Property valuations generally improved a touch in Q4 on the back of a nearly 50bps fall in equity earnings yields as equity prices rose. This was the fourth consecutive quarter in which valuations had improved, albeit the smallest improvement in that series. That said, movements in alternative asset yields in the first two months of 2020, triggered by the coronavirus-driven market sell-off, point to a significant improvement in property’s relative valuation in the first quarter of 2020.
- Property valuations generally improved a touch in Q4 on the back of a nearly 50bps fall in equity earnings yields as equity prices rose. This was the fourth consecutive quarter in which valuations had improved, albeit the smallest improvement in that series. That said, movements in alternative asset yields in the first two months of 2020, triggered by the coronavirus-driven market sell-off, point to a significant improvement in property’s relative valuation in the first quarter of 2020. (See Chart 1.)
- Property yields held steady again in Q4, as the office and industrial sectors saw slight falls and the retail and apartments sectors saw small rises. Within the retail sub-sectors, power centres saw a substantial rise, climbing by 18bps on the quarter and 34bps year-on-year.
- Treasury yields rose by 24bps in Q4, marking the first rise since Q3 2018. However, yields dropped back by 82bps in the first two months of 2020, suggesting that this will be more than reversed in our Q1 analysis. Equity earnings yields dropped by 47bps in Q4 as equity markets rallied and prices climbed. This has been only partially reversed in Q1 to-date.
- All-property valuation scores saw little change in Q4, as moves in Treasury yields and equity earnings yields mostly offset each other. Of larger note is the implied improvement in Q1 2020 valuations, based on moves in alternative asset yields in the first two months of the year on the back of coronavirus-related fears.
- Among sector and city valuations, all sectors saw an improvement in Q4, with the exception of industrial property, where valuation scores held steady. The six largest office markets all saw an improvement in the quarter, although pricing in Chicago and LA still looks the most stretched. The retail sub-sectors look fairly valued, but we believe they need to correct further before they look attractive.
- A brief summary of our methodology is presented, for reference, on page 5.
Chart 1: Changes in all-property valuation scores
Source: Capital Economics
Chart 2: All-property yields were essentially flat again in Q4, for the fourth consecutive quarter.
Chart 3: This reflected mixed moves in the main sectors. Power centres saw a particularly sharp rise.
Chart 4: Having fallen through most of 2019, Treasury yields ticked up in Q4 as recession worries reduced.
Chart 5: The Q4 rise has been more than reversed in Q1, as investors have responded to coronavirus fears.
Chart 6: Our all-property valuation score saw a small increase in Q4 and is likely to rise further in Q1.
Chart 7: That marked the fourth consecutive quarter of improvement in the valuation score.
Chart 8: Despite only small changes in Q4, valuation scores by sector have risen substantially in the last year.
Chart 9: Amongst the six largest office markets, pricing in Chicago and LA looked the most stretched.
Sources: Refinitiv, Capital Economics
- The last quarter of 2019 saw a 24bps rise in Treasury yields as concerns over a potential US recession diminished. However, Treasury yields fell dramatically in the first two months of 2020, as fears over the potential effect of the new coronavirus on US growth drove investors to safe-haven assets (10). Earnings yields for the S&P500 saw the opposite as stock prices fell (11). However, it’s likely that company earnings will soften if the economy slows again, as we now expect.
- All-property yields were stable in 2019 at just over 4.3% (12). This meant that valuation shifts over the last year were driven by moves in alternative asset yields. Valuations against Treasuries saw a slight worsening in Q4 2019, given the rise in Treasury yields previously noted. But indications are that by the end of Q1, property will be at its best valuation position against bonds since Q1 2013 (13).
- Property values improved against equities in Q4, although this has been partially reversed by the higher equity earnings yield in 2020 to-date (14). The net effect of the Q4 changes on all-property valuations was marginal. But the moves so far in 2020 point to a substantial improvement in property valuations (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
- National office valuations saw a slim improvement in Q4 and, with the likely improvement in Q1, are set to be firmly in fair value territory (16). That increase in the valuation score was seen across all six major cities, although in Boston and New York City, the rise was marginal (17).
- In the apartments sector, our valuation score was already positive in Q3, at 0.1, and rose slightly in Q4, to 0.17. This was its highest valuation score since Q3 2016 (18). The industrial sector’s valuation score was unchanged in Q4, on the border between fair value and overvalued. However, given the structural downshift in industrial yields in this cycle, we think that the historical nature of the valuation score overestimates the extent to which pricing in the sector is stretched (19).
- Our overall retail valuation score turned positive in Q3 and rose slightly further in Q4. Nevertheless, with retail income streams already under pressure and further threat from the effect on footfall of the new coronavirus, we don’t think this yet indicates a buying signal (20). At a sub-sector basis, power centres saw the largest improvement in Q4, but this reflects the fact that the sector saw the largest correction in yields in Q4 (21). We think the sub-sector’s yields still have further to rise before they look appealing.
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
- 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.