For the past five years, most financial analysts have warned that rates would soon move higher. Just a couple of months ago, the concern was how the pricing of US stocks would respond when long-term US rates climb above the 3% mark.
Today, expectations have changed completely. Economic grown momentum is weak, and recession risk mounting. Further rate compression is therefore believed to be highly likely. In Europe, medium-term government bonds are trading at negative yields, with the 10-year swap rate in the 20-25 bp range. But how does that affect the pricing of investment property assets?
Fear of recession is exacerbating risk aversion
Growth momentum is slowing globally, and a small and open economy like Denmark will invariably be affected. This will serve to slow down economic growth in Denmark, it will stunt new job growth, and in the commercial letting market we will see the end of the downtrend in vacancy rates. Mainly outdated properties at less attractive locations will bear the brunt of this.
We have already seen diminished risk tolerance among banks and mortgage credit institutions. Competition cheerfully continues for the most secure and attractive loan engagements, whereas appetite has grown weaker when it comes to providing financing for less secure ones. In this case, the LTVs offered are slightly lower as is the propensity to grant interest-only loans.
Property market investors have grown less risk tolerant, too. They are prepared to take on controllable risks, provided risk is balanced by higher yield.
Placement requirements continue to grow
However, not all capital has vanished. In a global context, more capital than ever before is funnelled into property investments. Even lower bond yields will force investors to increase reallocations to alternative asset classes, predominantly real property.
At the same time, Denmark as an investment destination has broad appeal. In times of uncertainty, investors are seeking safe havens, and given Denmark’s AAA-rated economy and stable framework conditions, the Danish investment property market today attracts capital from near and far. In future, we will no doubt see growth in the number of investments not only by European pension funds, but also by Far Eastern institutionals.
Possibility of further decline in prime yields
Against this backdrop, prime yields – the net initial yield on top-quality investment property – may well drop below their current low levels.
This will apply mainly to the very best properties in the office and logistics markets, whereas structural challenges in the retail sector continue to dampen investor appetite in this segment.
In the market for residential rental properties, we see two opposing trends:
Investment demand for properties at attractive mid-market locations will remain stable and strong, in particular for properties featuring relatively small units, which are in exceptionally strong demand by tenants. This might combine with continued rate compression to drive down initial yield requirements.
However, it is important to remember that both Copenhagen and the largest provincial cities in Denmark have seen brisk newbuilding activity in recent years and that some markets are starting to see a certain degree of residential vacancy. Not all locations therefore warrant that you base your investment case on prospects of sustained full occupancy at a rent that is inflation-linked.
In addition, the market for residential rental properties is subject to political risks. In Denmark, like in so many other European countries, there is increased political awareness on safeguarding a supply of housing that home-hunters can afford, and on curbing rent increases in order that low- and medium-income groups may still afford to live in major cities.
Pension funds and other institutional investors from Denmark and abroad may help to safeguard a great supply of private rental housing in future. Nevertheless, it should not be ignored that private market players need to base their investments on a certain degree of predictability and a certain measure of stability in framework conditions in the investment market. After all, the objective of institutional investors is to secure long-term attractive and stable returns for the benefit of future old-age pensioners.