Summertime Limbo – How Low Can Yields Go?

Guy Barnard and Tim Gibson, Co-Heads of the Janus Henderson Global Property Equities Team, discuss the implications of negative-yielding bonds on listed property stocks and highlight the importance of active management in this environment.

Key Takeaways

  • Growth and inflation are likely to remain subdued, which should support income-producing assets like real estate. Analysis shows an allocation to REITs can potentially improve the risk-adjusted return of a balanced portfolio.
  • If investors believe lower bond yields are here to stay, a further move lower in yields (and an increase in real estate prices) could be expected. Transaction evidence year-to-date has shown robust demand in most property markets and some firmness in pricing across many sectors.
  • Analysis of historical yield curve inversions suggests that REITs could potentially outperform in the subsequent months.

In the summer months, financial markets can often feel like they are in a state of limbo, with lower transaction volumes as people head to the beach. So far in 2019, we have seen a different type of limbo as global central bank policy has sent bond yields ever lower. Most market forecasters have had to rip up their predictions from the start of the year and are now expecting further interest rate cuts globally and a restart of quantitative easing in Europe.

With $16 trillion of debt instruments due to return to investors at less than their current value,1 understanding and navigating the current investment environment has become even more challenging.

How Global Property Equities Fit into a Negative-Yielding Environment

While we do not claim to have greater foresight than others in predicting the macro gyrations of the global economy, we have been sympathetic of the view that there are structural as well as cyclical reasons for growth and inflation to remain subdued.

We view this low-growth environment as supportive of income-producing assets like real estate and real estate investment trusts (REITs), and it is one of the reasons we continue to advocate an allocation to REITs as part of a balanced portfolio. Recent portfolio optimization analysis shows that a 10% allocation to global REITs has the potential to provide the optimal Sharpe ratio (a measure of risk-adjusted return) within a typical balanced portfolio.2

How the Latest Move in Bond Yields Could Impact the Listed Real Estate Sector

On the positive side, we find ourselves asking what the right yield is (or cap rate) for real estate in a world of historically low or even negative bond yields. The following chart illustrates that the long-term “risk premium” for real estate versus long-dated government bond yields in the U.S. has been approximately 4%, but today it stands at close to 5%.

Therefore, if investors believe that lower bond yields are here to stay, then perhaps we should expect a further move lower in yields (and an increase in real estate prices) going forward. Transaction evidence year-to-date has shown robust demand in most property markets and some firmness in pricing across many sectors.

U.S. REITs Yield Spread vs. NAV Premium/Discount


Note: NAV = net asset value. Cap rate = expected rate of return on property based on net income. CoStar cap rate data represents 40 U.S. metropolitan statistical areas in the United States to end Q2 2019. Source: XoStar, Factset, S&P Global Market Intelligence, Raymond James research. Data as of August 2019. Past performance is not a guide to future performance. Basis Point (bp) equals 1/100 of a percentage point. 1 bp = 0.01%, 100 bps = 1%.

Historically, periods of elevated risk premiums for real estate have been associated with REITs trading at premiums to net asset value (NAV) as investors anticipate further capital growth. U.S. REITs are currently trading broadly in line with NAV and global REITs at a discount of around 10%, suggesting pricing is fair. This is reinforced by the fact that dividend yield spreads to BBB-rated corporate bonds are also close to the widest levels in the last decade.

The Importance of Active Management in a Low-Growth Environment

We must acknowledge the reason for today’s low bond yields and the associated macro and economic risks. Property yields are only likely to fall if investors feel they can rely on the income and feel confident that the asset class can weather an economic downturn.

As growth becomes scarcer, it becomes more valuable, which reinforces our belief that active management is required when investing in real estate and REITs against this backdrop. We continue to expect a two-tier market. Sectors that are less economically sensitive, such as rental residential and net lease, and those benefiting from changes in technology, such as logistics and data centers, look well positioned. Conversely, we believe caution is warranted for sectors that are more sensitive to economic growth, such as lodging, and those that are facing ongoing structural headwinds, such as retail.

Lessons from Past Yield Curve Inversions

Recently, we have seen equity markets react negatively to the inversion of the U.S. yield curve (when yields on longer-dated 10-year government bonds dropped below those of shorter-dated two-year bonds), which is often a predictor of a recession. Looking at the U.S. REIT market, analysis of historical yield curve inversions suggests that REITs could potentially outperform in the subsequent months. Following the previous two inversions in 2000 and 2006, REITs delivered more than 20% total returns within a year and outperformed the broader equities market.3

In conclusion, don’t stay in summertime limbo too long!

1Source: Bloomberg. Negative-yielding debt within the Bloomberg Barclays Global Aggregate Bond Index, as of 8/16/19.
2Source: Janus Henderson Investors as of June 2019. Based on analysis of asset class weights and risk/return characteristics in an optimal portfolio (maximum Sharpe ratio) when the FTSE EPRA Nareit Developed Index is included/excluded from the baseline balanced market portfolio.
3Source: S&P Global Intelligence, Jefferies, SNL US REIT Equity Index. Past performance is not a guide to future performance.

Concentrated investments in a single sector, industry or region will be more susceptible to factors affecting that group and may be more volatile than less concentrated investments or the market as a whole.
Net lease is a contractual agreement where in addition to rent, the tenant is required to pay for the taxes, insurance and maintenance costs associated with the property.