Over the last few weeks, spreads between commercial property yields and the 10-year bond rate have started to narrow, as bond rates started to rise. If this trend were to continue, it would inevitably lead to a softening in commercial property yields to maintain that positive spread. This, in turn, would lead to lower property values.
So how is commercial property placed? The long-term historical average positive spread between commercial property yields and bond rates ranges from 210 – 530 basis points (bps), depending on the property type. When determining spreads, the 10-year Commonwealth Government bond rate is used as a comparison as it’s considered the risk-free rate.
The long-term, the Q4 2020 and the current spread between property yields and the 10-year bond rate is shown in this chart. It clearly shows the impact of a rising 10-year bond on the spread.
Large-format retail currently has the largest spread. Assuming commercial property yields remain stable in Q1 2021 and applying the current bond rate, the spread is 445 bps (just below the average of past 10 years), while Regional shopping centres has the narrowest spread at 267 bps (more than 50 bps above the average of past 10 years). Regional retail yields softened through 2020, continuing a trend started in 2019. Prime CBD office spreads are also narrow at 284 bps (about the same level as the average of past 10 years).
For industrial, despite the lower 10-year bond rate, spreads narrowed in 2020 due to firming in the sector’s property yields. The average weighted prime industrial yield compressed 38 bps last calendar year and the secondary yield was down 52 bps. Not surprising, given the increased emphasis on supply chains and the rise in online retailing through the periods of lockdown.
The ongoing strength in the industrial sector may see prime industrial yields tighten further in 2021 and move below that of prime office; a situation also evidenced overseas, for example, in the USA.
Current CommBank forecasts of the 10-year bond rate over the next 12 months averages around 1.75%, which is not far off where it is right now.
If this is the case – acknowledging how difficult it is to forecast 10-year bond rates – then for 2021, the spread between commercial property and the 10-year bond rate will be reduced but remain comfortably positive.
The recent lift in the bond rate serves as a timely reminder that inevitably, whether it’s 2022 or later, the spread will narrow and property yields will need to soften to re-instate a positive spread and this will lead to the revaluation of assets.