Longing for lower?

In a market where low-risk income has been hard to come by, the real estate market has been more than happy to oblige. Some parts of the market have offered relatively high and stable income compared to that available on cash. Indeed, the performance of the real estate market of the last ten years or so has been driven, to some extent, by the view that the gap between interest rates and real estate yields has been “too high”: property has looked cheap because bonds have been expensive. So the relative value school of thought goes.

Whilst there is little doubt that interest rates have been low by historic standards, they have effectively been much lower than they appeared to be. For example, whilst the Fed funds rate is explicitly set, when it hit the “zero lower bound” alternative methods of stimulating the economy were used and the idea of the “shadow” Fed funds rate was brought into play. According to Xu and Wia’s calculations of the shadow Fed funds rate, the effective Fed funds rate, taking account of the unconventional policy actions that had been deployed at that time, was negative three percent (-3%) in May 2014.

Of course other countries also hit the lower bound of interest rates and, helpfully, a Senior Adviser at the Reserve Bank of New Zealand has seen fit to calculate the shadow rate for these, along with that for the US, using a consistent set of models in a paper entitled “Comparison of International Monetary Policy Measures”. Looking at these you can see that both the US and the UK now have shadow rates close to the rate set, but the euro area and Japan have shadow short rates of -6.3% and -8% respectively. The paper points out that the calculation of these is sensitive to the model used but they are highly unlikely to be above zero.

So, if you want to argue that the gap between real estate yields and short rates is too high, there is plenty more scope for this, especially in the euro area or Japan.

Another part of the discounted cashflow model, the cash flow itself (and its growth) needs to be consistent with those low rates. In 2017 the Bank of England pointed out that “Property rental yields remain low … suggesting that future rental income expectations embody growth prospects that are inconsistent with those embodied in the low risk-free rates by which they are being discounted.” Indeed, the reasons why interest rates have been kept low are not good ones.

Those still longing for lower should also consider whether the prospects for growth, consistent with their longing, may not be particularly compelling. For example, what assumptions regarding rental growth are consistent with a shadow rate of -8%? Longing for low interest rates is longing for some combination of low employment growth, low productivity growth and low inflation. It is not wholly clear how this might be good for real estate.