Could real estate and negative interest rates be the perfect match?
AT A GLANCE
- Negative and low interest rates continue to support real-estate prices
- Real estate offers attractive diversification in the current negative/low interest-rate environment
- There’s a clear difference between property and Investment Grade bonds due to forward inflation
- We pursue the same investment strategy, focused on ‘value-added’ investments
We are know the idiom “don’t put all your eggs in one basket”. And indeed investors have an intuitive sense that they should not invest too much of their wealth in a single investment or asset. Undeniably, if a high portion of a portfolio is invested in one type of asset class, then the investor is overexposed to a (partial) loss in the event of an adverse event. This is common sense, although many research papers quantify the benefits of portfolio diversification in terms of risk and return.
Admittedly, investors reap the benefits of diversification when the annual returns of different asset classes do not converge (or move less towards each other) over time. As a matter of fact, real estate, which is an important asset class (the other ones being cash, bonds and equities), offers investors good diversification. That said, real estate may not necessarily offer investors an exceptionally higher return. The main advantage of real estate is that property returns are not highly correlated with other asset classes, such as bonds and equities.
In recent months we have seen several events cause renewed volatility (and therefore risk) in the financial markets. Clearly, the ongoing trade war between Washington and Beijing is a major issue, which is fuelling fears of a global recession. Not to mention the increasing probability of a “hard” Brexit. Another key factor is the further monetary easing by the Federal Reserve System (Fed), with President Jerome Powell having lowered the benchmark interest rate for the second time this year to 1.75%-2% on 18 September. As a reminder, in July, the Fed had cut its target range for the federal funds rate to 2-2.25% for the first time since 2008.
The continued decline in nominal and real long-term interest rates—adjusted for inflation—is still a key parameter! The following graph shows negative 10-year government bond yields in some economically mature regions since 2004. The United States is still an exception, although US real bond yields are hardly positive at the present time.
Europe is a particularly striking example of how low long interest rates can go. General uncertainty has pushed yields on European government debt into deep negative territory. For example, the Germany 10-year nominal government bond reached a record low of -0.73% in August (source: TradingEconomics).
Negative and low yields have been supportive for real-estate prices in recent months and years. Nonetheless, property cycles will still matter eventually, even though the pace and timing of the swings in the various property cycles are more difficult to predict in the current negative/low interest rate environment.
So, when is the trend of tumbling interest rates finally going to reverse? And when will real interest rates rise (if at all)? It does not look as though this will happen soon, at least not suddenly. Therefore, it is easy to understand why real estate plays a major role in any asset allocation process. To underline this point, property prices are less subject to market volatility than other assets. Compared with bonds for example, the diversification benefits of property are more difficult to assess. Actually, at present, prime real estate (“stable” properties in excellent locations) tends to perform more or less in line with Investment Grade government bonds. When interest rates fall, bonds and property prices go up almost simultaneously, and vice versa.
Yet, there’s still a significant difference between bonds and prime property. Although real estate is not a “perfect” hedge against inflation, real-estate returns in the private property market have a habit of being positively correlated with core inflation. Today, inflation rates are low in many parts of the world, so the inflation-protection characteristics of real estate are less apparent. But this may change in the not so distant future. Long-term non-indexed bonds are exposed to inflation, as opposed to real estate, which is not, as long as the assets are financed at fixed-interest rates when inflation starts surging. In other words, core inflation drives up real-estate returns in the long term.
As such, our real-estate investment strategy is consistent and unchanged, with a particular recommendation for the “value-added” property segment, especially in Europe (including the United Kingdom). Nonetheless, real-estate investments in top-tiered locations remain attractive, even though tier-1 assets are quite pricey as we are nearing the final stage of the property cycle. The focus should therefore be on the net rental yield (i.e. the tenant), and less on capital appreciation return prospects. In a future article, we will analyse the health of some occupier markets.