Bond market correction vs relative value of CRE: Cushman

Bond yields have risen sharply recently triggering stock market weakness, at the time of writing the Dow is down 4.6%. This note analyses how this might impact Australian Commercial Real Estate (CRE).

Rising bond yields reduce CRE relative value. The extent of the reduction depends on both the size and duration of the bond selloff, as well as how other asset classes perform and economic growth is impacted.

As the potential scale and duration of any bond market correction is unknowable, we review three possible scenarios and their potential impact on CRE for investors to assess:

  1. Limited to moderate bond yield increase, 50-100bps: Australian CRE remains relatively attractive with further potential for limited yield compression in the near term. Rising interest rates are a sign of stronger economic growth which should support CRE capital growth and help maintain relative value.
  2. Moderate to strong and sustained bond yield increase, 100-200 bps: Australian CRE yields rise to be equal with or above bond yields. In this scenario, relative value would focus on total returns and risk premium. Markets with solid growth prospects, such as Sydney CBD office property, should remain in demand, particularly from investors with a total return focus. Markets where growth is soft may find pricing at current levels harder to justify and yields rise accordingly.
  3. Severe bond market sell off, +200 bps: A severe bond market selloff is likely to initially impact equity markets and Australian CRE may benefit from its relative stability. Longer term CRE yields may increase depending economic weakness flowing from financial market disruption and/or increase in cost of funding.

What to watch: Major market meltdowns are relatively rare but equity market corrections, even fairly large ones (10%-20%) are fairly common. Many are suggesting the US equity market is due for a correction, if stock markets markets fall 10-20% and stabilise and bond yields do not move significantly higher, Scenarios 1 and 2 are more likely. A rapid rise in bond yields in the order of +200 bps in Australia, while less likely, would bring Scenario 3 into play.

Scenarios 1 and 2 suggest Australian CRE markets with solid growth prospects should remain in demand. If global CRE markets do correct as per Scenario 3, Australia’s stable economy and comparatively high yields  suggest the market should be relatively resilient.

The Cushman & Wakefield Research team would be more than happy to discuss the scenarios and market outlook with you or your team, we are strategy day presentation specialists.  Please contact the team for further details.

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Scenario 1
Limited to moderate bond yield increase, 50-100 bps

Australian 10 year government bond yields have increased to around 2.9% on Monday 5 February. At the same time, Cushman & Wakefield Research reported Australian CRE (CRE) yields in many sectors and locations have declined to near historic lows. The decline in property yields and increase in bond yields has reduced the relative value of Australian CRE.

But while Australian 10 year bond yields have risen by around 40 basis points (BPS) from the low in November, the yield remains a little lower than the 2.98% reached in March. After large increases in late 2016 and early 2017, Australian bond yields have tended to range trade between about 2.4% and 2.9%. The latest increase, so far, is consistent with this.

A key difference with this rise is the significant lift in US Treasury yields. The US 10 Year Treasury yield was trading, at the time of writing, around 2.75%, an increase of around 70 bps from the low of 2.05% in September.

The relatively strong rise in US compared to Australian bonds has resulted in the US/Australian bond yield spread falling to its narrowest level in around 20 years! (Figure 2). The narrowing US/Australian bond yield gap reflects the alternate interest rate and inflation scenarios of the two countries. US rates are expected to rise over 2017, while limited inflation pressure in Australia is prompting the market, as indicated by the ASX 30 Day Interbank Cash Rate Futures as at 5 February, to price in the chance of only one 25 basis point rate hike by Q1 2019 and the chance of a second hike by mid-2019.

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Sydney Prime CBD office yields compressed to 4.4% in Q4 2017, indicating a spread to 10 year Australian government bonds of around 150 bps, Figure 1. This suggests Australian bond yields could rise significantly more before relative value spread turns negative.

It’s also worth noting that the reason for rising US interest rates and bond yields is a stronger US and global economy. While putting upward pressure on bond yields and narrowing investment spreads, a strong economy supports property income growth by improving occupier market conditions.

Scenario 2
Moderate to strong and sustained bond yield increase, 100-200 bps

If Australian 10 year government bond yields were to increase by a further 100 to 200 bps points and remain near this level, Australian CRE could be viewed as relatively expensive, i.e. the further rise in the bond yields could result in a higher yield, with an arguably lower risk, than some CRE assets.

However, this does not take into account the potential for capital gain from CRE assets which lift CRE’s total return. Capital gains since the GFC have often been associated with yield compression from the global hunt for yield. However, a strong economy can also support capital gains from income growth, which includes inflation. Currently, data from IPD indicate the total returns for Australian CRE are around 12%, Figure 3, with retail and industrial total returns closer to 10% and office a little over 13%.

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If the rise in bond yields reflects a higher income growth and/or inflationary environment, the total return offered could result in demand for Australian CRE being maintained. Particularly by investors, such as unlisted funds, with a total return focus.

This suggests markets where growth is expected to remain relatively strong, such as Sydney CBD office, should remain in demand but any markets or assets where the growth outlook is more muted may struggle to attract interest, at current pricing, in a higher bond yield environment.

Scenario 3
Severe bond market sell off, +200 bps

In 1994, US 10 bond yields rose by over 400 bps and Australian bond yields by over 200 bps. A similar rise in Australia would put many CRE market yields below the bond rate. However, as noted above, the property-bond yield spread does not include capital gains.  The current spread between Australian CRE total returns and 10 year bond yields is around 900 bps, and even allowing for a significant risk premium, CRE should remain relatively attractive if capital returns can be maintained.

This suggests any bond market meltdown which spills over into an equity market collapse could result in investors seeking the relative stability of CRE. Figure 3 highlights solid CRE total returns following both the 1987 share market and 1994 bond market crash.

CRE’s relatively stability should help support investor demand in the short term, but there are two potential risks from a bond and/or stock market meltdown.

  1. Financial market turmoil results in slowing economic growth and recession. The recession in 1991 resulted in vacancy rates increasing significantly and income falling. As a result total returns fell well below bond yields.
  2. The rise in bond yields spills over into other debt markets and funding costs increase as per the GFC, (see BBB corporate bond yields in Figure1).  In 2009, rising debt costs and frozen capital markets put upward pressure on CRE yields in Australia. Some owners were forced to liquidate stock and buyers were inhibited by a lack of capital. The resulting increase in CRE yields pushed total returns below bond yields. Whilst gearing levels for CRE owners are now arguably lower than in 2007/2008, rising funding costs are likely to reduce the number of potential buyers and make deals harder to stack up at current pricing levels.

The possibilities outlined in Scenario 3, if they eventuate, are likely to impact Australian CRE valuations, but it should be noted that Australian CRE remains in strong demand from global investors, supported by its stability and relatively attractive returns. If global CRE markets do correct, Australia’s solid economy and comparatively high yields (Figure 4) suggest the market should be relatively resilient.

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