REAL ESTATE INVESTORS NEED NOT BE CONCERNED ABOUT INTEREST RATE NORMALISATION
CBRE Analysis Suggests Long-Term Interest Rates to Increase to Only 2.5% Over Next Decade, 0.5% in “Real Terms” and Much Less than the Consensus
Property investor concerns about rising interest rates may be overblown, with the likely increase to be much less than the consensus of economic forecasters and well below pre-2008 levels, according to the latest research from global property advisor CBRE. The CBRE research focusses on real long-term interest rates which, the authors argue, are the main long-term driver of property yields.
Since the Global Financial Crisis (GFC), long-term interest rates have fallen to very low levels and commercial real estate has been in high demand from investors. Property yields have fallen substantially driving a substantial across-the-board increase in property prices. Since 2009, globally prime commercial property prices have risen by 85% and the UK, prime central London office values, for example, have doubled.
This fall in long-term interest rates has been widely attributed to quantitative easing (QE) programs both in the UK and elsewhere. With the global economy now in full recovery, interest rates are on a path to normalization and some real estate investors are concerned that interest rates will revert to pre-GFC levels and cause asset prices to fall.
New analysis by CBRE suggests that real U.K. long-term interest rates (10-year Gilt yields) will increase to only 0.5% in 10 years, much less than the consensus forecast of 1.4% or the pre-GFC average of 3.1%. With inflation stable at 2%, this equates to a 2.5% yield on 10-year Gilts up from 1.4% now but much lower than the “consensus” view of 3.5% or the pre-GFC average of 4.7%. CBRE forecasts that nominal long-term interest rates will effectively put a ceiling on the cyclical highs for short-term policy rates. This still implies higher policy rates than today, but well below pre-GFC levels
It is unlikely that the rise in interest rates will be anywhere near as sharp as some economists predict. Interest rates were falling long before the GFC, due to global demographic factors, and these powerful forces remain in play, limiting the extent to which central banks or politicians can hike rates. This is good news for real estate.
As a consequence, institutional investors, who are weighted towards bonds, may struggle to meet retirement-income requirements in a period of sustained low real interest rates. As is now widely recognized, real estate is part of the solution.
While the predicted rise in real long-term interest rates might put some upward pressure on property yields over the next 10 years, the potential impact is small—particularly if growth continues—because the spread between yields and real interest rates will fall back to pre-GFC levels.
The years of high returns from rapid yield compression may have passed, but a period of heavy yield decompression is unlikely. Yields will continue to respond to rental growth expectations and other factors; it is unlikely that the cycle in cap rates will ever disappear. However, there are good reasons to believe that there has been a structural shift downwards in yields and real interest rates that is not going away in the foreseeable future.