CBRE’s benchmark global office yield remained stable last quarter. Of the 32 prime office markets included in the survey, 10 saw falling yields, 14 remained the same and 8 saw increases. In all cases, yield movements were extremely small and there was no regional pattern. The largest yield compression over the quarter was in the German cities of Berlin (-15 basis points) and Frankfurt (-20 basis points).
Global pricing is stable, underpinned by three factors:
- A pick-up in global GDP growth, with the expectation of modest further improvements to come.
- A pick-up in global investor activity. The level of transactions in Q3 2017 was up by 4% on Q3 2016. Year-to-date levels were up by 4%.1
- Most significantly for real estate, bond markets have been as stable as can be. The average 10-year yield, for the markets covered by this study, was 2.06 at the end of Q3 2017 versus 2.04 in Q2 and 2.06 at the end of Q1. Taking account of inflation, real interest rates are close to zero.
Can we take continued bond market stability for granted? Some recent studies shed light.
Gertjan Vlieghe of the Bank of England2 shows that the current situation of ultra-low real interest rates is far from unusual, but reflects the long-run norm in the post gold-standard world.
- Prior to 1921, when the gold standard was in operation, real interest rates were relatively high, around 3.5%. Since 1921, real interest rates have been lower, at about 1.6%. In the absence of the gold standard, he argues, leverage has built up in the global economy, which makes recessions much worse and therefore increases the demand for riskless assets (government bonds).
- Leverage also makes unsustainable booms more likely, which further increases risk for households. Since 1921, there have been sub-periods in which real interest rates have been pushed into negative territory by wars or financial crises or both. These periods are 1910 to 1920, 1935 to 1950, 1970 to 1975 and 2010 to now.
- Importantly, Vlieghe suggests the current period of deleveraging which followed the Great Financial Crisis, particularly by U.S. households, is now over and this will push real interest rates up. Given firming of inflation, this will feed through into higher nominal bond rates from now on.
Hyun Song Shin of the Bank For International Settlements3 shows that there may be an upward sloping demand function for long-term bonds. In other words, as the price of bonds goes up, demand also goes up.
- Institutions, such as pension funds and insurance companies, have long-term liabilities (10 years or more) generally matched by assets which are only medium- to long-term in nature (under 10 years, on average). So when interest rates fall (and bond prices increase), the value of long duration liabilities increases by more than the value of the relatively shorter duration assets.
- There is an asset-liability gap which widens as interest rates go down. As bond prices rise, so the demand for them increases.
- Shin does not make this point, but the same presumably operates in reverse: As bond prices go down, demand for them falls, so prices fall further than expected.
What are the implications for real estate?
There a tendency in economics to produce theories that fit the facts of the day, but are incomplete. The situation of persistently low interest rates is generating a lot of new economic thinking which should be treated with a degree of skepticism. Nevertheless, if correct, the implications of the recent work are as follows:
- When interest rates do start to rise, bond prices will fall further than expected. The market will overshoot.
- Bond yields will settle at a higher level than they are now, but nowhere near the level they were between 1975 and 2005. The global average will be around 3.5%.
- Real estate yields will rise over the next five years, but not by very much, particularly if real estate investors hold their nerve.
1 There are some material differences among regions in the level of real estate investment transactions, with the Americas down by 6.9% year to date, but EMEA and APAC up by 18% and 14.6%, respectively. However, overall real estate conditions remain buoyant.
2 “Real interest rates and risk,” Gertjan Vlieghe, Society of Business Economists Annual Conference, London, September 2017.
3 “How much should we read into shifts in long dated yields?,” Hyun Song Shin, U.S. Monetary Policy Forum, New York, March 2017.