Room for further Cap Rate Compression ?
The yield spread to 10 year bond rates is often a key measure of whether real estate assets are over or under priced or whether the risks in real estate are higher or lower than the historic norms.
The trick is to know the difference and to have the conviction to act on it.
CMA and RESourceData continually examine the 10 year bond rates and the evidence from transactions across each sector of the market to understand how the market is pricing the sector.
The chart below shows the US and Australian 10 year bond rates since 2014, through to 21st November. The drop in bond rates in 2019 from 2.8% to 0.9% has been remarkable and driven by global markets and their relative view of the Australian economy.
Historically, real estate returns have averaged about 2% to 4% above bond yields due to the inherent risks in real estate, predominantly illiquidity.
Whilst cap rates have been lower in 2019, the spread to 10 year bonds has in fact increased. The chart below shows how the spread in 2018, which averaged at 3% above bond yields has now pushed above to approx 4.5% above bond yields.
So, is this a signal that cap rates could decline further to bring back the yield spread to the historical range or has the marketed shifted its thinking that the risk margin should be higher than the historic range?
My view is that the later is the case.
The Retail sector spread has moved to 500Bps above 10 year bond rates. Over the last 18 months or more this sector has faced some significant challenges with changing demographics, advances in technology, changes in distribution patterns and the general consumer and business sentiment driving consumers away from malls. The need for substantial capital expenditure and the prospect of lower rents, means that the risk in the retail sector is structurally different to what it would have been 10 years ago.
The Industrial sector has likewise shifted to around 475Bps above 10 year bonds. Whilst there are many industrial assets with long leases trading on or near 5.0% yields, there are many more industrial assets trading in the mid 6%'s and 8%'s. Older industrial assets are still faced with significant obsolescence and key tenant risks which have typically priced them well above office and retail assets. In some cities, like Sydney and Melbourne there has been ample supply of new industrial land which has kept rental growth low. Global capital will likely continue to flow to Australian industrial markets chasing prime assets and thus a two tier industrial market will become more evident, ie new assets with long leases and older style assets with short leases and higher risks.
The Office sector is trading at around 430Bps above 10 year bonds. Just as in the Industrial sector, those assets with WALEs in excess of 5 years will trade at sharper yields than those with short term WALEs. Whilst we have also seen a period of strong rental growth, the current low in business and consumer sentiment and slowing white collar employment may mean that demand for new space may not meet the future supply, particularly in Melbourne. As a result the risks in the commercial sector are increasing. We don't see this as a structural change and therefore we feel that cap rates in the office market will continue to sharper as the acceptance of lower for longer bonds yields allow investment groups to rationally bid asset prices up higher.