As interest rates rise and uncertainty grows, markets unable to demonstrate any rental growth prospects will lose their appeal. Joe Valente reports

The theory is nothing if not straightforward. There should be a clear relationship between property yield levels and the expectation of future rental growth in a particular sector/location. Investors will entertain the notion of lower property yields in the belief, and hope, that this will be balanced by above-average rental growth in future. The theory may be simple and straightforward, the problem with it only comes when real investors and the real world are introduced into the equation. It is at that point that the elegance of the theory begins to fray at the edges, as clearly evident over the recent past.
The repricing of real estate over the 2001-06 period, the low interest rate/low inflation environment that prevailed over the period and the boom in liquidity have all combined to distort, albeit temporarily, the equation between rents and yields. Over this period, the historical differential in yields across global markets was stark and reflected both differences in interest rates and varying rental growth prospects. From 2000 onwards, property yields compressed around the globe to the point where the historical differential all but disappeared.
However, stable economic and financial conditions prevailing throughout the period is an inadequate explanation for the level of compression that occurred. After all, yield differentials have been squeezed even within individual countries where similar macroeconomic conditions apply. In the UK, yield differentials eroded both between sectors and across geographical markets. In the US average yields in office markets fell from an average of around 8.5% in the 1992-97 period to around 7.25% in more recent times. However, the key is not so much that yields compressed but that the differential between locations (prime and secondary) and sectors narrowed as reflected in lower standard deviation. What we saw both in the UK as well as the US was replicated throughout the world and cannot simply be attributed to macro-financial conditions.
The full explanation for these trends lies in the other major component that has been such a dominant feature of this cycle - the growth in global liquidity and the sheer weight of capital looking to be invested in real estate worldwide.
Since 2000 investment purchases worldwide rose sharply from $150bn at the beginning of the period to over $600bn in 2006. Total capital flows - the total amount of equity and debt raised to invest in real estate - rose to a peak of just under $900bn, over the same period. Equally important was the fact that cross-border activity increased from around 20% of all investment purchases in 2004 to approximately 35% over the last 12 months or so. International capital and the insatiable appetite for real estate drove yields down across global markets that had, until then, been largely driven by local supply/demand and domestic interest rate policy. Indeed, yields were compressed globally with little, or no, relationship to the prospects for rental growth.
Sub-prime is something of a red herring within the context of the trends described above. However it has, indirectly, had a significant impact on pricing and certainly helped to speed up the correction in global real estate prices which was already evident at the start of 2007.
The recent turmoil in the financial markets triggered by sub-prime has:

Dented confidence and therefore ushered in a more cautious approach by investors;  Raised the cost of capital significantly which will impact on turnover in the market as well as pricing. After all if the ready availability of credit helped to inflate prices, it is inevitable that a credit squeeze will soften prices; Curtailed the ability of the public debt market to provide a viable exit point. This in turn increases investment uncertainty particularly over the outlook for large lot size transactions.

The inevitable consequences of this is that the primary driver for yield compression (weight of capital) is significantly less important, risk is repriced and yields move out, particularly in those locations/sectors with poor rental growth prospects.
This creates another important dynamic: yields are global, rents are local. Rent is a function of local supply/demand and will, therefore, be much more variable.
Over the 2007-11 period, half of all the rental growth expected in the 50 largest office markets in Europe will be generated by just 10 locations. These locations will record reasonable rates of rental growth which may be sufficient to sustain current pricing or, at least, ameliorate the impact of sub-prime. In the other 40 locations that is simply not clear-cut. Rates of growth will be more moderate and, in the end, will not be sufficient to anchor current pricing levels. Yields and pricing have begun to drift out in some major markets and this will extend to other sectors such as specialist asset classes where the yields differential narrowed too quickly.
The correction in pricing was already evident in a large number of markets prior to July 2007. Sub-prime speeded that process up as a period of caution spread through the investor and lending community. Lower transaction volumes, higher cost of capital and softer prices will certainly be a feature of the next three to six months.
Over the medium term, much will depend on the attitude of central banks in cutting interest rates, particularly the Fed, in order to avert a possible recession in the US. The sharp and aggressive cut in rates could increase investor activity in the next few months but such a policy regime is not without significant downside risk of potentially inflating a larger bubble in the years ahead.