Register For Our Mailing List

Register to receive our free weekly newsletter including editorials.

Home / 405

The economy, bond yields and real estate: where to from here?

The past year was one for the record books as the pandemic inflicted synchronised economic impacts across the globe. The economic downturn generated significant challenges in determining the path forward. However, as the year progressed, it was evident this economic recession was different from the GFC, distinguished by the magnitude of the initial downturn but also the speed of the recovery.

The Australian recovery experience

The Australian economy has benefited from strong government fiscal support and the exemplary containment of the virus, resulting in a materially stronger than anticipated economic recovery. In April 2020, consensus GDP forecasts for 2020 ranged between -3.4% and -10.0%. These forecasts strengthened over time, with 2020 growth results finishing the year at a manageable -1.1%.

Perhaps even more remarkable was the recovery across the labour market, with forecasts that the unemployment rate would exceed 10% over the year. It peaked at 7.5% before progressively reducing to the most recent reading of 5.8% in March 2021). This is approximately 0.5% above the pre-pandemic trend of 5.25%, a level most economists didn’t expect until 2022. Although many advanced economies shared similar recoveries, Australia’s comparative containment of the virus and effective policy support fuelled a shorter downturn and subsequently, a stronger economic recovery.

The economic recovery and bond yields

Given the speed of the economic recovery, the stimulatory government policy support and the further relaxation of government restrictions, forward projections for growth in Australia have been upgraded. These factors and the rebound in commodity prices have increased expectations for inflation, wages and longer-term economic growth. As such, bond yields have now lifted from historically-low levels.

The Reserve Bank has separately suggested that both wage growth and the consumer price index (CPI) could initially show some ‘catch up’ after slowing sharply during the depths of the pandemic. However, annual inflation is not expected to move within its target range of 2-3% for several years. In response to this relatively good news, over the calendar year 2021, the 10-year bond yield increased from around 1.0% to a high of 1.9% before more recently trading down to approximately 1.7% (at the time of printing).

Bond yields and real estate

The gap between property yields and bond yields is known as the ‘risk premium’, or the excess yield that can be achieved from investment in commercial property versus the ‘risk-free rate’ of an investment in a government bond.

So even though bond yields are increasing (this is known as the ‘steepening’ of the yield curve), the spread – or the difference between commercial real estate yields and bond yields, remains high – even when compared to historical levels (as illustrated in the office and industrial yield charts below). Based on these measures, this signals limited downside risks to commercial real estate valuations.

Prime industrial yield versus 10-year government bond rates

Industrial spreads have narrowed and approached the lower bound of historical movements. However, given the structural tailwinds, implied risk premiums are being adjusted lower.

Prime office yield versus 10-year government bond rates

Office risk premiums remain within typical historical ranges.

Source: JLL Research, Charter Hall Research


Register here to receive the Firstlinks weekly newsletter for free

Sector and industry outlook

Assets with long Weighted Average Lease Expiries (WALE) and quality income streams from strong tenants are well placed to absorb any sustained rise in bond yields. Further strength can be found in assets that benefit from leases with fixed annual rental escalations, as this hedges against any significant and sustained increases in inflation.

Average ‘risk premiums’ should reflect the associated risk and future growth of an investment.

As an example, the discretionary retail and industrial real estate sectors have been experiencing very different structural changes from the rapid growth in online retailing. These trends are being reflected with the two sectors undergoing different ‘re-ratings’: industrial risk premiums are narrowing, while regional and sub-regional retail risk premiums are expanding. The discretionary retail sector can be further compared to non-discretionary retail (think Bunnings, Coles or Woolworths), which have performed strongly over the last year. The average risk premiums for neighbourhood shopping centres that have a majority of non-discretionary retailers as tenants have also been narrowing.

There are several reasons to be positive about the near-term outlook for the Australian economy and the real estate sector. Global and US growth has strengthened significantly, the Australian housing market is in a cyclical upswing, and the drag on the economy generated by Australia’s adjustment to lower commodity prices have now passed. In fact, commodity prices have now increased to decade highs, providing a real income boost for the wider economy. These factors are expected to support the momentum already underway across the Australian commercial real estate sectors, in particular for the industrial, non-discretionary retail and social infrastructure sectors.

 

Adrian Harrington is Head of Capital and Product Development at Charter Hall, a sponsor of Firstlinks. This article is for general information and does not consider the circumstances of any investor.

For more articles and papers from Charter Hall, please click here.

 

RELATED ARTICLES

Are bonds failing us as a warning signal?

banner

Most viewed in recent weeks

Super changes, the Budget and 2021 versus 2022

Josh Frydenberg's third budget contained changes to superannuation and other rules but their effective date is expected to be 1 July 2022. Take care not to confuse them with changes due on 1 July 2021.

Noel's share winners and loser plus budget reality check

Among the share success stories is a poor personal experience as Telstra's service needs improving. Plus why the new budget announcements on downsizing and buying a home don't deserve the super hype.

Grantham interview on the coming day of reckoning

Jeremy Grantham has seen it all before, with bubbles every 15 years or so. The higher you go, the longer and greater the fall. You can have a high-priced asset or a high-yielding asset, but not both at the same time.

Whoyagonnacall? 10 unspoken risks buying off-the-plan

All new apartment buildings have defects, and inexperienced owners assume someone else will fix them. But developers and builders will not volunteer to spend time and money unless someone fights them. Part 1

Buffett says stock picking is too hard for most investors

Warren Buffett explained why he believes most investors should not pick stocks but simply own an S&P 500 index fund. "There's a lot more to picking stocks than figuring out what’s going to be a wonderful industry."

Should investors brace for uncomfortably high inflation?

The global recession came quickly and deeply but it has given way to a strong rebound. What are the lessons for investors, how should a portfolio change and what role will inflation play?

Latest Updates

Exchange traded products

ETFs are the Marvel of listed galaxies, even with star WAR

Until 2018, LICs and LITs dominated ETFs, much like the Star Wars franchise was the most lucrative in the world until Marvel came along. Now ETFs are double their rivals, just as Marvel conquered Star Wars.

Shares

Four leading tech stocks now look cheap

There are few opportunities to buy tech heavyweights at attractive prices. In Morningstar’s view, four global leaders are trading at decent discounts to their fair values, indicating potential for upside.

Shares

Why copper prices are at all-time highs

Known as Dr Copper for the uncanny way its price anticipates future economic activity, copper has hit all-time highs. What are the forces at play and strategies to benefit from the electric metal’s strength?

Economy

Baby bust: will infertility shape Australia's future?

In 1961, Australian women had 3.5 children on average but by 2018, this figure stood at just 1.7. Falling fertility creates a shift in demographics and the ratio of retirees to working-age people.

SMSF strategies

The Ultimate SMSF EOFY Checklist 2021

The end of FY2021 means rules and regulations to check for members of public super funds and SMSFs. Take advantage of opportunities but also avoid a knock on the door. Here are 25 items to check.

Economy

How long will the bad inflation news last?

The answer to whether the US inflation increase will prove temporary or permanent depends on the rates of growth of the quantity of money. It needs to be brought down to about 0.3% a month, and that's a problem.

Economy

The ‘cosmic’ forces leading the US to Modern Monetary Theory

If the world’s largest economy adopted a true MMT framework, the investment implications would be enormous. Economic growth would be materially greater but inflation and interest rates would also be much higher.

Sponsors

Alliances

© 2021 Morningstar, Inc. All rights reserved.

Disclaimer
The data, research and opinions provided here are for information purposes; are not an offer to buy or sell a security; and are not warranted to be correct, complete or accurate. Morningstar, its affiliates, and third-party content providers are not responsible for any investment decisions, damages or losses resulting from, or related to, the data and analyses or their use. Any general advice or ‘regulated financial advice’ under New Zealand law has been prepared by Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892) and/or Morningstar Research Ltd, subsidiaries of Morningstar, Inc, without reference to your objectives, financial situation or needs. For more information refer to our Financial Services Guide (AU) and Financial Advice Provider Disclosure Statement (NZ). You should consider the advice in light of these matters and if applicable, the relevant Product Disclosure Statement before making any decision to invest. Past performance does not necessarily indicate a financial product’s future performance. To obtain advice tailored to your situation, contact a professional financial adviser. Articles are current as at date of publication.
This website contains information and opinions provided by third parties. Inclusion of this information does not necessarily represent Morningstar’s positions, strategies or opinions and should not be considered an endorsement by Morningstar.

Website Development by Master Publisher.