The Reserve Bank of Australia has the commercial property market in its sights. In its most recent 6‑monthly Financial Stability Review, the central bank highlighted the risk of commercial asset re-pricing and associated market dislocation given the clear divergence between the capital and leasing markets.

To suitably assess this pricing risk, a key question that needs answering is; “how low can yields go”? Yields across the office, industrial, and retail sectors compressed significantly in 2014, despite weak leasing market conditions. Historically, yields and vacancy have a moderately positive relationship. However, using the office market as an illustration, this relationship started to break down in the beginning of 2013. Between 1Q13 and 1Q15, the national CBD office market vacancy rate increased by 2.3 percentage points to 12.1%, while the weighted CBD prime office equivalent yield fell by 44 basis points to 6.94%.

Given the weak occupier market, yield compression in the current cycle is being driven not by market fundamentals, but rather by a combination of:

• lower return expectations given the low treasury yield environment;
• the low cost of debt;
• the weight of capital in the market;
• residential conversion / redevelopment opportunity, and;
• the distinct lack of prime grade investment product available for acquisition relative to demand.

Nonetheless, despite strong compression in 2014, the national weighted CBD prime office yield of 6.94% is still 93 basis points higher than in the previous cycle’s (2007) trough of 6.01%, and it still maintains a wide risk premium. The risk premium is the average equivalent yield minus the real risk free rate. Taking the national weighted CBD prime office equivalent yield mid-point of 6.94%, and subtracting it from the inflation indexed bond rate of 0.58% (March 2015), generates a spread of 637 basis points (Figure 1). The ten-year average is 502 basis points. The excess spread of 135 basis points implies that prime grade office assets are still attractively priced in a historical context.

Part of the explanation for the wide spread is the low treasury yield environment. Deloitte Access Economics forecasts that the inflation indexed bond rate will average 1.88% until 2024 (0.58% currently). Even assuming yields remain constant and the inflation indexed bond rate increases as projected, the spread between the national weighted CBD prime office yield and the inflation indexed bond rate will be 502 basis points. Based on this pricing model, the spread is exactly on par with the historical hurdle rate of 502 basis points. So, while market commentary around the rationality of yield compression in this cycle is understandable given the broad weakness in the leasing market, on historical benchmarks and risk adjusted metrics, asset pricing (in the office market) generally reflects fair market value.

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