Risks to income streams nullify improved valuations - Capital Economics
US Commercial Property

Risks to income streams nullify improved valuations

US Commercial Property Valuation Monitor
Written by Kiran Raichura
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Property valuations improved markedly in Q1 thanks to a more-than 120 bps fall in Treasury yields as investors flocked to safe-haven assets. This marked the fifth consecutive quarter of improving valuations, with the apartments and retail sectors nudging into undervalued territory. Nevertheless, with property income streams likely to take a hit over the next 12 months as occupancy and rents both fall, we don’t see current valuations as providing a “buy” signal just yet.

  • Property valuations improved markedly in Q1 thanks to a more-than 120 bps fall in Treasury yields as investors flocked to safe-haven assets. This marked the fifth consecutive quarter of improving valuations, with the apartments and retail sectors nudging into undervalued territory. (See Chart 1.) Nevertheless, with property income streams likely to take a hit over the next 12 months as occupancy and rents both fall, we don’t see current valuations as providing a “buy” signal just yet.
  • Property yields only ticked 2 bps higher in Q1, but we expect a bigger rise in Q2. The office and retail sectors saw the biggest rises, with regional malls seeing a 16 bps rise compared to Q4 2019.
  • Treasury yields plummeted by 121 bps as investors flocked to safe-haven assets. They have held onto those falls in Q2 so far. Equity earnings yields rose by 114 bps in Q1, reflecting falls in equity prices, although that fall in yields has been almost totally reversed in Q2, as they have fallen back by 97 bps, thanks to support for the economy from the Fed and the US government.
  • All-property valuation scores improved in Q1, driven higher by the huge rise in the gap to Treasury yields. Financial market data to May 25th points to a further improvement in Q2, but we don’t think this should be seen as a “buy” signal yet. After all, we expect occupancy rates to take a hit in the coming quarters and rents are set to fall too in most sectors, meaning that the income streams those valuation scores are based on are unlikely to be realised.
  • Sector and city valuations all improved in Q1 thanks to that drop in Treasury yields. Retail and apartments have the highest valuation scores this quarter amongst the main sectors. At a city level, New York City and Washington DC are also both in undervalued territory.
  • A brief summary of our methodology is presented, for reference, on page 5.

Chart 1: Valuation Scores by Sector

Source: Capital Economics


Overview

Chart 2: All-property yields saw a slight upwards lift in Q1, ahead of likely larger rises in the coming quarters.

Chart 3: That uptick was mostly driven by offices and regional malls. Power centres reversed their Q4 rise.

Chart 4: Treasury yields hit an all-time low, falling by 121 bps in Q1…

Chart 5: …whereas corporate bonds and equity earnings yields rocketed. They’ve since dropped back in Q2.

Chart 6: Valuations rose sharply in Q1 and have continued to improve in Q2.

Chart 7: This was the fifth consecutive quarter of improvement in the valuation score.

Chart 8: As it was driven mostly by moves in Treasury yields, that improvement was seen across all sectors.

Chart 9: Similarly, valuations improved in all six major office markets, with NYC and DC looking undervalued.

Sources: Refinitiv, Capital Economics


All-property Valuations

  • As concern about the economic effects of the coronavirus grew in Q1, investors sought “safe” assets, causing Treasury yields to fall by 121 bps. They have held broadly steady so far in Q2 (10). Concerns about companies’ earnings, as well as their ability to service their debt caused equity prices to fall and earnings yields to rise and corporate bond yields to spike in Q1. Fiscal and monetary support has seen both drop back since (11).
  • Despite the price shifts in financial markets, all-property yields only ticked 2 bps higher in Q1 (12). There was, however, a more substantial rise of 15 bps in regional mall yields. Yet valuations against Treasuries improved markedly in Q1 due to that huge shift in Treasury yields (13).
  • Property values deteriorated significantly against equities in Q1, but as the S&P500 has rebounded in Q2, that has almost completely been reversed (14). The more substantial valuation shift against Treasuries meant that the overall valuation score improved markedly in Q1, while the rebound in the valuation score against equities in Q2 to-date points towards property looking undervalued in Q2 (15).

Chart 10: 10-Year Treasury Yields (Chg. over qtr, Bps)

Chart 11: Alternative Asset Yields (%)

Chart 12: All-property NOI Yields (%)

Chart 13: All-property Valuations vs. Treasuries

Chart 14: All-property Valuations vs. S&P500

Chart 15: All-property Valuation Scores

Sources: Refinitiv, Capital Economics


Sector and City Valuations

  • Valuations improved in all sectors thanks to the huge fall in Treasury yields. However, it should be noted that these valuations assume that property income streams are maintained, which looks unlikely. The national office valuation score improved from -0.1 to 0.3, though the sector remained fairly valued (16). All six major cities saw improvement. New York City and Washington DC now look undervalued (17).
  • In the apartments sector, valuations have just tipped into undervalued territory this quarter, having been overvalued at the end of 2018 (18). The industrial sector valuation score moved into fair value range for the first time since Q3 2017, although we believe some of the recent falls in industrial yields to be structural, meaning that yields will tend to be lower in the future than in the past (19).
  • Similarly to the apartments sector, retail nudged into the undervalued zone, at 0.6. However, income streams in this sector are probably most at risk in the short-term, meaning that valuations won’t count for much in terms of investor demand and pricing in the near-term. (20). All three retail sub-sectors saw improved valuation scores in Q1, but none stand out as looking appealing at present, given the outlook for occupancy and rents (21).

Chart 16: Office Valuation Scores

Chart 17: City-Level Office Valuation Scores

Chart 18: Apartment Valuation Scores

Chart 19: Industrial Valuation Scores

Chart 20: Retail 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&P500 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