On September 12, the Governing Council of the European Central Bank (ECB) unveiled a package of monetary measures intended to stimulate the European economy. Speaking at a press conference after the announcement, ECB President Mario Draghi justified the move by the fact that inflation is persistently below target.
The ECB package, which was widely anticipated by the market following previous statements, comprises a 10 bp decrease to the interest rate on the deposit facility to -0.50 %; the resumption of net asset purchases (Quantitative Easing) at a monthly pace of €20 billion from November 1; softened conditions on the third series of targeted longer-term refinancing operations (TLTRO III); and better conditions for banks on the remuneration of their excess liquidity.
With the U.S. Federal Reserve expected to decide upon a further rate cut at its meeting this week, central banks’ accommodative policies are set to continue. If their real and long-term impact on the economy can be questioned (Mario Draghi has stated that governments with fiscal space – such as Germany – should act to support economic activity), it clearly reinforces the scenario of lower interest rates for longer. Although this was already the case before the ECB announcement, German, French, Dutch, Danish and several other government 10-year bond yields are firmly below zero.
What does it mean for real estate?
The ‘lower for longer’ scenario is considered as a favourable one for property as it shows a comfortable - and larger than ever - real estate premium over government bonds. However, as central banks pour vast sums of capital into the financial system, this money will compete for the same investment opportunities, inflating asset prices and lowering yields. CBRE believes this scenario has two concerning side effects for real estate.
Firstly, lower yields mean investors must adjust their return prospects, starting with value-add strategies. They will also have to increase their risk tolerance, which could see more core investors consider value-add opportunities. In this context, for example, how will pension funds evolve their strategy: more risk to maintain pensions or an equivalent level of risk but less benefits?
Secondly, yields are converging. Bond yields may have gone negative but prime property yields appear to nearing their floors. This means that further significant yield compression is only likely for higher risk/lower quality investments or those with very solid rental growth prospects.
As a result, the relative risk premium between two investments with very different risk profile has narrowed. One can therefore question if the relative risk, not to government bond yields, but to prime real estate, is properly priced.