pronounced loosening of lending standards for real estate. Margins were cut and loan-to-value (LTV) ratios rose significantly. Of course, many banks suffered significant losses on their real-estate books in the wake of the global financial crisis and lending was cut back sharply. Subsequent regulatory changes have also added to this pressure. There have been signs in recent quarters that lending standards for commercial real estate are loosening. Regulators have already flagged slackening lending criteria in the commercial property market as a growing concern, although they maintain that the risks are still well below those seen in the lead up to the previous crisis. The spreads of real-estate yields to borrowing costs remain relatively generous Finally, even though lending margins haven t compressed as they did in the run-up to the global financial crisis, the absolute cost of lending has declined significantly in recent years due to the pronounced declines in the underlying market rates from which lending tends to be priced (see Chart 8). In the US, for instance, the ten-year swap rate is running at a little over two per cent 4. This is a long way from the five to six per cent levels recorded during 2007/8. As a result, the spreads of real-estate yields to borrowing costs are relatively generous and rate rises of the nature we envisage are unlikely to be significantly disruptive. 4 Source: economagic.com. Ten-year rate of 2.27 per cent as at 11 November avivainvestors.com Interest rates and property yields 9

10 Chart 7 Debt as a percentage of real-estate stock 80% 70% 60% 50% 40% 30% 20% 10% 0% North America Europe Asia Pacific Global Source: DTZ MIP/Aviva Investors as at 30 November 2015 Chart 8 Benchmark lending rates, per cent 9% 8% 7% 6% 5% 4% 3% 2% 1% 0% USD 10y Swap EUR 5y Swap AUD 3m money rate JPY 3m money rate Source: Thomson Reuters Datastream as at 30 November 2015 avivainvestors.com Interest rates and property yields 10

11 APPENDIX Table 1 Upside/downside risk with market pricing scenarios Market Property yield (15Q3) Historic spread Market projected bond yield (as at 24/11/15) Implied property yield Upside/downside risk to values (%) France Germany Italy Spain Sweden OFFICE RETAIL UK Australia Hong Kong Singapore Japan China PPR France Germany Spain Italy Sweden UK Australia Hong Kong Singapore Japan China PPR Table 2 Upside/downside risk in office values after incorporating rental growth expectations Market Office yield (15Q3) Market projected bond yield (as at 24/11/15) Risk premium Average rental growth for next five years Fair value office yield Upside/downside risk to values (%) France Germany Italy Spain Sweden UK Australia Hong Kong Singapore Japan China UST UST Sources: Rental growth forecasts for Europe, Aviva Investors; forecasts for Asia Pacific, Property Market Analysis/Aviva Investors; forecasts for US, CoStar/Aviva Investors. Risk premia are based on in-house estimations. avivainvestors.com Interest rates and property yields 11

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