Investment Update - Nov 2016
I am not an economist nor interested in politics, however the recent election of Donald Trump has caused me to have deeper look at what the implications could be for Australian real estate in a new world where Trump tries new ways to spur on growth in the US. To start with I thought that I would review what has been happening with bonds - after all they reflect the markets view of inflation and interest rates. Government Bonds Prior to Trumps election, capital was continuing to chase quality yielding assets in safe markets as a “lower for longer” cry rang out across the globe. Australian Government Bonds were seen as a safe haven hand as the price of bonds was bid up, their yield has dropped. The illustration below shows the yield on Australian 10 year Government Bonds for the past 12 months. Having come down from a high of 6.5% after the GFC, yields were just under 3% 12 months ago and hit a low of 1.82% in August.
In other words, prior to Trump, the markets have expected that the global economic conditions will be “lower for longer” sufficient to enable someone buying a 10 year government bond back in August to accept a return of 1.8%, which they assess is sufficient to cover the predictable rise in inflation and the cost of the money. Trumps election has changed those thoughts as is shown above with an immediate upward lift in bond yields to close recently at 2.77%. Despite the sudden turn around, yields are still near historical lows. Implications for Property Assets Commercial property assets are valued based on an assessment of future income with reference to cap rates, yields and IRRs derived from market evidence. Each of these indicators are however influenced by a wide range of variables including supply & demand, capital flows, interest rates, risk appetite and the health of the local economy.
The correlation between bond yields (an indicator of raising interest rates) and cap rates isn’t strong but a moderate correlation exists. There are obvious timing discrepancies between valuation lags, actual transactional evidence and other matters such as lease tenure and vacancy rates which explain the variations.
As shown in the chart to the right, property will generally trade at a 150-350Bps premium to bonds subject to the markets perception of those other market variables and the risks they present. The greater the risk of the other variables reducing the return, the higher the premium to bonds will be and vica versa.
In the period leading up to the GFC, the weight of money flowing into property pushed the spread into negative teritory leading to a very sharp unwinding in 2009. Currently, the gap between bond yields and office yields (“yield spread”) has moderated from a decade high of just under 400Bps, to around 290Bps. Whether the more recent move in bond yields translates into changes in cap rates and capital values or just a reduction in the yield spread remains to be seen as the other influences on value can have a more significant impact in the short term. Strong income growth (as a result of a period of high demand and low supply) will provide greatest protection against adverse movements in cap rates. Of course the supply and demand equation for each market is different and whilst Sydney is experiencing strong absorption, low vacancy and strong rental growth, other cities are not.
One of our next Investment Updates will take a look at each of the capital city office markets to understand which may be more resilient in the medium term.
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