Property valuations look solid despite rising bond yields - Capital Economics
US Commercial Property

Property valuations look solid despite rising bond yields

US Commercial Property Update
Written by Kiran Raichura
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A few weeks ago, we nudged up our Treasury yield forecasts for year-end 2021 and 2022, to 1.5% and 1.75% respectively. While intra-day yields exceeded 1.6% at one point last week, we don’t expect a continuation of those rises this year. And the bigger picture is that, with real estate enjoying a historically large yield gap over bonds, we see little cause for concern over valuations in the next few years.

  • A few weeks ago, we nudged up our Treasury yield forecasts for year-end 2021 and 2022, to 1.5% and 1.75% respectively. While intra-day yields exceeded 1.6% at one point last week, we don’t expect a continuation of those rises this year. And the bigger picture is that, with real estate enjoying a historically large yield gap over bonds, we see little cause for concern over valuations in the next few years.
  • In the space of two weeks between 11th and 25th February, 10-Year Treasury yields rose by 36bps, to hit 1.5%, having at one stage on 25th February exceeded 1.6%. Our Global Markets and Asset Allocation services are the places to find more analysis of those events and the broader implications for asset prices.
  • To put the recent bond yield rises into context, even with the increase of around 55bps since the start of the year, they are still below the levels seen before mid-February 2020, prior to their pandemic-driven fall. This means that, compared against the 10-year average of 2.1% Treasury yields still look low. And we expect Treasuries to end this year close to current levels at 1.5%.
  • What’s more, despite that run-up in bond yields, the spread of property over Treasuries is still close to its cyclical peak. (See Chart 1.) And our recent Valuation Monitor showed that the office, retail and apartments sectors all look undervalued, while industrial real estate looks fair value.
  • Of course, there are good reasons why the office yield gap should be elevated at present, given the downside risks to occupancy and rents in the sector. After all, there is significant uncertainty around the amount of floorspace that will be occupied by the middle of the decade. (We are predicting a net reduction of around 7%-8% by 2025. See here.) There are similar concerns about retail demand, although a strong rebound in consumer spending this year will partly offset the greater share of online spending. We expect these factors to prevent yields in either of these sectors finding new lows in this cycle.
  • And while bond yields are still low, we expect further gradual rises in the coming years. But although we see Treasuries reaching 1.75% by the end of 2022, we think rises thereafter will be extremely gradual, reaching just 2.1% by 2025. This will mean that the upward pressure on real estate yields in general will be limited in the next few years.
  • As a result, the outlook for commercial real estate over the next five years is still relatively positive, even if we do not expect to see as big a fall in real estate yields as we saw in the last two cycles. Indeed, our “back of the envelope” fair value calculations, which include a property risk premium and market rent growth expectations, suggest a mixed picture in the short-term, with office and retail property overvalued, and industrial and apartments undervalued. (See Chart 2.) But the gradual recoveries we expect in the retail and office sectors mean that even with Treasury yields at 2% by the end of 2023, at current yields, all four sectors would look undervalued with expected returns exceeding required returns.

Chart 1: US Office Yields & 10-Year Treasury Yields (%)

Chart 2: CE Fair Value Estimates (%)

Sources: MSCI, Refinitiv, Capital Economics

Sources: MSCI, Refinitiv, Capital Economics


Kiran Raichura, Senior Property Economist, kiran.raichura@capitaleconomics.com