In conversation with... Daniel Dickens
Insight | 14 minute read
Interest rates tell you how high the cost of borrowing is, or how high the rewards are for saving. So, if you are a borrower, the interest rate is the amount you are charged for borrowing money, shown as a percentage of the total amount of the loan. In 2022, interest rates have risen across Australia, Europe and the US.
The relationship between interest rates and real estate yields is important for investors to understand, given the potential impact of the former on the latter.
While we believe that recent interest rate increase will place upwards pressure on real estate yields, our research implies that other real estate fundamentals are also important, and theses will limit the extent of yield softening.
Statistically, our analysis shows there is a very close relationship between 10-year government bonds and real estate yields.
Government bonds are viewed as proxy for the ‘risk-free rate’, which is the theoretical rate of return for an investment that has no risk of financial loss. An increase in interest rates encourages saving and deters borrowing and in so doing raises the required rate of return for real estate investment.
In figure 1, we compare Eurozone government bonds to prime Eurozone office yields. A score of 1 means two variables are perfectly correlated, meaning they move in unison. A correlation of 0 means there is no relationship between them. The correlation between Eurozone government bonds and prime office yields over this period is 0.89. This implies a strong relationship and the long downward trend in real estate yields since 2001 is heavily linked to the fall in interest rates.
Although there is a strong correlation between the two variables, the magnitude of moves in real estate yields and bond yields has differed significantly over the past two decades. Figure 2 shows that real estate yields fell by an average of 280bp across major European markets from peak to trough, while bond yields reduced by 495bp over the same period. This suggests that real estate yield movements, although in line with bond yields, are far less volatile and are subject to other forces.
Figure 3 shows the spread between prime UK office yields and 10-year government bonds, and we have used data from the UK office market due its stable history. The spread at the end of 2021 was around 476bps, compared to the long-term average of 306bps. While there is no mathematical rule to indicate the spread which can trigger repricing, we believe the bond yield must first rise to reduce the spread to levels comparable with the long-term average before exerting direct upwards pressure on real estate yields.
Figure 2 also shows that since 1992, there are two periods where the spread between UK prime office yields and 10-year government bonds significantly reduced: between 1993-7, and 2005-8. In both periods the UK was experiencing inflation above the Bank of England (BoE) target of 2%. This suggests that investors are willing to accept a lower spread between real estate yields and government bonds in periods of high inflation due to the perception that real estate is an inflationary hedge.
The volatility in the real estate-bond yield spread suggests the complex influence of several factors playing a role in affecting real estate yields. These include capital markets, macroeconomic variables, and real estate fundamentals.
The spread is related to the expectations around rental and capital value growth, which in turn are related to the supply/demand dynamics of a particular market. If demand for real estate from investors and/or occupiers is high relative to supply, then there will be a downward yield pressure. Where supply is high, for example due to a wave of development completions or occupier bankruptcies, this would exert upward yield pressure.
Despite the disruption brought on by the pandemic, many markets in both the office and logistics sector are undersupplied with available space. Figure 4 shows how the vacancy rates across European office and logistics and industrial properties are significantly below the levels witnessed in the aftermath of the GFC.
A combination of rising construction costs and economic uncertainty has also impacted the development pipeline for both the office and logistics sector. The lack of new stock being brought to the market will exacerbate the current supply/demand dynamics and cause faster prime rental growth.
Debt financing availability has also risen over the last decade due to greater availability of non-bank lenders. This will help maintain yields more than has been done in the past when interest rates rise.
Companies are also in a much healthier position today than they were during the GFC. Figure 5 shows the average loan to value ratio across Europe which has declined from a high of 58% in 2009 to 35% at the end of Q2 2022. As such companies should be better able to protect the downside during a weaker economic environment and, crucially for real estate investors, continue to pay their rent.
The weight of capital targeting real estate across Europe has doubled over the last ten years due to both greater desire for real estate exposure amongst historic investors and new entrants to the market such as sovereign wealth funds.
The significant weight of capital was reflected in the investment volume during the first half of 2022 which totalled €143bn according to RCA. This was the largest transaction volume recorded in H1, and also makes Q2 2022 the second highest rolling 12-month period on record, reflecting investors strong desire to put their money into real estate.
The combination of positive rental growth expectations brought on by encouraging supply/demand dynamics, the versatility in the debt markets, and sheer amount of money allocated towards real estate suggests that the spread between 10-year government bonds and real estate yields will be lower in the future. This would therefore reduce the rate of yield softening brought on by rising interest rates.
Although we have used data on the European real estate market to explore this topic, the same trends permeate all western markets, and the implications are likely to be the same.