Remember to retain a degree of caution in asset pricing models

August 23, 2011 / By  

In commercial property, we look at the spread between the yield and indexed bond rate as a valuation benchmark. The rule of thumb for calculating the indexed bond rate (published daily on the Reserve Bank of Australia’s website) is the 10-year Australian Government Bond yield minus the Consumer Price Index.

In Q2 2011, prime equivalent yields in the Sydney CBD ranged from 6.25% to 7.50%, implying that the average risk premium for prime grade assets in the Sydney CBD is 435 basis points based on an indexed bond rate of 2.55% (end-June).

Investor risk aversion is on the rise. Yields on Australian Government bonds have fallen, whilst the spread to corporate bonds, especially for lower-rated instruments has increased. The indexed bond rate declined to 2.00% (23-August), widening the spread from prime-grade assets in the Sydney CBD to 490 basis points – the widest spread since 1993. In 1993, the vacancy rate in the Sydney CBD was 21.0%, compared with 8.0% today.

The 20-year average spread is 360 basis points, implying that prime-grade assets in the Sydney CBD are the cheap side of fair value. Assets can look cheap for a reason, in part reflecting a weak growth outlook. However, the growth outlook for the Sydney CBD is relatively positive.

Over the 12 months to Q2 2011, prime gross effective rents increased by 5.5% in the Sydney CBD. Whilst the needle has started to move on leasing incentives, at an average of 26% on a 10-year lease, incentives are still above the level normally associated with a vacancy rate of 8.0% (circa 18% to 20%). Over the next 24-36 months, leasing incentives are expected to be wound back and there is forecast to be upward pressure on face rents. As a result, the Sydney CBD is projected to record a three-year period of above-trend gross effective rental growth.

The latent salesman in me would highlight the prospect for significant yield compression of at least 100 basis points in the Sydney CBD to get prime-grade assets back towards fair value territory. However, the analyst in me notes that there are two moving parts to this particular asset pricing model – the commercial property yield and the indexed bond rate.

Assuming the Australian economy moves back towards trend growth in 2012 (this is currently the RBA base case assumption), the indexed bond rate is likely to trade closer to the historical average of 2.85%. Nevertheless, when adjusting the reference rate back towards the long-term average, the spread falls to 405 basis points – 45 basis points above the historical risk premium of 360 basis points.

In asset pricing models, it is important to take a view of all moving parts. We have demonstrated that there is scope for further yield compression in the Sydney CBD of around 50 basis points – can the same be said for other commercial property markets and asset classes?

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