Hot, warm or cold? Government bond yields provide a meaningful benchmark against which to judge the relative pricing of property, say Tony McGough and Ben Burston

In the grip of the worst global recession since World War II, monetary authorities around the world implemented a wide range of accommodative policies and lowered base rates to record lows. The low base rates were the natural response to the downturn, and given the outlook for a gradual rather than strong economic recovery, market participants tend to view lower base rates as likely to persist for several years.

In this environment, investors have driven bond yields across a wide range of maturities down to very low levels in the US, major European and advanced Asian economies. The lowering of yields has reflected both the low interest rate outlook in the major economies of the world, and also a search for safe haven assets given increased uncertainty over the global economic outlook.

Higher yields in troubled European economies
The crisis has, however, exposed significant sovereign risk in several European economies, and notwithstanding low base rates within the eurozone, since late last year, yields on government bonds in Greece, Portugal and Ireland have risen sharply, reflecting investors' wariness about exposure to government debt given considerable uncertainty over fiscal sustainability within these countries. Yields in Spain and Italy have also shown greater volatility, with the widening spread with German and French bonds reflecting the perception of higher sovereign risk.

The debt crisis reached breaking point in May, when European authorities were effectively forced to announce a comprehensive rescue package or else face a possible serial default. The multi-faceted package guarantees ongoing financing for debt-laden national governments and sends a clear signal that the European Union is prepared to stand by troubled economies.

The package has ensured liquidity in bond markets and allayed fears of default in the near term, as evidenced by the decline in the bond yields of affected markets immediately following the announcement. However, the package does not amount to a bailout so much as a guarantee of ongoing access to financing, and the fundamental problem of excessive public debt remains to be addressed.

Since then, the divergence between the yields of core and non-core European markets has widened further. Investors are clearly distinguishing between the relative stability and subdued outlook for the major European markets, implying low bond yields, and the uncertainty surrounding the troubled markets, implying much higher yields. In core markets, despite a strong second quarter led by Germany, the outlook remains subdued and with talk of a second round of quantitative easing in the UK, the period of monetary accommodation and low base rates looks set to continue.

In the troubled states, yields have drifted out once more, with investors distinguishing between shorter-term maturities, which will assuredly be rolled over given the guarantee from the EU, and longer term maturities which are subject to more uncertainty.

Property market impact
If we accept that government bond yields provide a meaningful benchmark against which to judge the relative pricing of property, then we would expect this as one aspect of a divergent impact on global markets. Core markets will continue to benefit from heightened investor interest given the relative attractiveness of property relative to government bonds. Meanwhile markets in troubled European economies continue to face difficulties as investors seek to minimise their exposure given the attendant risks of fiscal sustainability and the weak occupier market outlook that will inevitably follow as the authorities implement the required harsh austerity measures.

Core markets
In the most transparent core markets around the world, the crisis hit early and exacerbated the cyclical correction that was already taking place. Rents fell sharply with demand, and given the outlook for ongoing rental decline and the broader weakness of the financial system, yields quickly moved out and compounded the negative impact on capital values.

Since then, volatility in core markets has continued, but this time in the opposite direction as investors responded to the overshooting that occurred by re-entering the market and bidding yields down once more in markets such as London and Paris.

In part, the lower yields available in core markets reflect an improved economic outlook, with rental recovery now expected to varying degrees. However, the lower yields also reflect the broader financial environment and the rational response on the part of investors to the comparatively low rate of return available on government bonds.

Markets in troubled economies

In contrast to the recovery now expected in the major finance hubs, the prospects for occupier markets in the troubled economies look bleak. Even under the optimistic projections set out in Greece's IMF programme, Greek government debt is set to hit 149 per cent of GDP in 2011. The scale of the budget cuts required to set its debt level back on a sustainable path will entail an ongoing recession, with clear negative implications for occupier demand.

Likewise, the sizable fiscal retrenchments required in Portugal, Ireland, Spain, and Italy also ensure a weak outlook for rental growth. To a lesser extent, this also applies to smaller regional markets in the major economies that are heavily reliant on public sector employment.

In the investment market, negative sentiment about heightened default risk - as reflected in government bond yields - can be expected to keep property yields at higher levels across southern Europe and Ireland in the near term.

Fair value in property markets
Recognising the important link between the bond market and the property investment market, DTZ Research evaluates the attractiveness of different property markets by comparing expected returns in each market against a required return benchmark based on government bond yields.

The DTZ Fair Value Index™ assesses relative value in property markets by comparing the returns a property investor could expect over a five-year investment horizon in the chosen market with the estimated risk-adjusted nominal required return for that market, where required returns are defined as the return available from a government bond of the same duration, allowing for the additional cost and risk associated with property investment (the property premium).

We define fair value in a market as being reached when the market yield, in combination with forecast future capital growth, offers investors an expected return on property investment in excess of the return available on government bonds by an amount equal to the property premium. If the expected return on property is above the return available on bonds after allowing for the property premium, we would consider property to be an attractive investment. Likewise, if the expected return on property investment is below the return available on bonds after allowing for the property premium, we would regard property investment as unattractive to investors.

This assessment of pricing can be viewed through the lens of the market yield. If pricing is above fair value, then the investor would require a higher purchase yield than that available in the market to generate an expected return sufficient to make them indifferent between investment in property and bonds. Likewise, if pricing is below fair value, then the investor could achieve the required return with a lower purchase yield than that available in the market.*

In this way, our assessment of relative value is directly linked to the broader financial environment and takes into account shifts in government bond pricing. All else being equal, we consider that higher government bond yields will raise the required return for prospective investors, while lower bond yields will lower the required return.

Current opportunities
With our approach to assessing value, we see the current difference in bond yields as presenting a challenging market environment for investors to navigate, given corresponding divergent impacts on the relative attractiveness of different markets.

In core markets, investors are faced with low government bond yields and property looks relatively attractive in comparison. As already discussed, we believe that this has been a key driver of recent yield compression in the major European markets such as London and Paris.

Looking ahead, given the subdued outlook for the economy we expect low bond yields to persist in the near term, and as such we expect property yields to remain low for some time. The generally favourable outlook for occupier markets in these key hubs also supports low yields as the private sector recovery takes hold.

We would place markets such as London City offices, West End retail, Paris retail and Munich offices in this category, where these fundamental drivers have supported recent capital value growth. As such, notwithstanding recent downward pressure on yields, we consider that there are several attractive opportunities in core European property markets, with table 1 setting out our views on prominent markets.

The London City office market is expected to experience strong rental growth over the medium term, as it continues its rapid recovery from the economic downturn. This will provide solid capital value growth and consequently attractive returns over the next five years.

In Frankfurt, investors are able to purchase property at very attractive yields relative to recent experience in the tight German market; however, rental growth is expected to be subdued, dampening prospective returns.

It is worth noting however, that regional markets in the major economies are generally less attractive than these major locations. While investors are responding to the prospects for value growth in major markets, smaller regional markets such as Newcastle and Birmingham in the UK have not recovered as strongly, and given their greater exposure to cuts in public sector employment growth in rents and capital values is expected to continue to lag behind.

Property markets in more troubled economies face a higher required return, as reflected in the high government bond yields faced by these countries as they struggle to attract investor interest. Yields have remained higher in these markets, and they certainly face a weaker rental outlook, but current pricing is still attractive in some of these markets given the extent of the fall in values and the prospects for a recovery in the medium term. Buyers will, however, need to be careful with regards to stock selection in order to minimise tenant default risk and also take a medium-term view rather than expect a rapid recovery.

Ben Burston (far left) is associate director, forecasting & strategy research; Tony McGough is global head of forecasting & strategy at DTZ