The conundrum of investment yields at or close to record lows despite relatively subdued market fundamentals is an issue facing many Australian (and global) commercial real estate markets. The issue becomes even starker if we compare the current cycle to the market peak of 2007.

The cyclical peak in 2007 was characterised by robust occupier demand, low vacancy, and strong rental growth, factors mostly absent in the current cycle. Inevitably, such comparisons invoke discussions of real estate “bubbles” and impending market downturns. It is also at this point in the cycle when we start hearing, “This time it’s different”. And, while it’s easy to roll out this phrase (or dismiss it, depending on which side of the fence you’re sitting on), the one clear difference between now and 2007 is the direct role of financial markets in this cycle.

Table 1: 2007 / 20015 sector comparison

Clearly, in the absence of positive market fundamentals (Table 1), strong investment into Australian real estate is being largely under-pinned by historically low interest rates. We benchmark Australian real estate yields against the 10-year inflation-indexed government bond rate (that is, the “risk free” rate). This risk free rate has trended downwards in recent years and is now currently close to historic lows (Figure 1). The impact of this is two-fold:

1) it lowers the costs of capital (both debt and equity), and
2) it widens the bond to real estate yield spread (risk premium).

Figure 1: Average upper yields by sector and risk free rate, 2005-2015

Access to lower cost funding will clearly increase investment demand for real estate assets, or indeed, any institutional grade asset class. However, in a low growth world where many investors seek stable and consistent returns, investment demand for high yield-low growth assets, such as real estate, will be relatively greater. In Australia, direct commercial real estate generally delivers higher yields relative to other asset classes. It is also a low beta market, attractive to investors looking for a safe haven against expensive bond markets and volatile equity markets.

Additionally, while Australian commercial real estate yields have fallen, they have not compressed as much as bond yields (Table 1). This has resulted in a wider than average spread.  This implies that either there is a larger risk premium for real estate assets or there is mispricing in the bond and/or real estate markets, or both. We take the position that both factors are having an impact. Thus, given the relatively wide risk premium, we believe that yields have shifted to a permanently lower level.

What is not so clear however is how investment markets will behave when bond yields eventually do start to rise, particularly if this coincides with an improvement in real estate market fundamentals. This, in fact, is the scenario likely to play out in Australia over the next few years. And, given that we have never experienced such competing market dynamics, and at such extremes, we really can say, “This time it’s different”.

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