The economic landscape has changed dramatically from the low interest rate, low inflation environment that was evident following the Global Financial Crisis (GFC). We are currently in a period of economic turmoil, while central banks combat high inflation by increasing interest rates. By being immersed in negative sentiment and constantly watching short-term data, it can be easy to assume that these changes will become permanent as opposed to being transitory. At times like this it is useful to take a step back and look to the structural, longer-term drivers that help to shape the financial landscape.

This is especially true in real estate. Over the past 18 months, real estate yields have moved out significantly and there is now considerable divergence in views as to their long-term sustainable level across Europe. Although there is short-term uncertainty about how much further real estate yields will rise and how long this period of volatility will last, it would be a mistake to assume that real estate yields will stay high into perpetuity. There are structural factors and evidence that suggest this will not be the case.

Outlook for long duration government bond yields

Interest rates, including long duration government bond yields, are intrinsically linked with real estate pricing. The long-term outlook for 10-year bond yields, the proxy for the risk-free rate, is key to this discussion.

Government bond yields have been trending lower for the past several decades (Exhibit 1). Demographic factors, such as people living longer, and slowing productivity growth are the major factors behind this downward trend. As life expectancy increases so does aggregate wealth in the economy; older people tend to have higher levels of savings. Neither of these factors have gone away; they have just been temporarily masked by the current economic situation. Hence, these longer-term forces should mean that interest rates will once again converge toward pre-pandemic levels after we are through the current period.¹

Although forecasts vary on the exact level where interest rates will stablise, most experts suggest that interest rates will trend downwards from where they are currently. The IMF, Bank of England, ECB and the Federal Reserve of New York have all published papers in recent years suggesting that the natural real interest rate will continue to be low due to these structural changes.² Oxford Economics forecasts 10-year bonds to be circa 2.4% in France and 2.75% in the UK by the end of 2028.

Real estate spreads

A longer-term view on the bond yield outlook provides the first step toward estimating real estate pricing. Let’s consider the spread between the government bond yield and real estate yields using London City offices as an example (Exhibit 2).

There are three distinct time periods evident:

• Pre-GFC (2000 - 2005) - a more normalised monetary policy environment; the spread averaged 1.2%. 
• Post-GFC (2009 - 2018) - an economically difficult environment in the UK and eurozone with very low interest rates; the spread averaged 2.25%. 
• 2019 - 2021 - a period of extraordinary monetary policy with negative rates in the eurozone and near zero in the UK; the spread averaged 3.3%. 

The logic for higher spreads in times of economic turmoil or extraordinary monetary policy is relatively straightforward. Investors don’t believe that it will continue and expect that rates will rise in the near future. This was especially evident just prior to the pandemic.

So what happens next?

Let’s take a very simplistic approach using historic averages. UK 10-year bond yields are forecast to stabilise at circa 2.75% (Oxford Economics) and, taking the historic average spreads of 1.2% pre-GFC and 2.5% post-GFC, that would place London City prime office yields between 3.95% and 5.25%.

Although this seems like a reasonable range, the methodology is too simplistic; the spread isn’t equal to the risk premium for investing in real estate. There are other factors, such as rental growth expectations and capex/depreciation, to take into account.

Dividend discount model approach

An alternative approach, using more elements than just bond yields, is a derivative of a dividend discount model. The basic principle of the approach is:

Real estate yield = Risk-free rate + Required risk premia – Rental growth expectations + Capex/depreciation

Taking each element separately:

• Risk-free rate: Stabilised 10-year government bond yield of 2.75%.
• Required risk premia: This may vary between investors and markets, but research (Geltner et al., 2007) suggests circa 2% for core real estate investment.
• Rental growth expectations: Over the last 20 years, prime London City offices have averaged 2.2% per annum (p.a.). However, a more conservative approach would be to assume rental growth is equal to inflation; at target, this would be circa 2%.
• Capex/depreciation: Historical studies (such as Baum, 1991) suggest 0.8% p.a. for depreciation, while MSCI recorded a 130bps difference between NOI yield and NOI yield adjusted for capex for global offices in 2018.³ There is a strong argument that capex going forward will rise as ESG and tenant occupation requirements increase; a reasonable estimate would be circa 1.5% p.a.

Using the above:

London City office yield = 2.75% + 2.0% – 2.0% + 1.5% = 4.25%

To put this in context, prime London City office yields are currently in the range of 5.25% - 5.75%. It is worth noting the above does not take into account any structural changes currently taking place in the office occupational market and is focused on the prime end of the sector. Asset selection will be crucial and secondary assets/locations are likely to trade well above this.

Using this methodology, we can look to a few other cities to see how their current prime office yield compares to the longer-term sustainable yield using the approach above.

In many cities there is a significant difference between the current pricing and the longer-term sustainable yield. The difference suggests there is currently an opportunity to buy high-quality assets at temporarily higher yields in cities such as Munich, Paris and London. This is similar to the opportunity presented post-GFC. However, this time it is much more nuanced due to changing occupier market drivers. Asset selection will be even more crucial; selecting the assets that will remain prime and in demand is essential.

There are risk factors to consider, including:

• The exact timing of when pricing will move back toward this level is difficult to forecast, and there is a risk of inflation proving stickier, which will elongate the cycle.
• There is flexibility behind these assumptions, which would change the sustainable yield.

However, this methodology does highlight the differences between the current short-term outlook and the longer-term structural drivers behind real estate pricing. It is all too easy to be pulled into the negative sentiment and the “this time it’s different” discussions that occur every time we are in the midst of economic turmoil. There are strong reasons to believe that, over the longer term, real estate yields will move back down, perhaps even further than many investors can currently envision. 

¹ Source: IMF, The Natural Rate of Interest: Drivers and Implications for Policy, April 2023.

² The “natural” real interest rate means the real interest rate that is neither stimulatory nor contractionary and is consistent with output at potential and stable inflation (IMF).

³ Source: MSCI, Real estate may be yielding less than you thought, September 12, 2019.