Despite the swirling uncertainty around the interest rate outlook—after 7 years of Zero Interest Rate Policy (ZIRP), property yields can only go one way—up, commercial property here in Hong Kong continues to transact at record high prices with initial yields in some recent sales coming in at below 3%. So why are investors still so eager to dive into the market? Either they’ve done their math wrong or there’s more to it than meets the eye.
Property yield levels are dependent on a variety factors including rental growth potential, economic situation and interest rate expectations, to name a few. Of these, perhaps the potential changes in interest rates have garnered the most attention in recent months given the US Federal Reserve’s plans to move away from ZIRP.
Under the linked exchange rate system between HKD and USD, interest rates in Hong Kong closely follow their US counterparts. After the US Federal Reserve decided to hold the Federal Fund Rate (FFR) at its current level at its latest meeting, the first rate hike may not occur until as late as March 2016, as indicated by the FFR future markets. There is, however, no guarantee that interest rates will rise by the same amount along the yield curve. For property, investors typically benchmark returns against 10-year government bonds, which—unlike short term rates—are mainly determined by the demand and supply of funds in the capital market.
US Household Debt to GDP Ratio and 10-year Treasury Yield
Source: FRED, Federal Reserve Bank of St. Louis
As shown in the chart above, household debt in the US was nearly 80% of GDP in 2014. Although things have improved somewhat since 2009, it essentially means that corporates and individuals are still heavily indebted hence spend more on paying down debt rather than borrowing more. Yields on 10-year treasuries have historically trended downwards when the Household Debt-to-GDP ratio rises above its long-term average and vice versa. With demand for funds in the capital market remaining low, long-term interest rates are likely stay low. It took 6 years for the US’s household debt level to drop from nearly 100% at the onset of the Global Financial Crisis (GFC) to its current level of 80%. It might take another 6 years for it to drop down to its long-term average level of 60%. Against this backdrop, the yield on 10-year treasuries is unlikely to return to its pre-GFC level of 4% before the deleveraging process in the US’s private sector has run its course.
For Hong Kong, this means that property yields are unlikely to rise significantly over the short-term if the yield on US 10-year treasuries—the risk free rate—stays at low levels. Yes, there is only one way for yields to go but it will be a long and slow uphill journey; which means any downward pressure on prices would not be as obvious as expected.
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