Rising Treasury yields squeezing property valuations - Capital Economics
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Rising Treasury yields squeezing property valuations

US Commercial Property Valuation Monitor
Written by Sam Hall
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On the back of rising Treasury yields, property valuations took their first hit in eight quarters during Q4. And, with Treasury yields climbing higher since, it is likely that valuation scores will fall further in Q1. Despite valuation scores declining in Q4, the retail, office and apartments sectors still look undervalued, whereas the industrial sector now appears fair value. However, retail and office income streams face a weak outlook over the next couple of years, with vacancy set to rise further and rental values to fall. In turn, office and retail yields may need to rise further to be considered good value.

  • On the back of rising Treasury yields, property valuations took their first hit in eight quarters during Q4. And, with Treasury yields climbing higher since, it is likely that valuation scores will fall further in Q1. Despite valuation scores declining in Q4, the retail, office and apartments sectors still look undervalued, whereas the industrial sector now appears fair value. However, retail and office income streams face a weak outlook over the next couple of years, with vacancy set to rise further and rental values to fall. In turn, office and retail yields may need to rise further to be considered good value.
  • Property yields fell by 11bps in Q4. Yields declined in the retail, industrial and apartments sectors and nudged higher in the office sector. The same movements were also seen in gross yields.
  • 10-Yr Treasury yields kept close to record lows in the first three quarters of 2020 but climbed 24bps in Q4. They have since risen by another 60bps in Q1 2021.
  • Equity earnings yields fell by 17bps in Q4, offsetting some of the impact of Treasury yields on valuation scores. This fall was far smaller than the 122bps and 68bps declines in Q2 and Q3, respectively.
  • All-property valuation scores fell for the first time in eight quarters, thanks to the rise in Treasury yields and the fall in NOI property yields. The Treasury yield movements seen in Q1 so far point to further declines in valuation scores. (See Chart 1.)
  • All sector valuations worsened this quarter, mostly reflecting the rise in Treasury yields. This left the retail, office and apartments sectors undervalued and the industrial sector fair value. On the whole, city valuation scores for offices and apartments fell in Q4. While Chicago offices appear fair value, all other office and apartments markets are undervalued according to our estimates.
  • 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 again in Q4, consistent with signs of a pickup in investor demand.

Chart 3: That was driven by falls in residential and retail yields.

Chart 4: Corporate bond and equity earnings yields fell in Q4, while Treasury yields rose from record lows.

Chart 5: Treasury yields continued to increase in Q1, driven by rising real yields and inflation compensation.

Chart 6: Our all-property valuation score fell in Q4, as Treasury yields rose and property yields dropped back.

Chart 7: This marked the first quarterly decline in the valuation score since 2018 and could be repeated in Q1.

Chart 8: Valuation scores fell in each sector this quarter, but most sectors remain undervalued.

Chart 9: All six city office markets look undervalued, apart from Chicago.

Sources: Refinitiv, MSCI, Capital Economics


All-property Valuations

  • Rising inflation expectations pushed 10-Yr Treasury yields 24bps higher in Q4. Meanwhile, BBB-rated corporate bond yields and S&P 500 earnings yields fell for the third consecutive quarter (10). Since then, Treasury and corporate bond yields have ticked higher, while equity earnings yields have fallen further (11).
  • All-property NOI yields dropped back further in Q4, leaving yields 17bps down on the year (12). This was largely driven by a fall in income received by retailers, which caused retail NOI yields to decline 55bps over the year. All-property gross yields also ticked lower in Q4, thanks to falls in retail, industrial and apartment yields.
  • The rise in Treasury yields and fall in all-property yields meant that property valuations against bonds fell back in Q4 (13). However, the drop in S&P 500 earnings yields was large enough to outweigh the fall in all-property yields. As a result, valuations against equity earnings yields nudged higher in Q4 (14). Taken together, property valuations worsened in Q4, though remain undervalued overall (15). And rising Treasury yields point to further valuation score declines in Q1 2021.

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

Chart 11: Alternative Asset Yields (%)

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

Chart 13: All-property Valuations vs. Treasuries

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

Chart 15: All-property Valuation Scores

Sources: Refinitiv, MSCI, Capital Economics


Sector and City Valuations

  • Valuation scores fell in each of the main property sectors in Q4, largely due to rising Treasury yields. While apartments, retail and offices still look undervalued, the industrial sector looks fair value, with its valuation score slipping below 0.5 (16), (17), (18) and (19).
  • While our estimates suggest that retail is undervalued, we still don’t think that retail valuations are sufficiently appealing to attract investors. This is because the short-term outlook still looks tough, especially for super-regional and regional malls. (See here.)
  • Q4 marked the end of an impressive run of improving valuation scores in five of the six major office markets we cover. San Francisco was the exception, with its score rising to 1.6, the highest score on record (20). Despite the general worsening, all six office markets appear undervalued, apart from Chicago.
  • The declines in apartment valuation scores across the six cities were more severe, with NYC seeing the largest decline (21). But despite the falling valuation scores, each of the six cities still look undervalued.

Chart 16: Apartment Valuation Scores

Chart 17: Retail Sub-Sector Valuation Scores

Chart 18: Office Sub-Sector Valuation Scores

Chart 19: Industrial Valuation Score

Chart 20: City-Level Office Valuation Scores

Chart 21: City-Level Apartment 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.

Sam Hall, Assistant Property Economist, sam.hall@capitaleconomics.com