Retail and office pricing still unattractive - Capital Economics
US Commercial Property

Retail and office pricing still unattractive

US Commercial Property Valuation Monitor
Written by Kiran Raichura
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Property valuations improved for the seventh consecutive quarter in Q3, following another sharp fall in equities earnings yields. But this was the smallest rise in valuation scores this year and changes so far in Q4 point to a partial reversal.  All four sectors now look undervalued, but outside the industrial sector, the short-term outlook looks tough. And, while apartments may also weather the storm reasonably well, we think office and retail assets need to see further yield rises before they truly represent good value.

  • Property valuations improved for the seventh consecutive quarter in Q3, following another sharp fall in equities earnings yields. But this was the smallest rise in valuation scores this year and changes so far in Q4 point to a partial reversal. (See Chart 1.) All four sectors now look undervalued, but outside the industrial sector, the short-term outlook looks tough. And, while apartments may also weather the storm reasonably well, we think office and retail assets need to see further yield rises before they truly represent good value.
  • Property yields fell by 9 bps in Q3. The biggest driver of this was the sharp fall in retail net operating incomes (NOIs), but there were falls in gross yields for both the industrial and apartments sectors.
  • Treasury yields were flat for the second consecutive quarter, although they have since ticked a little higher in Q4. Equity earnings yields dropped again, although by “just” 68 bps, following the huge 122 bps fall in Q2. They have since nudged a little lower in Q4, balancing out some of the rise in Treasury yields.
  • All-property valuation scores improved again in Q3, mostly thanks to the drop in equity earnings yields, although the NOI yield fall also helped. Moves in alternative asset yields so far in Q4 point to a stable valuation score next quarter.
  • All four main sectors look undervalued for the first time this cycle, following a rise in the industrial valuation score, which pushed it into undervalued territory. Aside from Chicago, all six major office markets also look undervalued, although the larger markets have so far been the worst hit by rising sub-let availability and falling asking rents. (See more here.) We don’t believe that average office stock in those cities is necessarily good value, but the best assets are likely to hold up.
  • A brief summary of our methodology is presented, for reference, on page 5.

Chart 1: Quarterly Change in All-Property Valuation Score

Source: Capital Economics

Overview

Chart 2: All-property NOI yields fell in Q3, as the pricing correction came to a surprising end.

Chart 3: This was driven by a large drop in regional mall yields as NOIs fell sharply in Q3.

Chart 4: Treasury yields were stable and S&P 500 earnings yields fell substantially in Q3.

Chart 5: Although other asset yields have since nudged higher, they remain close to record lows.

Chart 6: These yield movements means that the all-property valuation score improved again in Q3.

Chart 7: But the rise was a much smaller one this quarter and any change in Q4 looks likely to be smaller still.

Chart 8: Following a rise in the industrial valuation score this quarter, all four main sectors look undervalued.

Chart 9: There were also widespread improvements in city office market valuation scores last quarter.

 

Sources: Refinitiv, Capital Economics


All-property Valuations

  • Treasury yields were stable in Q3, but BBB-rated corporate bond yields ticked lower and S&P 500 earnings yields continued to drop back sharply (10). This partly reflected the growing confidence in the recovery amongst investors which drove equity prices higher, but also due to falls in earnings. Since then, the yields of all three alternative assets have nudged higher. But from a valuation perspective, the bigger picture is that all remain close to historical lows (11).
  • All-property NOI yields dropped back a little in Q3, but this was influenced by the retail NOI yield plunging further as retail incomes continued to fall dramatically (12). Nevertheless, gross yields also ticked lower in Q3, thanks to falls in industrial and apartment yields as values stabilised.
  • The small fall in the all-property yield, with Treasury yields holding steady, meant that valuations against bonds fell back slightly in Q3 (13). But a sharp drop in S&P 500 earnings yields pushed up valuations against equities (14). Taken together, property valuations improved again in Q3 (15). However, alternative asset yield shifts so far point to a more stable quarter in Q4.

Chart 10: Alternative Asset Yields (bps, chg. over qtr)

Chart 11: Alternative Asset Yields (%)

Chart 12: All-property NOI Yield Shift (bps, q/q)

Chart 13: All-property Valuations vs. Treasuries

Chart 14: All-property Valuations vs. S&P 500

Chart 15: All-property Valuation Scores

 

Sources: Refinitiv, Capital Economics


Sector and City Valuations

  • Valuation changes this quarter left all four sectors looking undervalued. This reflected the impact of the fall in equity earnings yields, which pushed the industrial valuation score above 0.5 for the first time since 2010 (16), (17), (18) and (19). There was a slight deterioration in the valuation score for retail, but this reflected the fall in NOI already noted. Indeed, falling income is exactly why we think retail valuations are not sufficiently appealing yet, despite the sector appearing undervalued on our scoring system.
  • All six major office markets saw improved valuation scores once again this quarter, with San Francisco experiencing the largest increase for the second consecutive quarter (20). This reflected the 14bps rise in San Francisco NOI yields this quarter, following a similar increase in Q2.
  • There was a varied picture across the retail sub-sectors. The 35 bps fall in super-regional and regional mall NOI yields was the major driver of a fall in that subsector’s valuation score from 0.9 in Q2 to 0.75 in Q3. On the other hand, neighbourhood & community centres and power centres saw improvements in their valuations (21).

Chart 16: Office Valuation Scores

Chart 17: Apartment Valuation Score

Chart 18: Industrial Valuation Score

Chart 19: Retail Valuation Score

Chart 20: City-Level Office Valuation Scores

Chart 21: Retail Sub-Sector Valuation Scores

 

Source: Capital Economics


Methodology

  • Assessing value in property markets is not an easy task. But assessing the relative value of commercial property against a range of alternative asset classes – government bonds, corporate bonds and equities – and its own long-term history is a useful approach. We have formulated a composite valuation measure, based on historical data, which is applicable to the all-property data, as well as the major sectors and sub-sectors and office markets. This provides an objective rationale upon which we can rank markets according to their relative valuation scores.
  • Our valuation measure focuses on the income yield of property and alternative asset class yields. Other property valuation measures tend to factor in expectations for rental growth. However, in our view, this risks falsely justifying aggressive market pricing, particularly near the peak of a cycle. Therefore, we base our analysis on the current income yield, which we believe provides a fair and prudent comparison.
  • In order to reach a valuation score for each measure, we calculate the average quarterly yield gap between prime property and the alternative asset’s yield over the last 10 years. This long-term yield gap is then added to the current yield on the alternative asset to form a required yield or ‘fair value yield’. We then compare this required yield to the current property yield in that sector or city to determine whether a market is undervalued, fair value or overvalued. Our fair value band is centred on zero, but has a 50bps range either side, with markets being undervalued or overvalued if their yields diverge by more than 50bps from their required yield. Our analysis aggregates valuation scores against different asset classes to provide a single valuation score for each property market and sector. Our current weights are 65% for the valuation score against Treasuries and 35% for the valuation score against S&P 500 earnings yields.
  • Our valuation measure has been used in our European Commercial Property Service since 2015 and, within that service, we have back-tested the valuation methodology to ensure that it will send the appropriate signals when property moves too far away from fair value. Our analysis of the 2000s period, for the markets where we had sufficient data, showed that the measure would have highlighted the overvaluation of Madrid offices in Q4 2006, for example. At that time, historically low yields were justified by double-digit annual rental growth expectations and therefore, traditional models of fair value would have still shown the market to be reasonably well-valued.

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