Will Australian property yields follow bond yields down?

June 15, 2012 / By

The recent rise in investor risk aversion has pushed the Australian Government 10-year bond yield to 2.98% (12-June) – a rate not recorded since the 1940s. Valuations are determined in relation to a risk-free rate. As a result, low treasury yields are making commercial property appear very attractive on conventional pricing models. The spread between the Sydney CBD prime-grade office yield and the real risk-free rate is 609 basis points – the widest spread on record.

In North America and Western Europe, property yields followed bond yields down in 2010. The 10-year average prime-grade yield is 5.60% in New York and 6.60% in the Sydney CBD. The bulk of the yield differential (85 basis points) can be explained by the lower real risk-free rate in the US. The average for the 10-year Treasury Inflation Protected bonds (TIPS) in the US is 2.00%, while the Australian inflation-indexed bond rate is 2.85%.

At the moment, the average prime-grade yield in New York is 4.30%, 258 basis points tighter than the Sydney CBD at 6.88%. The real risk-free rate is 130 basis points higher in Australia (0.80%) than the US (-0.50%). There is, however, a 130 basis points spread unexplained by the real risk-free rate.

A higher spread could be explained by the space market fundamentals. At a glance, however, the conditions look broadly comparable. Vacancy is line with the long-term average in Sydney (8.7%) and New York (10.5%). While the demand environment is challenging, there is limited risk of an over-supply. Ironically, the development pipeline in both markets equates to 1.8% of total stock.

A number of Australian funds (listed and unlisted) have looked to reduce their offshore exposure and focus on growing their domestic portfolio. For domestic fund managers, the cost of capital is more important than arbitrage opportunities between global markets.

The Weighted Average Cost of Capital (WACC) is calculated by the cost of equity (multiplied by the proportion of equity used) plus the cost of debt (multiplied by the proportion of debt used). We have calculated the cost of equity at 10% for a domestic investor seeking a prime-grade asset in the Sydney CBD. The cost of debt has fallen significantly over the past 12 months. As an illustration, the Reserve Bank of Australia reported that the BBB-rated corporate bond yield (with a 1-5 year maturity) was 5.90% in May-2012 – 151 basis points lower than May-2011.

Assume that a domestic investor will use leverage of 30%. The WACC has, therefore, fallen by 45 basis points to 8.77% over the 12 months to May-2012. Jones Lang LaSalle Research projects that Sydney CBD prime-grade assets will deliver an IRR of 10.7% between 2011 and 2014.

Jones Lang LaSalle does not forecast a significant yield compression cycle in Australia. However, the prospect of treasury yields staying lower for longer and a lower cost of capital will increase competition between offshore and domestic investors. This provides a framework for property yields in Australia to tighten against treasury yields over the next 12-18 months.

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