Why This Yield Gap Could Send Property Higher

‘Cheap’ is not a word you hear associated with Australian property often. But when it comes to commercial real estate, last week one professor said that’s exactly what it looks like to him.

His name is Andrew Baum. He’s in town as a visiting academic. Baum says commercial real estate is cheap because, when you take the yield available on bonds compared to commercial property, there’s a very healthy margin between them.

In Australia, the average yield gap between property and treasury indexed bond yields is 3.4%, according to the Australian Financial Review. It’s currently around 4.9%. So at 1.5% above average, that’s high.

Baum’s position is that this gap is likely to narrow via property yields going lower, rather than bond yields going higher. So what he’s saying is investors will bid property prices up.

That’s not to say he’s 100% certain. But if bond yields stay low, the conclusion is that commercial property right now is a ‘screaming buy’.

So much in the financial world depends on interest rates and yields. And what Baum is saying is perfectly possible.

And if you ask me, it’s more than likely. There’s staggering amounts of money under management all over the world looking for a return. It will go looking for discrepancies like this.

Sovereign Wealth Funds Looking For Property Investments

Take the Norwegian Sovereign Wealth Fund, as an example. This might seem like a leap, but stay with me. The government in Oslo caused slight consternation recently when it revealed it had actually run down the fund by US$5.5 billion.

This is to cover the government’s spending shortfall in this period of current low oil prices. It’s the first time in two decades the Norwegian government has taken money out.

It’s not doing anything illegal. The government is allowed to take out 4% of the fund every year. But here’s the thing. This benchmark was set when such a rate of return was considered reasonable. The idea was the government could spend the gains, but never run down the capital.

Now that rate of a return looks very ambitious. The fund returned 1.3% in the second quarter and just 0.6% in the past year, according to the Financial Times.

That means either the government has to reduce its allowance, or the fund has to increase its rate of return.

Now the second option is a problem when you have 37% of your portfolio in bonds, as the Norwegian Wealth Fund does. A quarter of its fixed income portfolio trades below zero.

So it’s looking at more equities and property. Its mandate has changed to allow it to increase its unlisted property investments to 7% of its total assets, which is more than double the previous 3%. They might not sound like high percentages, but don’t forget the total size of the fund is US$890 billion.

Sovereign wealth funds are a new factor in global real estate in this regard. Don’t think it’s just Norway either. An affiliate of the Qatari sovereign wealth fund just took a US$622 million stake in the trust that controls the Empire State Building in New York.

In fact, the race for assets is happening all over the world. Bloomberg reported recently that China has made more acquisitions in Brazil this year than any other country. These assets are going cheap as Brazilian firms try to reduce debt and survive its current recession. Any decline in the local currency can make acquisitions like this even more compelling.

This process is not going to stop anytime soon. Consider it’s now estimated that the amount of negative yielding bonds is US$13.4 trillion. This is a staggering figure.

Absolutely nobody foresaw this. Yet it is the one big item that has turned the real estate cycle upwards in the face of extreme scepticism. There is probably no more important topic to follow and understand.

Suffice to say, to those who think Australian property can’t go higher, don’t be so sure. Go here to see why it can and most likely will.


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Callum is a feature editor for Money Morning. He covers areas of interest arising from world markets and the global economy that could mean new investment opportunities for Aussie investors.

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