Another active year in the property market is coming to an end. It got off to a rocky start: We closed the book on 2018 recording severe losses in the financial markets, with a distinctly jittery sentiment gripping investors. Were we heading for recession with a slowdown in employment and consumer spending set to drive up commercial vacancy rates? To top it all, quite a few voices of gloom predicted interest rate hikes.
The anticipation of recession and rate hikes hardly bears witness to an utterly logical mindset: An economic downturn is normally not a phenomenon that drives up interest rates, quite the contrary. However, once the jittery sentiment takes over, we apparently tend to resort to an irrational train of thought.
More central bank easing
In resolute response to deteriorating key macroeconomic indicators and sustained low inflation, however, central banks implemented further monetary easing, with the summer months seeing a decline in global interest rates. As a result, both short- and long-term interest rates dipped into negative territory in many parts of the world, with bonds worth more than USD 15,000bn now estimated to trade at negative yields.
This resolute response no doubt had a favourable effect on economies in both Europe and the United States. We are therefore once again experiencing a so-called Goldilocks economy: An economy neither in recession nor heading for overheating, with moderate growth and low inflation, making it possible to implement a lenient monetary policy.
One might sometimes resort to wondering if we really do live in a society with no appreciable inflation. It is true that we see no increases in consumer prices on goods and services, nor for that matter in wages, as far as most Danes, Europeans and Americans are concerned. However, the prices of financial assets have surged, with some parts of the labour market now also seeing quite substantial wage increases.
But the way we are wont to measure inflation means that inflation is low.
The weight of money
Most market players have gradually come to consider exceptionally low or negative interest rates as a long-term, if not lasting, phenomenon. When savings are growing in both pension funds and all other sorts of places, and bonds fail to produce any returns, you will of course turn to other asset classes (other forms of investments, including property), where you can at least expect certain returns.
Investor demand for properties has therefore picked up dramatically in recent months. When prime investment properties with solid cash flows in the most attractive cities in Europe are offered for sale in the market, it is not uncommon to see 10, 20 or even sometimes 50 bidders. Every time there is only a single winner – and a great many investors fail to achieve the exposure they demand judging from their bids.
Downtrend in yield requirements on top properties
You may well wonder why this massive investment demand has not driven down initial yield requirements even further – the yield spread, defined as the spread between the first-year income return on a prime investment property and the effective yield on a Danish 10-year government bond, has actually hit a 20-year high.
The only explanation is a combination of a monstrously disciplined approach in investor circles and continuously cautious behaviour in the financial sector, which, regardless of enormous deposit surpluses, has so far not (on any significant scale) allowed itself to be tempted to ease credit quality requirements.
It may be the obvious reaction to blame the banks for being excessively cautious. If you buy an office property at a 4% income return, the financing rate is 1.0% or 1.5%, and if you want to take out a loan for 60% and apply 40% equity financing, it is hard to imagine that things will go completely wrong. You are able to suffer quite substantial rent reductions or exceptionally high vacancy rates before finding it difficult to service interest payments out of the cash flows generated by the property.
The disciplined and cautious approach in investor circles and in the financial sector is however what prevents the investment market from overheating. Assuming that Danish economy stays clear of recession, we are convinced that 2020 will be another year of brisk market activity and slightly uptrending prices on the best properties. In other words, to use the concepts associated with the classical bubble theory: Property investors are confident, but not yet enthusiastic – and they are no way near the point where greed completely eliminates fear.