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Will rate hikes drive up yield requirements on investment property?

Ejendomsinvestering renter

For years on end, interest rates have been low, tracing a continuous downward trend; Denmark has seen negative interest rates on government bonds, including even long-term bonds. At the same time, investors’ yield requirements on property investments have dropped. Has the decline in interest rates halted, giving way to an increase, and will investors demand higher income returns on property investments as a result?

Has the 40-year long interest rate decline finally halted? Bond yields fluctuate every single day. However, put in a longer time perspective, yields have come down.

In February 1982, the yield on a 2-year government bond peaked a 20.82%. Almost around the same time, in 1981, the US prime rate – the variable loan rate offered by US banks to first-rate clients – exceeded 20%.

When the Danish short-term interest rate, for the first time in history, dipped into negative territory in 2012, many subscribed to the view that this would be a short-lived and altogether exceptional phenomenon.

Today, short-term interest rates have been negative for nearly a decade, and we have grown accustomed to negative yields on government bonds with a maturity of 10 years.

Nevertheless, the massive capital injections made after the outbreak of COVID-19, along with prospects of very strong economic growth and rallying energy prices, have for the first time in years given rise to concerns of an inflationary increase. As a result, long-term interest rates have seen a fairly sharp increase in 2021.

Initial yields on property investments tracking downward trend in interest rates

When interest rates come down, it is not surprising that initial yields on property investments come down too. It becomes less expensive to finance property investments, and negative yields on bond investments serve to whet investor appetite for alternative investment assets offering higher initial yields. In consequence, the prolonged downward trend in interest rates seen in recent years has driven down initial yield requirements, spurring an increase in investment property prices.

Every property investor dreams of declining vacancy rates and climbing rental prices because they herald increasing property values.

For the past five years, the prices of commercial and investment property have on average increased by some 26.5% in total. These price hikes are only to a minor extent driven by increasing rental income. 85% of capital growth is in fact driven by yield compression, with operational improvements accounting for only 15%, see figure 1.

Ejendomsinvestering renter

In the long term, this development is of course untenable. We increasingly hear concerns being voiced that rate hikes will drive up initial yield requirements on property investments, prompting a decline in prices as a result.

Inflationary increase benefits property prices

However, it is by no means certain that rate hikes will persist. In particular the US central bank, the FED, has expressed little concern, even if the rate of inflation should for a while exceed the long-term inflationary target, and both the FED and the ECB seem highly determined to keep interest rates at a very low level by means of continued massive-scale asset purchase programmes.

In addition, a surge in economic activity and an inflationary increase are actually in themselves drivers of property prices. On the back of accelerating economic growth follow higher employment figures and higher levels of consumer spending, and, by extension, higher demand for commercial space. At the same time, rental prices are typically subject to NPI-linked adjustments, and a higher inflation rate will therefore drive up rental income. Finally, strong economic activity and an inflationary increase will invariably drive up construction prices.

In consequence, provided the increase in long-term interest rates is caused by rising inflation, the effect on property prices will not necessarily be detrimental. If property investors expect inflation to rise, they will factor in climbing rental prices over time – and an inflationary increase will consequently not as such drive up yield requirements.

In fact, the yield gap, that is, the spread between the initial yield on a prime investment property and a 10-year government bond yield, has been historically wide for many years, exactly because nobody expected inflation to be a factor. When inflationary expectations are rising, an increase in long-term interest rates will not drive up yield requirements on property investment. Prospects of an inflationary increase will therefore serve to narrow the yield gap: it is easier to accept a lower initial yield when faced with prospects of higher rental prices.

The greatest risk is overproduction

It cannot be ruled out that some geographical areas and some segments will see investors’ yield requirements go up, driving down prices in the process. However, such a scenario will not be attributable to climbing interest rates. Such risks are predominantly associated with the underlying demand for and supply of space.

In addition, there is a possible risk that the massive demand for investment property may spawn newbuilding on such a scale as to outstrip demand. This could upset the supply and demand balance in terms of both commercial and residential space, with an oversupply typically driving down market rental prices, inflation or not. In the property market, risk is therefore not related to accelerating economic growth and rising inflation, but to overproduction. However, we have not (yet) reached this point.


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Peter Winther

Executive Director | Partner | MRICS

Copenhagen

Peter is Executive Director and heads Colliers’ Danish Investment & Capital Markets teams. Peter provides strategic property consultancy services and facilitates the sale of commercial and investment properties, including hotels and shopping centres, as well as property portfolios and companies.

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