Will property yields follow interest rates lower?

Risk premiums will determine the scope for yield compression in this cycle.

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• With the world's major central banks beginning to cut interest rates ahead of an easing cycle that may run for several years, there are many who anticipate a similar trend in property yields. In some countries, this expectation is holding back activity in capital markets, as vendors wait out for improved pricing before bringing their assets to market.
• Of course, there are two primary ways that property values can increase; through rental growth, or via yield compression. But with central banks now beginning to ease policy rates, the current focus is very much on the latter. The question, therefore, is whether this expectation is valid?
• The simple answer is yes. At the heart of the Capital Asset Pricing Model (CAPM) is the ‘risk free’ rate of return, which is typically considered to be equivalent to the yield on a long term government bond. This sets the minimum level of return available in the market, from which all other assets are benchmarked.
• All else being equal, it thus follows that as the risk-free rate of return falls, so too does the return on all other asset classes. Over the long term, this is indeed what has happened, with property yields showing a structural relationship with interest rates.

• However, while there is reasonable correlation in the long term, there is significant variation in the short term. In the UK, the rolling 1-year and 3-year correlation coefficients are close to zero, implying no relationship either up or down. Property yields are typically modelled as a function of the risk free rate of return (as per the CAPM), an illiquidity premium, and expectations of future income growth. These factors do not always move in sync.
• We can see this in the recent data. While property yields did follow interest rates higher over the last two years, the shift upwards was much less extreme. This is partly due to the relative strength in occupational markets, so helping to offset the impact of higher interest rates via rising market rental growth.
• This has squeezed risk premiums (i.e., the difference between property yields and the 10-year government bond yield) relative to pre-Covid levels; based on MSCI data, global risk premiums in the first half of this year were around 100-150bps below the average of 2015-19.

• An increase in the risk premium is to be expected as interest rates fall, to encourage institutional investors back into the market and support a recovery in transactional activity. This will offset some of the impact of falling interest rates. Indeed, this is what a model of UK all-property yields – which is based on economic and financial market indicators – implies.

• However, this model has a major flaw; it uses historical relationships to make future predictions. It therefore necessitates a recovery in the risk premium to some long term average, which is around 2.5%, and so fails to account for any structural change in the market that allows the risk premium to rebase higher or lower. The big question, therefore, is where will the risk premium will settle in the future?
• First, the case for a lower risk premium. The real estate market is much larger than it was in the past; according to MSCI, the size of the professionally managed global real estate investment market was US$13.3tn in 2023, rising by around 60% in the last decade. With this size comes greater transparency, greater competition and liquidity, and more experience and expertise. All this would support a lower risk premium.
• Furthermore, the market can continue to function at a lower risk premium. It is less leveraged than in the past; average LTVs in the US have fallen from around 70% in the lead up to the GFC, to around 55% in the last 12-18 months, which means that pricing is less sensitive to changes in the cost of debt. Investors are more focused on income growth rather than capital values, and much of the excess premium in the years following the GFC was artificial, to compensate investors for a future rise in interest rates that never materialised (so a lower risk premium is to be expected).?
• But equally there is a case for a higher risk premium. We have argued before that we are amidst a regime change in the macroeconomic landscape, shifting to an environment of greater volatility in outcomes. And commercial property is facing growing obsolescence risk owing to rapidly changing occupier requirements and ever more stringent ESG mandates/regulations. In both cases, more risk implies a higher premium.
• There is merit to both arguments, which means something in the middle will likely prevail, with significant divergence across asset type and geography. But in aggregate, given where risk premiums are currently, it would suggest that there is limited scope of significant yield compression in this cycle.?