Do rising bond yields threaten property yields? If interest rates rise in line with forecasts we will see reverse yield gaps in several European cities, says Sotiris Tsolacos


There is consensus among economic forecasters that interest rates are on a rising path. Further, the consensus is that the rises will be significant, with 10-year government bond yields reaching 5% in most euro area economies and in the UK by 2014. Should the property industry worry about higher bond yields, narrower property-bond yield spreads, and possible adjustments to property yields?

Property yields equal the required rate of return minus the expected net income growth. The required rate of return is decomposed into the return on the risk-free asset — commonly taken to be the 10-year government bond yield — and the real estate risk premium. The latter captures a range of influences, including investor confidence and liquidity, returns on other assets, and particular market characteristics.

In this framework, rising bond yields should exert upward pressure on property yields. Indeed, basic correlation analysis would suggest there is a moderate to strong correlation between property and bond yields in most markets. However, such correlations are distorted by yields having a strong trend that renders correlations biased. Nevertheless, research has confirmed this association statistically. It has also shown that the impact has not been historically proportionate and that it varies by market and sector. Therefore, we should expect some impact on property yields — but not a proportionate one — from the forecast rise of between 120 and 150 basis points in bond yields.

It is argued that this outcome can be mitigated or entirely offset by improving investor confidence and lower risk premia. Investors expect stronger net income growth, reflecting acceleration in GDP growth rates and lower vacancy levels and probability of tenant defaults. Lower risk premia can result from greater appreciation of property as an inflation hedge. Further, high liquidity levels from a variety of investor types will keep yields under pressure despite the higher interest rates, particularly at the prime end. To a degree, these arguments apply to non-prime assets and smaller markets. Hence, several conjectures can be made as to whether property yields, in particular in the prime segment of the market, will react to the rising bond yields.

We should, however, examine the relationship more closely and from another perspective to gain more insight about market adjustments. We have found that bond and property yields are linked through an equilibrium relationship. Trends in interest rates in general and bond yields determine this equilibrium path, around which property yields fluctuate for the reasons mentioned earlier (risk premia reassessments, changing expectations of future income, etc). On such evidence, it is expected that deviations from the equilibrium path will be restored through adjustments in relative yields.

Figure 1 shows the cyclical deviations around the equilibrium path for three office markets. Periods when markets are above or below equilibrium are followed by periods of adjustment, with markets moving back to equilibrium and on to the other direction, reflecting the inherent market cyclicality. In 2006 and 2007, significant negative deviations were recorded in all markets, followed by return to equilibrium in 2008 and deviations in the opposite direction in 2009. The magnitude of deviations differs by market. In this example, deviations are milder for Frankfurt than for La Defénse; however, in the recent cycle more synchronisation can be observed across all markets. Although annual figures are shown in Figure 1 the analysis can be constantly updated with quarterly data, since within a quarter, interest rates can move significantly (for example, in Spain in 1Q 2011).

Figure 2 plots the departures from equilibrium for 10 office markets in 2009 and 2010 and the expected gap at the end of 2011. By 2011, most markets will have moved into negative territory, although the deviations are not major. However as bond yields are expected to rise further in 2013 and 2014, we would expect the negative deviations to increase and adjustments to take place. As the historical analysis of deviations illustrates, markets can remain in disequilibrium with interest rates for prolonged periods of two to three years, but corrections will eventually occur.

In the applied finance literature, it is established that the gap between equity and gilt yields signals whether the equity or bond market is overpriced. It is assumed that the gap between bond and equity yields has a long-run equilibrium level, departures from which can signal buy or sell opportunities. A similar argument can be made for the relationship of the real estate market with the bond market. If the gap is too high, property is underpriced relative to bonds and vice versa.

Figure 3 shows the spreads between prime office yields and bond yields in the respective countries. A major development has been the positive gap between property and bond yields in most markets since 1998, following the inverse yield gap (property yields lower than bond yields) of the 1990s. A threshold value for the spread in each market and sector could guide whether the spread is too tight or soft. The threshold value can be statistically estimated; it can be subjective, reflecting the risk aversion of the investor; or it can be a combination of both. On the basis of the spreads achieved in the 2000s, spreads look attractive as of the end of 2010. However, bond yields have increased in the first quarter, especially for Spain, making the spread less favourable.

The rise of 120-150 basis points in bond yields will make the spread tighter, even if yields remain at current levels. What action might be seen in the market? Much depends on whether investors see a continuation of the positive spread, and not a return to an inverse-yield-gap paradigm. If the former is true, there will be implications for pricing and perhaps for liquidity once the threshold spread value is attained and actual spreads are compressed below that value.

Disequilibrium situations will emerge from 2012, and spreads will get tighter if interest rate forecasts prove correct. Notwithstanding better income prospects and the belief that property is a good hedge against inflation, including cost push inflation, in an environment of higher interest rates there will be pressures for property yields to adjust towards sustainable spreads and equilibrium relationships with interest rates.

Sotiris Tsolacos is director of European research at Costar Group