On the heels of yesterday's decision by the Federal Reserve to raise short-term interest rates by 25-basis points, and yet while expected, many in the real estate industry around the world still took notice.
Within the U.S. market, the National Association of Realtors Chief Economist Lawrence Yun told The World Property Journal, "Rising inflation will predominantly dictate the next monetary policy decision, but another short-term rate hike should be expected by the end of the summer. Right now, rents and housing costs are increasing faster than other components because of the stubborn housing shortages in much of the U.S. To contain inflation and slow the pace of future rate hikes, more home construction is needed now."
Overseas, JLL reports further market reactions in many countries across the Asia Pacific region.
JLL says that investors in Asia Pacific commercial real estate have long expected the US Fed to raise rates by 0.25% on March 15, 2017, following a hike of similar magnitude last December. US President Trump's intended stimulus will likely encourage the Fed to accelerate the pace of monetary policy normalization, even though the fiscal stimulus will not be passed by Congress until the start of next year. Market consensus is for at least three rate hikes this year, taking the Fed funds rate to between 1.5% and 1.75% by end-2017.
Nominal rate rises at the same time as inflation growth will leave real rates similar to their current status. In a recent report, we show that prime office yields in the majority of Asia Pacific real estate markets are closely linked to the US real 10- year government bond rates. With real rates stable, core real estate yields can continue to stay low and yields in some markets even have the potential to compress further when compared to their long-term ranges.
Spreads for real estate over real government bond rates still remain attractive and when you add on the ability to take on debt, leveraged cash-on-cash returns are still significantly higher than real government bond yields in major markets, says JLL.
Furthermore, the inflation hedging characteristics of real estate as an asset class will continue to attract investors seeking protection against higher inflation. However, some risks lie in the adjustment process away from the prolonged low interest rates and low inflation rates ("low-low") environment to a high interest rates and high inflation rates ("high-high") world. For example, if interest rates and borrowing costs are to rise faster than-anticipated, rising costs of debt service payments may squeeze cash flows for over-leveraged investors in the short-term.
JLL says the AUD is expected to be the main transmission mechanism of the Fed rate increase. While a narrowing of the interest rate differential between the US and Australia should exert downward pressure on the AUD exchange rate, a confluence of factors should help to support the AUD. Australian GDP surprised on the upside in Q4 and the positive tailwind from income growth should support economic growth in 2017. Part of this trend is related to commodity prices and while iron ore and coal have eased back from recent peaks, prices for both commodities are up over the past 12 months.
The current valuation of commercial real estate in Australia still has the ability to absorb further increases in the real risk-free rate. While property yields in core sectors have compressed towards 2007 levels, investors have remained disciplined, and the spread between property yields and the real risk-free rate is wider than historical benchmarks.
In addition, the Fed is raising interest rates in response to a strengthening US economy, and historically, we have observed a positive correlation between the US GDP and office net absorption in the Sydney CBD. Assuming this relationship is maintained, we expect positive tenant demand in Sydney to push vacancy rates to a cyclical low of 5.0% in 2019.
JLL says US interest rate hikes will have interesting consequences for the Japanese economy and real estate market. At its latest policy meeting, the Bank of Japan (BOJ) stated a target yield of 0% on the 10-year government yield benchmark, and positioned itself to directing the yield curve toward an appropriate upward shape. With much of the shorter end of the JPY yield curve in negative territory, the US rate hike has pushed the yield spread between the two markets wider, leading to the Yen depreciating considerably by nearly 14% to USD/JPY 117.5 (from USD/JPY 101) since the November 8 election.
Yen depreciation has led to strong gains in the equity market, with the Nikkei 225 index exceeding 19,000 points, its highest reading in over a year. The recent December Tankan survey showed business conditions have improved almost across the board since the September survey, particularly within the all-important manufacturing sector.
Regarding the real estate market, a weaker yen will offer support to the export-oriented industrial sector, as well as to the already burgeoning tourism market which tends deliver benefits for both the hotel and retail sectors. Property investors have been a key beneficiary of favorable credit conditions with banks' willingness to provide loans of longer durations. The BOJ's policies also result in relative yield stability across the yield curve, which will ease any upward pressure on cap rates that may be evident in other markets.
JLL reports that US interest rate movements should have minimal impact on the Chinese real estate market. We estimate that short-term interest rates in China have no co-movements with the US, likely because of its large economy and independent monetary policy cycle. Historically, the onshore yuan bond market also shows little co-movements together with foreign bond markets due to restrictions and limited foreign access.
The main transmission mechanism of the Fed rate increase should be via the RMB exchange rate against the USD. China's government has become more cautious towards further downward pressure on RMB and accelerating capital outflow. The government is closely monitoring overseas investment in areas including real estate. There may be some short-term deal risks due to capital controls. Nevertheless, the momentum of outbound capital flows will continue into 2017, as part of the structural shift of Chinese capital going global.
On the other hand, corporates and individuals that find it more difficult to invest overseas might be forced to look at domestic assets. While that may not push up property prices further because of the new purchase restrictions implemented, this should help to stabilize property prices in China. We expect Chinese investors to remain the main buyers in China's market (domestic investors accounted for 87% of all transactions in China in 2016), and Chinese insurance companies to expand their real estate exposure. With ample liquidity, we expect real estate prices in China to remain high and yields will likely compress further, especially in Tier I cities such as Shanghai, Beijing, Shenzhen and Guangzhou.
JLL reports HIBOR rates have already edged higher in anticipation of the US rate hike, and local banks have responded by lowering spreads on HIBOR-based mortgages. For commercial real estate investment, however, higher financing costs may have been passed onto borrowers. Overall, local banks are unlikely to raise lending rates amid stiff competition, as mortgage businesses plummet against low transaction volumes following the government's cooling measures. Therefore, any effect of rising interest rates on property prices will likely occur later in the rate hike cycle. A quick observation of local banks suggests that they are likely to absorb up to two interest rate hikes from the US Fed before adjusting borrowing rates locally.
In comparison, the Chinese government's growing caution towards outbound investments is likely to have a bigger impact on Hong Kong's property market. Mainland buyers have been among the most active in the property investment market over the past 18 months and involved in the largest transactions over the period. Whether this will help reverse the upward trend in prices, however, remains to be seen.
JLL says financial markets in Singapore should have fully priced-in the US Fed hike, as 3-month and 6-month SIBOR base rates have spiked by about 50 bps since November 2016 to about 0.94% and 1.25% respectively. Benchmark borrowing rates continue to stay at low levels, and banks remain willing to lend up to 50-60% for development and completed assets with margin stable at 150-200 bps. Hence, the overall all-in-cost of capital for property investors remains relatively low.
The Singapore government also has significant capacity to loosen property market policies to offset the gradual rise in interest rates. On 10 March 2017, the government reduced seller stamp duties and relaxed rules on total debt servicing ratio caps, the first loosening measures since they started tightening the residential market in 2010.
JLL expects more policy relaxation in the next two-three years as interest rates normalize. Singapore developers and REITs continue to have the capacity to invest as they have very conservative balance sheets and low gearing ratios. Furthermore, the level of interest for new projects is strong as observed from recent aggressive land price bids for good projects by local and regional groups.