Are Australian yields sustainable?February 22, 2013 / By
Australia has been the destination for 45 cents in every dollar of direct real estate investment that flowed into the Asia Pacific region from elsewhere (2011 and 2012). One of the key attractions of Australia is the high yields delivered by prime grade assets compared to equivalent assets in other mature markets with similar levels of transparency. The yield spread between Australian office markets and other mature markets is demonstrated in the table below. The spread between Australian retail yields and the rest of the world is similarly wide. Two questions arise – why are yields so high, and are they sustainable?
High yields may reflect a risk premium applied to Australian property. Currency risk could be part of the story. The Australian dollar has been very strong, particularly against the USD, the Euro and Sterling. With 29% of total investment volumes in 2012 coming from offshore, foreign investors have been influential in setting prices in the Australian market. Australia’s high interest rate structure may be a contributory reason for the yield spread between Australia and other comparable markets. The Reserve Bank of Australia’s policy interest rate is 3%, when policy rates in the US, UK/Europe and Japan are close to zero. Further, investors in the relatively small Australian market may require a premium for liquidity, particularly when financial markets are fragile.
Nevertheless, basic economics suggests that cross-border capital flows should lead to a convergence of asset values. As investment flows into the Australian market rise there is a growing debate as to whether the persisting yield spreads are founded on economic fundamentals such as risk and liquidity, or whether there is an aberration in asset pricing.
The next 12 months should go some way in answering this question. In an efficient market asset values should equalise. So, if yield spreads stay where they are through 2013 we should look for fundamental reasons for Australia’s high yields and their lack of compression. However, if yield spreads do narrow it suggests that currently inertia on the part of investors is resulting in temporary mispricing.
There are advocates on both sides of the debate at present.
Behind this debate are two conflicting theories of how markets work. Behavioural theory suggests that cognitive biases and emotions can influence investment decisions. This can be amplified when access to information is limited, as it often is in property markets where local knowledge and expertise are important. If it is indeed the case that investor irrationality is keeping yields inflated, it can be expected that the market will re-calibrate and the yield spread to international markets will narrow.
In contrast, the efficient markets theory argues that prices always reflect all publicly available information. Australia’s high yields therefore arise from fundamental factors, and the spread to other markets is likely to persist.
The next twelve months will be an interesting test of these theories. Pragmatically, Jones Lang LaSalle forecasts moderate tightening at the upper end of the prime yield range in 2013. It is expected that demand for ‘trophy assets’ from foreign investors will finally give way to some yield compression. But we do not see a major narrowing of the yield gap during 2013.
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