Persisting pressure on yields

Yields have risen substantially since last summer, and remain under pressure. Nevertheless, much of their rise is likely to be behind us.

Published 07.03.2023 20:28

Last changed 12.04.2023 18:26

Interest rates are naturally the most important driver behind the change in yields. Pressure from this source has increased following an easing around the New Year. At the time of writing, the 10-year swap rate is 3.48 per cent1 after rising by about 60 basis points (bps) since mid-January. The market and a number of analysts expect Norges Bank to increase its benchmark interest rate to 3.75 per cent during 2023. Developments in the interest-rate market indicates that the three-month Nibor will top out at just under four per cent.

Three-month Nibor Forward (interest-rate expectations)

Credit spreads have fortunately moved in the opposite direction, narrowing by about 50 bps for Norwegian property companies with an IG rating2The bank margin has flattened out and will perhaps decline slightly in coming months. Both these indicators are nevertheless historically high. The overall financing interest rate lies in most cases between 5.5 and six per cent after having risen somewhat since UNION’s bank survey was conducted in mid-February.

Property must deliver a competitive return

The obverse of a big increase in borrowing costs is naturally that returns on alternative investments have also risen a lot. In the years up to 2022, quantitative easing by the central banks to stimulate the economy yielded record-low interest rates. A great many investors allocated more cash to property and other alternative assets, such as infrastructure and private equity, during this period in order to achieve an adequate return. This is often described as “the wall of money”.

However, there is nothing automatic about a great deal of money moving into property. Capital flows to where the expected return is highest in relation to risk. The increase in interest rates has made competition over capital more demanding. Sharply rising rates make debt investments more attractive and the “hunt for yield” less intense. Without competitive returns, no wall of money.

Many life insurance and pension companies saw the value of their equity and bond portfolios fall more than their property holdings last year – at least in terms of asset valuations. That means many of them have implicitly increased the relative exposure to property in their overall portfolio.

Global volume of debt with negative yield (USD trillion)

Yield depends on many factors in the short term

The relationship between interest rates and yields is a little more complicated than it might appear at first glance. Naturally, a strong correlation undoubtedly exists between the two – but this is not perfect, and the differential between them has varied considerably at times. One factor which could persuade the market to accept the yield gap narrowing with higher interest rates is that the cause of this rise – which will typically be stronger growth in the economy – creates expectations of a sharp rise in rents. The office rental market in Oslo was the strongest it has been since 2007.

Admittedly, we expect a marked reversal in this market during 2023, but if this proves the case it will probably coincide with declining interest rates (expectations). And vice versa. Should growth in the Norwegian economy continue to surprise positively, with the consequences that might have for interest rates, the rental market will probably deliver better income growth than we have assumed. Rates, yields and rents are not independent variables. They must be viewed interactively.

In addition, actual and expected inflation will have a different effect on real assets such as property than on debt investment. Norway unfortunately lacks any good measure of the long-term real interest rate, but this has probably risen substantially over the past year. In the USA, which has a liquid market for real-rate bonds, real interest rates have risen by about 250 bps.

If we get a roughly similar development in Norway, a reasonable assumption in our view, yields are naturally likely to rise even though property offers a measure of protection against inflation. Fortunately, property yields did not decline as much as interest rates during the pandemic.

Interest rates on US Treasury bonds

Yields likely to rise further 

Although the correlation between interest rates and yields is not one-to-one, the latter have probably not risen enough yet. It is fully possible – even fairly likely – that interest rates will fall back when the economy cools down and inflation slows. DNB Markets, for example, forecasts that the 10-year swap rate will be around 2.75 per cent in a year’s time. Nevertheless, little today indicates that interest rates will be close to falling back to the levels we’ve come from.

Developments so far have helped to lift prime yield in Oslo from 3.25 per cent to at least 4.00 per cent. We see yield moving, and believe it will rise further – probably towards 4.50 per cent. In other words, our view is that we must assume yields which are 100-125 bps above the low point. Such a trend will naturally drive up yields for properties in other towns and segments up by a corresponding amount or more. 

As the latest developments in key economic figures illustrate, however, much uncertainty continues to prevail about future growth, inflation and interest-rate trends. And considerable uncertainty persists about where yields will find their new equilibrium in a stabilised market.

Yield developments for office properties in Oslo

What about asset value?

Developments in asset value are naturally influenced by several factors, which affect different properties to varying degrees. Moreover, identifying the effect of individual drivers in isolation is difficult since they interact and correlate with each other.

According to MSCI, the asset value of Norwegian commercial property fell by 3.1 per cent during 2022 (unleveraged). Viewed in isolation, the yield effect contributed to a value decline of roughly 10 per cent. That corresponds to a rise of about 40-50 bps on the yield. At the same time, the income side contributed to a growth in asset value of about eight per cent. This illustrates the significance of a strong rental market and high inflation.

Our view is naturally that yields have in reality increased more, and thereby that the fall in asset value is greater in practice than appears from figures for return based on asset value assessments. It is well known that the latter involve both time lags and smoothing effects.3

If our forecasts for yields and rents prove more or less accurate, property values will fall, roughly speaking, by around 15 per cent from peak to trough. In the event, that would be in line with our earlier forecasts.

1 Source: DNB Markets at 6 March 2023.
Source: DNB Markets.
3 Source: MSCI.