US 10-year Treasury Bill rates have been at an all-time low, having fallen below 2% for the first time in 2017. UK government bond (10 year) yields have also been lower than they have been at any time and 10 year Treasuries in Australia are trading at all time low yields. Short-term interest rates have also been at all-time lows. We habitually (and for good reason – see below) connect low interest rates and bond yields to low property yields and high prices.
However, recent rises in US treasuries have got us all wondering. Is this the start of a downturn for property values? Let’s get one thing straight – I don’t know, and or does anyone else. That’s because I do not know where bond yields and interest rates are going from here, But if I did, I would be able to hazard more than a guess. And if, when you read this, they have already moved, there may still be time to use the information I am going to share to protect yourself.
Real risk free rates, proxied by the yield on government-issued inflation indexed bonds, are also trading at very low or negative rates. US Treasury Inflation Protected Securities have been issued offering negative yields since 2010 and UK index linked gilts have been priced at negative yields since 2011. Australian Treasury Indexed Bonds have never offered negative yields, but are now being issued at all-time lows of around 0.5%.
There is much debate over how long such low yields will continue, and the implications for real estate prices. Real estate capitalisation (cap) rates (the inverse of price-earnings ratios) are low in many markets, albeit not – yet – at all time lows.
How strongly have real estate capitalisation rates been connected or correlated with conventional bond yields, short term interest rates and indexed bond yields? What will happen to real estate prices if bond yields revert back to more ‘normal’ levels over the next few years? And what will happen to prices if they do not?
In order to gain an insight into these questions, we need to go back to re-explore the theory supporting the determination if the yield on bonds. A good starting point is the work of Irving Fisher in the 1920s.
The Fisher equation
The Fisher equation (Fisher, 1930) considers the components of total return delivered by an investment. It states that:
R = l + i + RP (1)
R is the total required return
l is a reward for liquidity preference (deferred consumption)
i is expected inflation
RP is the risk premium