This article is from the Australian Property Journal archive
The outlook for Australian commercial property yields is flat. Putting it bluntly, the outlook is depressingly boring.
Yields are close to fair value, suggesting the yield compression we have seen in office, retail and industrial property over the last few years is nearly complete, while the weight of money from the Superannuation Guarantee will keep yields down unless there is a significant increase in interest rates, a recession or speculative oversupply of stock.
Can a forecast be flat?
A frequent criticism of the flat yield outlook is that there has to be a cycle in financial asset prices, it is impossible to have a flat outlook. So the first question to ask is can there indeed be long periods of flat yields?
The simple answer is yes, but there are two parts to the answer. Firstly, while asset prices may be relatively volatile, basic finance theory tells us prices should reflect the present value of future income in a relatively constant relationship. So yields – the ratio of income to price – shouldn’t, in theory move very much. Secondly, while in theory yields should be stable, they are not. But there can be extended periods without much movement, and we need to look at the underlying drivers of yield change. The two main drivers are inflation expectations and the risk premium.
We should, however, first point out there are numerous definitions and ‘types’ of yields.1
Unfortunately, at a time of increasing global capital flows, there is no one definition in common usage across the world. For the purposes of this article, we refer to an ‘equivalent yield’, defined as weighted average of the initial yield and reversionary yield and represents the return a property will produce based upon the timing of the income received.
Why Property Yields Should Not Vary
A property yield reflects the ratio of income to price and so, all things being equal, yields should be relatively stable even if prices and income vary considerably in the cycle. Figure 1 shows that between March 1995 and September 2001, the average Australian prime CBD office yield only varied by just 30 basis points ranging between 7.8% and 8.1% while rental and capital value growth ranged from -2.3% to 18.2%. So while there was considerable volatility in rents and capital values, there was remarkably little change in yields for six years.
Why Yields Move
Figure 2 shows yields in the three main commercial property markets have generally been drifting down since 1993. This largely reflects a change to a low inflation environment. The Reserve Bank of Australia’s adoption of an inflation target and the Bank’s success in its control has allowed a re-rating of the inflation premium and kept bond yields relatively stable since the late 1990s. Many forecasters expect ten-year Commonwealth Government Treasury yields to continue to trade indefinitely in a 5% to 6% range, or for as long as the RBA succeeds in its inflation targeting. This in turn provides a stable platform for commercial property yields.
Property yields compress during periods of low inflation as it generally provides a more stable income environment. During periods of higher inflation, costs rise more rapidly and financial risk increases with higher interest rates. The economic cycle is also exagerated during high inflation as the pace of growth is harder to control. With a higher degree of income certainty from a low inflation environment, investors are more willing to accept a lower risk premium for their investments, or alternatively, pay a higher price for a given income, i.e. a higher PE ratio. While the relationship is not perfect, figure 3 shows that the Sydney Sub-Regional Retail ‘PE’ ratio (inverse of yield) is generally higher when inflation is lower. Conversely, increased income uncertainty will push yields higher (lower the PE). Figure 2 shows the rise in office yields following the 1991 recession, when vacancy rates soared on an oversupply of stock and plummeting demand.
Since the 1991 crash, as discussed in the Economic Insight of May 2006, ‘Where did the volatility go?’, the volatility in the total returns of Australian Commercial Property sectors has fallen substantially, averaging less than 2% per annum, while Australian bond price volatility has averaged around 4% and Australian equities 10%. The stability of returns, particularly retail and industrial, along with stable interest rates has allowed yields to compress significantly.
Yields can also vary when investors view property investments on a ‘total return’ basis. If investors require a total return or IRR of say 8%, when strong capital growth is expected, they may be willing to accept a lower yield. This is particularly evident in the residential market, but also applies to commercial property.
An example of which occurred in Melbourne at the end of the last millennium when the average prime CBD office yield fell to 5% in anticipation of huge rental growth. Unfortunately, the growth failed to appear, indeed rents fell, and yields rose to 8% within two years. To a certain extent, we are currently seeing a similar phenomenon in Perth and Brisbane as yields compress on record breaking rental growth.
Can Yields Go Lower?
In July 2005, Jones Lang LaSalle introduced the Property Risk Premium (PRP) indicator as a guide to the relative value of property compared to a risk free rate. The indicator also takes a ‘total return’ approach, incorporating expected capital growth as well as the current yield. The PRP continues to show that most commercial property markets and sectors remain good to fair value (please contact author for more information) suggesting that generally yields can fall a little more but that we have probably seen the bulk of the compression.
However, while it has been shown that financial markets do tend to revert to a ‘fair value’ level, i.e. yields rise and fall around a long term average, there can be substantial periods when the market could be considered ‘poor value’.2 Indeed, former US Federal Reserve Chairman Alan Greenspan made his famous ‘Irrational Exuberance’ comment in 1996, four years before the tech bubble finally burst. It is therefore possible that yields could fall below the ‘fair value’ level for many years before correcting if investors continue to trim their risk premium or take a very sanguine view of growth potential.
What Could Send Yields Higher?
We feel there are five scenarios that could see property yields move substantially higher, but none is our central case:
· A property bubble. If property became overbought and yields fell substantially, the eventual bursting of the bubble could see yields overshoot in the opposite direction, as occurred in the Melbourne office market between 1999 and 2002. However, this is not a central case. A contributing factor in the Melbourne example was the fallout from tech wreck and currently most financial markets could not be considered to be ‘in a bubble’, though there is some risk in commodity markets. Additionally, unlike the equity or residential property markets, commercial investment grade property is generally not subject to excessive speculative buying, with many investors and financiers well aware of the effects of the 1991 crash. Indeed yields are now at a level where many market participants are search for opportunities offshore.
· An economic recession. Just as the recession of 1991 contributed to yields increasing, so could a future one, possibly driven by substantial fuel price increases. This is not a central case of most economic forecasts and indeed the effects of the recession of 1991 were compounded by property markets being ‘poor value’ relative to a risk free rate as well as the office market suffering from excessive oversupply. Currently, supply and demand appear well balanced, and property is generally fair to good value.
· The end of the Superannuation Guarantee or a taxation change to make it less attractive. The huge weight of money from the Superannuation Guarantee or compulsory retirement saving has also been a contributing factor to commercial property yield compression, creating a strong and steady source of demand for investment-grade property investments. However, as Australia’s population ages, it is unlikely there will be any move in the short to medium term to decrease retirement savings. Indeed some commentators are suggesting the contribution should be increased above the current 9% of salary and a proposed legislative change to change the tax ruling on allocated pensions is anticipated to greatly increase voluntary retirement savings.
· A substantial rise in interest rates. The PRP indicator suggests that interest rates would need to rise by around 200 basis points before commercial property yields would be considered poor value. While throughout 2006, rates did rise on increased inflation concerns, many commentators are now suggesting interest rates are near a peak in this cycle.
· The aging population. A longer-term risk factor will be the eventual drawing down of retirement savings and liquidation of investment portfolios as the population ages. However, this is still some time away. ABS forecasts suggesting Australia’s ‘retired’ population (those 65 and over) will not exceed 20% of the population until 2024 and 25% of the population until 2044, some 38 years away. This is a very long term risk and the government is well aware that ‘demography is destiny’. A recent plan to encourage delayed retirement and increased saving is the ‘Tax Laws Amendment (Simplified Superannuation) Bill’ introduced to parliament on 7 December 2006. Part of its effect is to encourage ‘annuity style’ products that will help to keep retirement savings in managed investment products.
Summary
Following the compression of commercial property yields over the last five or so years to reflect a low inflation/low volatility environment, it is likely the bulk of the compression in commercial property yields has now occurred. However, without a substantial shock to the economy, it is unlikely yields should rise either. Therefore, the most likely outlook is one of a dull flat yield profile, with investors focusing their attention on the total returns available from commercial investment.
By John Sears, head of forecasting services – research and consulting, Jones Lang LaSalle.*
