Date
14 December 2017
The current yield gap between REITs and 10-year US government bond represents some buffer to withstand interest rate increases. Photo: Admiral Investment
The current yield gap between REITs and 10-year US government bond represents some buffer to withstand interest rate increases. Photo: Admiral Investment

Why higher rates may not lead to a similar rise in REIT yield

According to Bloomberg, the market currently prices in one additional rate hike before the end of the year.

In the long end of the curve, the market expects the 10-year US Treasury rates to increase by about 20 basis points.

In other words, while we agree that the world has entered an interest rate upcycle, the rate of increase remains manageable, especially at the long end of the curve, which is the most relevant measure when pricing other securities.

We have previously said a key factor in the real estate market is whether the speed of rental increases can be maintained.

Hong Kong has gone through multiple real estate cycles, most recently between 2003 and 2007, but also in the mid-’90s, when real estate rents and prices continued to rise even though interest rates were also increasing.

We don’t think it is in the interest of any government to hike rates at a speed that hurts the long-term growth rate of the global economy.

The ultimate question, thus, is whether Hong Kong has enough demand to justify continued rent increases.

Overall, real estate supply continues to be muted, except in selected areas such as hotels and office space in Kowloon East.

As discussed last month in this column, developers and investors are still targeting various new office nodes, suggesting that at least some investors remain confident in the medium-term growth of the Hong Kong office market.

The economic outlook, especially in terms of retail sales and tourist arrivals, has also gradually improved from 2015.

While retail rents are still reported to be falling, many news stories merely show that leasing contracts are renewed to the current market level, which can be 20 to 30 percent lower than the peak recorded in 2012.

Market rents today, when compared to a year ago, are falling by a much smaller margin because much of the previous excess has been corrected.

Incrementally, Hong Kong’s ability to withstand interest rate increases today is higher than it was two years ago.

Furthermore, the yield spread between Asia-Pacific real estate and the USD government rates remain healthy when compared to historical precedence.

According to the GPR/APREA Asia Pacific REIT Index, the dividend yield of all Asia Pacific REITs was 4.7 percent in 2007, in line with the dividend yield of 4.6 to 4.7 percent between 2013 and 2016.

In 2007, however, the 10-year US government bond rate was between 4.5 and 5.0 percent, meaning that the yield spread between Asia Pacific REITs and USD government rate was around zero.

Investors back in 2007 was willing to take on the additional risks of owning real estate without any compensation in yield. Presumably, this meant that investors expected that the price growth in real estate would provide enough compensation.

Currently, the yield gap between Asia Pacific REITs and the 10-year US government bond rate is about 200 bps, which is wide by historical standards.

This means that investors are only accepting real estate assets when they are compensated by a higher cash income.

This reflects the collective wisdom of investors in the last several years: they didn’t assume the ultra-low interest rate was going to be permanent.

The current yield gap represents some buffer to withstand interest rate increases.

Thus, in the next year or so, rate rises will not necessitate similar increases in real estate yield.

We believe the yield gap will first shrink before real estate yield needs to increase.

– Contact us at [email protected]

RT/CG

A relatively wide yield gap means rising rates will not necessitate similar increases in real estate yield. Photo: Admiral Investment


Chief Investment Officer, Admiral Investment Ltd.

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