Interest rates yield to property

The structural decline in rates has been occurring for many years, incorporating key events such as the early 1990s recession and the global financial crisis of 2007/08. While the cash rate initially increased post-GFC, it has since fallen from a peak of 4.75 per cent in mid-2011 to today’s 1 per cent.

This most recent kick downwards in rates reflects a significant turnaround in expectations. At the start of the year, just three out of 30 economists polled by Bloomberg forecast rates to be cut in 2019. Most economists expected rates to remain on hold all year, while eight economists initially forecast rate hikes in 2019.

As forecast by those three economists, the RBA has now cut the cash rate by 50 basis points so far in 2019. Further, the market thinks the RBA is not done yet and is pricing in one more cut of 25 basis points before Christmas with another in 2020.

It’s important to note that even with the cash rate at 1 per cent, the RBA still has further room to cut rates. The graph below shows the lowest rates reached by the central banks of other developed economies around the world, suggesting Australia (1 per cent) and New Zealand (1.5 per cent) are still well above other countries which have seen rates fall to zero or even negative territory.

Although RBA Governor Lowe has said he hopes the Reserve Bank will not need to take the cash rate as low as some European central banks, there is certainly capacity for rates even lower than today if required.

Yields also dropping

This lower interest rate environment isn’t limited to the RBA’s cash rate. The first graph above shows the decline in rates extends to both private and public and short term and long term bond yields. 10-year Government bond yields have fallen sharply since the start of the year and now also sit at a record low of just 1 per cent.

One of the flow-on consequences of these low returns is there has been a widespread search for yield. Rather than accepting a sub-3 per cent return on Government bonds for the last five years, investors are increasingly looking further afield for better returns. As a result, Australia’s property sector has seen strong capital inflows, given the better returns on offer.

The investment in Australian property is also coming from overseas sources. Much of this likely reflects the same dynamic - a search for yield that has become global. Savills research shows office yields in Hong Kong (2.3 per cent), Tokyo (2.9 per cent) and Shanghai (3.9 per cent) are all lower than the average returns in Australia. As a result, foreign capital spent on Australian commercial offices reached a record $A11.9 billion in calendar 2018. This is more than 10 times the post-GFC trough in 2010.

Movement of capital is occurring within Australia as well. A recent visit to Perth and Adelaide highlighted the increasing presence of east-coast investors, attracted by the greater yields available in these markets compared with Sydney and Melbourne.

Extra demand

The upshot of this additional demand for Australian property is that yields continue to compress across all states and sectors – greater demand means investors will pay higher prices which means yields decline.

However, it is necessary to keep in mind that while property yields are around the lowest levels on record, they still offer an attractive premium over government bonds. Economists call this gap the ‘risk premium’, as it reflects the additional yield that can be achieved by investing in the property sector rather than ‘risk free’ government bonds. The figure below shows the risk premium for various assets is either in line with or slightly above its long run average.

Historically, headline yields of sub-5 per cent were considered low-yielding. But in this increasingly low interest rate world, a 5 per cent return can be relatively attractive. And with the full impact of the recent rate cuts likely to take some time to flow through, yields could compress even further from here.

Global volatility and a lower dollar

A search for yield is not the only factor supporting foreign investment in Australian property. The lower Australian dollar (AUD) makes Australian assets more affordable and there is also likely to be an element of diversification away from parts of Asia given concerns around the escalating trade war.

Much attention has been given in recent weeks to rising geopolitical tensions, particularly between the US and China. But these tensions are not new. They have been simmering at least since President Trump suggested he would implement significant tariffs on China during the 2016 election campaign. For most of that period there has likely been an element of investors, particularly in China, seeking to move money out of the country. This is likely to continue for as long as the US and China remain at loggerheads.

Another side effect of this global uncertainty and volatility is that ‘riskier’ currencies such as the AUD have come under considerable downward pressure. The relationship between the AUD and the USD gets the most attention but the AUD has also fallen significantly against many Asian currencies.

Over the past two years the AUD has fallen 10 per cent against the Chinese Yuan, nearly 15 per cent against the Singapore Dollar and nearly 20 per cent against the Japanese Yen. This will have worked to offset essentially all of the increase in capital values in Australia’s Office segment over the same time period, ensuring that foreign demand for Australian property remains solid.

What does that mean for investment decisions? As long as the Australian economy remains in reasonable shape, demand for property will continue. But as the low interest rate environment becomes increasingly entrenched, we will continue to see deals with lower yields than what we have been historically accustomed to.

Just as the Australian Prudential Regulation Authority has recently recognised that no one will have to pay 7.25 per cent on their mortgage, so too has the rate of investment return on property shifted down from years gone by.

Daniel Gradwell is Associate Director - Property at ANZ