Real interest rates and property yields [CBRE report]


Long term interest rates are a key driver of property prices, and a recent report by CBRE in Sept 2018 show a close relationship between real interest rates and property yields.

In the report, the authors claim that concerns about rising real and nominal long-term interest rates are overblown.

Increase in rates will likely be below the consensus of economic forecasters and they will level off well below pre-GFC levels.

Noting a downward trend in property yields for the US since the mid-1990’s, the fall has been closely liked to the fall in real interest rates.

CBRE makes a note that the long downward trend in yields is not just a product of QE.

us yields and interest ratesAlso read: Investors becoming more keen on allocating to real estate

The picture is the same in the UK , though the relationship is a little complicated by the monetary turbulence of the 1970’s.

The long-term relationship between yields and real interest rates shows through clearly. There is also statistical evidence of a 1-for-1 relationship in the long run, albeit with a lag.

uk property yields and interest ratesWith the pictures of the US and UK property market in mind, investors should consider this formula.

Cap Rate = Real Interest Rate + Spread

Where the Spread is affected by expected rent growth, debt availability and performance of other assets.

At this point of time, it would be wise also to consider what really drives long-term real interest rates, because that inadvertently affects property yield and pricing.

CBRE offers a few suggestions, namely

  • Demographic trends, such as aging baby boomers saving for retirement
  • Shift of manufacturing activity from low savings economies in the West to China and elsewhere in Asia, where savings rates are higher
  • Rise in global population of high-net-worth individuals
  • Falling cost of investing in physical capital (e.g. computers), boosting companies’ profit levels
  • Slowing global growth due to an aging population and/or fewer innovations

Among these suggestions, demographic trends is the biggest driver of changes in real interest rates.

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The rise of high-net-worth individuals had no impact on real interest rates. GDP growth is important in driving real interest rates for some economies (US and Germany) but are not for the UK.

The following chart shows the positive relationship between real US 10 year bond yields and the share of world’s population not aged 40-54.
10y bond yields and demographicsThe chart implies that the surge in share of the world’s population aged 40 to 54 was a major factor behind the fall in real long-term interest rates since the mid-1980’s (hump in the chart).

What is the future path of real long-term interest rates?

With the relationship between real interest rates and demographics in mind made clear, the next question on what property investors should look out for is – what’s the future path of real long term interest rates?

What is likely possible is an increase in rates in the near future.

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A declining share of world population aged 40 to 54 years will cause an approximately 20-to-30-bps increase in interest rates over the next 10 years.

A minor rise of interest rates won’t greatly push up property yields, suggesting that property prices could be well supported over the medium to long term future.

Report from CBRE: What interest rate normalization means for global real estate investors