04 / June 2017
T H E T R I U VA N E W S L E T T E R
PRIME YIELDS:
UP OR DOWN?
Initial yields in theory
and practice
What happens in the face
of rising interest rates?
Rental situation more important
than interest rates
TRIUVA / Compass
On the other side of the pond it has already happened
and chances are Europe may not be too far behind.
Post 2010 it has been all downhill for initial yields
(globally) although in the US they have risen slightly in
recent quarters. The reason for this is the interest rate
reversal initiated by the Federal Reserve.
Though the European economy lags behind the US
economy, it is also recovering. With higher economic
growth and the return of inflation beginning to set in,
interest rates are on the rise in Europe. What does
this mean for the real estate ­investment market?
rental growth increases to the same extent as
interest rates, the initial yield does not change.
Figure 1 shows that a relationship exists between
prime yields, interest rates and rental prices. It
depicts the aggregated prime yields, long-term
interest rates and prime rents for the Eurozone‘s
largest office centres. Looking at the figure,
it is evident that the price development is affected
to a large extent by the prevailing Eurozone
10-year government bond yields and the rental
growth:
Initial yield
= Interest on a risk-free investment
+ Risk premium
– Long-term annual rental growth
Initial
yields in
theory …
… and
in practice
This formula is the real estate version of the so-called
Gordon growth model; a simple but illustrative
theoretical explanation of the price development in
real estate investment markets. The initial yield is
equivalent to the sum of the opportunity cost of a
fixed-rate investment and the compensation for the
risks associated with a real estate investment. In
addition, the expected change in rents is priced in.
Anticipating rising rents, buyers will accept higher
prices or lower initial yields, to a certain degree. In
the case of falling rents, a transaction will only be
concluded, if the buyer receives a price discount or
yield premium for the lower future earnings.
>During the ‚mini-boom‘ between 2005 and 2007, interest rates rose slightly, nevertheless, prime yields dropped to a new low, due to strong
performing rental markets.
>With the onset of the financial crisis, interest rates fell during 2007 and 2008, however, rents and rental expectations have declined even more, leading to a rise in prime yields.
>Since 2009 both variables work in the same direction. During the long recovery phase, interest rates have experienced a sharp decline and at the same time, office rents have increased, pushing down prime yields further still.
The model explains the impact of rising interest
rates. The price must drop or the initial yield rise,
all other things being equal – otherwise, the risk
premium would be too low and investors would
switch to a risk-free investment. The model also
explains that the initial yield does not necessarily
rise with higher interest rates. If the expectation of
In order to quantify the relationships between the
aforementioned variables, an econometric model
was applied to estimate the development of prime
Prime office yields, interest rates and rents in the Eurozone (Figure 1)
12
Prime yields and interest rates (in %)
Prime rental index
10
"Mini-
Financial
boom"
crisis
Long recovery phase
150
140
8
130
6
120
4
110
2
100
0
'90
'91
'92
'93
'94
'95
Prime yields
'96
'97
'98
'99
'00
'01
'02
'03
'04
'05
'06
Eurozone 10-year government bond yields
'07
'08
'09
'10
'11
'12
'13
'14
'15
'16
90
Prime rental index (1995=100)
Source: TRIUVA Research, Eurostat
www.triuva.com
Compass / TRIUVA
office yields in the main centres of the Eurozone,
for the period 1997 to 2016. The table below
summarises the main results.
Variable
10-year government bond yields
Rental growth
Elasticity
+ 0.23
- 0.07
remain fundamentally low:
>Structural barriers to interest rates are the declining productivity of enterprises, the slowdown in population growth and the uneven distribution of income.
Source: TRIUVA Research / The description of the model is available at
http://www.triuva.com/en/business-activities/research.html
>From a cyclical point of view, the compulsion to reduce debt and from a monetary policy & The result shows that prime yields do not move
political perspective, the struggle of the ECB to one-to-one with the development of both
maintain the cohesion of the Eurozone are variables, but rather, the reaction is somewhat
aspects in favour of long-term low interest rates. more subdued. The model asserts a significant rela- However, against the backdrop of returning tionship between the development of interest rates inflation, slowly rising (nominal) interest rates and prime yields. The interest rate elasticity is 0.23, are expected. In the financial markets, creditors ask for a higher inflation premium as
which means that a 100 bps rise in interest rates
leads to a 23 bps increase in prime yields. Likewise, compensation for the loss of purchasing power.
the rental growth has a significant impact on prime
yields. If rental growth is 1% per year, prime yields >The outlook for rental markets is positive. Demand is recovering, construction activity decrease by 7 bps.
remains low and conversion activities are high. Rental markets will remain in equilibrium and Both the anticipated development of interest rates
rents will continue to rise.
and rental markets suggest that prime yields will
Scenario
1 Slow normalisation of interest rates / Rental markets in equilibrium
2 Slow normalisation of interest rates / Severe scarcity of office space
3 Continuation of the zero interest rate environment / Severe scarcity of
office space
4 Continuation of the zero interest rate environment / Stagnation in the
rental markets
5 Strong rise in interest rates / Stagnation in the rental markets
The scenarios shown in the table above and the
results shown in figure 2 have no reference to a
specific forecast year. The results show the extent
to which prime yields react to basis point changes
in interest rates from the prevailing level, given the
rental growth (stated in the table) holds true in the
chosen forecast year. From our point of view, since
Interest rate
changes up to
the forecast
year
100 bps
100 bps
0 bps
0 bps
200 bps
No
one-to-one
relationship
Rental growth
during the
forecast year
3.5 %
6.0 %
6.0 %
0.0 %
0.0 %
we are expecting a slow rise in interest rates, the
year 2021 is a suitable year to forecast. The
expected value of 3.5% in scenario 1 corresponds
to a rental growth achieved on average in past
recovery phases; whereas a value of 6% (scenarios 2
and 3) was attained in boom years (e.g. during the
new economy boom). As the starting point, the
What will
the future
hold?
Change in the prime office yield for the different scenarios (Figure 2)
70
Prime yield change in bps
67.2
60
50
40
30
20
22.0
19.0
10
0.5
0
-10
-20
-30
-22.0
Scenario 1
Scenario 2
Scenario 3
Scenario 4
Scenario 5
Source: TRIUVA Research
www.triuva.com
TRIUVA / Compass
A glance
into the
crystal ball
inflation) would lead to a roughly 70 bps increase
in prime yields. However, the results also reveal
how strong rental markets (rising rental incomes at
the property level, accordingly) counteract higher
interest rates. A 6% rental growth would completely compensate for the effect of a 100 bps increase
in interest rates (scenario 2). If interest rates do not
rise and simultaneously there is a very positive
performance on rental markets, even a further
decline in yields exceeding 20 bps could be
expected (scenario 3).
current prime yield of 3.7% prevails. In scenario 1,
the positive effect of rental growth can partly
compensate for the negative effect of higher interest
rates, leading to a 19 bps increase in prime yields. A
similar result emerges for scenario 4: in the case of
stagnation, the persistently low interest rates
dampen the effects of the stagnating real estate
market. A significantly higher increase would be
expected in the case of stagflation (scenario 5).
The combination of stagnating rental markets and
markedly rising interest rates (as a result of high
As a matter of principle, in the discussion on interest rates
and initial yields, it should not be overlooked that, for
the most part, macroeconomic factors, such as interest
rate changes, are not the decisive factor for the long-term
success of a property.
Rental
situation
more
important
than
interest rates
The largest share of the long-term success of a
property is the rental situation, particularly
property-specific characteristics, such as
micro-location and quality. Properties that are
successful on the rental market will also prove
themselves with rising initial yields.
Total Return of existing office properties for the Eurozone, 2000-2015, excl. leverage effects (Figure 3)
0
1
2
Net cash flow return
Contact us:
TRIUVA
Kapitalverwaltungsgesellschaft mbH
Dr. Georg Pfleiderer
Portfolio Management & Operations |
Research
T +49 69 643505-1534
[email protected]
www.triuva.com
THE SQUAIRE 18 / Am Flughafen
60549 Frankfurt / Germany
www.triuva.com
This is confirmed by the aggregate total return for
existing office properties in the Eurozone. In the
period from 2000 to 2015, the cash flow return
generated a performance of 5.7%. The share of the
change in value, such as yield compression or rental
growth, accounted for only 0.3% of the total return.
3
4
Capital growth
5
6
%
Source: TRIUVA Research, MSCI
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