Property valuations improved substantially in Q2, on the back of a huge 120 bps drop in equities earnings yields. However, while the office, retail and apartment sectors look undervalued on our valuation measure, with income streams likely to fall over the next 12 months as occupancy and rental values fall, we don’t think that this should be taken as a “buy” signal just yet. Indeed, we would expect valuations to improve further in the second half of the year, as the pricing correction continues and property yields climb further.
- Property valuations improved substantially in Q2, on the back of a huge 120 bps drop in equities earnings yields. However, while the office, retail and apartment sectors look undervalued on our valuation measure, with income streams likely to fall over the next 12 months as occupancy and rental values fall, we don’t think that this should be taken as a “buy” signal just yet. Indeed, we would expect valuations to improve further in the second half of the year, as the pricing correction continues and property yields climb further.
- Property yields rose by just 2 bps in Q2, which was a smaller rise than we had expected. However, this partly reflects a fall in operating income in the retail sector, with NOI yields falling by 15 bps as a result.
- Treasury yields were essentially unchanged in Q2, although they have since ticked a little higher in the first half of Q3.
- Equity earnings yields more than reversed their 114 bps rise from Q1, with a fall of 122 bps as equity prices surged higher thanks to support from the Fed and the US government.
- All-property valuation scores therefore improved again in Q2, recording a sixth straight quarter of improvement. (See Chart 1.) What’s more, with earnings yields having fallen further in Q3 and property yields likely to have risen again, there could be a further improvement in valuations next quarter. However, with occupancy and rental values set to fall in the coming quarters, we think that property yields and valuation scores will need to rise further before more investors are enticed back to the market.
- Sector and city valuations all improved this quarter. This was despite the fall in retail NOI yields. The industrial sector is the only sector that does not look undervalued on the valuation scores, although it is the only major sector in which we have most confidence in the strength of income streams.
- 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
Chart 2: All-property yields continued to climb in Q2, but not as much as we had expected.
Chart 3: That was because retail NOI yields fell on the back of reduced rent receipts in Q2.
Chart 4: Corporate bond yields fell to new lows, while earnings yields are as low as they’ve been since 2002.
Chart 5: Treasury yields stabilised in Q2, although they have since tracked higher, by around 15bps.
Chart 6: Our valuation score improved again in Q2, on the back of the falls in equity earnings yields.
Chart 7: This marked the sixth quarter of improvement and the sharpest rise in the series to-date.
Chart 8: Improvement was seen in all sectors, but retail’s yield fall meant that it saw only a modest q/q change.
Chart 9: With the notable exception of Chicago, all of the six major office markets look undervalued.
Sources: Refinitiv, Capital Economics
- After the sharp fall in Treasury yields in Q1, Q2 saw a stabilisation (10). And while there has been a small rise so far in Q3, we broadly expect there to be little or no change in Treasury yields in H2. Equity prices rebounded in Q2, following announcements of economic support measures from both the government and the Federal Reserve. This meant that after a sharp rise in Q1, S&P500 earnings yields were back to their January 2018 lows by the end of July (11).
- All-property yields nudged higher in Q2, taking the annual rise to 5bps (12). The rise would have been more substantial, but for the fact that retail yields fell, due to income received in Q2 falling.
- With little change in both property yields and Treasury yields, all-property valuations against Treasuries saw limited change in Q2 (13). The sharp fall in S&P500 earnings yields meant that property valuations against equities more than reversed the drop they saw in Q1 (14). Taken together, these two measures meant that the all-property valuation score improved markedly in Q2. What’s more, although Treasury yields have climbed slightly since the end of Q2, there have been further substantial falls in earnings yields, which could see valuations rise further still in Q3 (15).
Chart 10: 10-Year Treasury Yields (Chg. over qtr, Bps)
Chart 11: Alternative Asset Yields (%)
Chart 12: All-property NOI Yields (y/y, bps)
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
- Valuations improved in all sectors in Q2, on the back of the large fall in earnings yields (16), (17), (18). Industrial was the only sector in which property did not look undervalued at the end of Q2 (19). That said, the property income streams that those scores rely on do not look at all certain at present, meaning that those valuations are unlikely to entice investors back to the market at current pricing levels.
- All six major office markets saw improved valuation scores in Q2, with the improvement in San Francisco valuations particularly pronounced (20). This reflected the 15bps rise in San Francisco yields in Q2, with the other five cities seeing 5bps-10bps yield rises in Q2.
- The improvement in retail valuation scores came despite the fall in retail NOI yields in Q2. This was replicated in all three main sub-sectors (21). Until retailers gain a more solid footing and have rationalised their store-based portfolios, we would expect our retail valuation scores to keep rising, as the majority of investors shy away from investing in the sector (21).
Chart 16: Office Valuation Scores
Chart 17: Apartment Valuation Scores
Chart 18: Retail Valuation Scores
Chart 19: Industrial Valuation Scores
Chart 20: City-Level Office Valuation Scores
Chart 21: Retail Sub-Sector Valuation Scores
Source: Capital Economics
- 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, +44 7739 932077, email@example.com