Research article

How Low Can They Go?

As yields around the world fall in primary cities, investors will need to look at secondary sites for value.

Yields are the universal language of real estate, but like so many global languages they are not always easily translated between one country and another. After all, even different regions within the same country speak different dialects. Here, we try to unpick the real global picture and see where each of our 12 cities sits in comparison.

Put simply, yield is the income you receive on the capital you use in real estate (annual rent as a percentage of capital value) and this figure can speak volumes about the state of any property market.

Currently, many world city prime yields are either at, or close to, all-time historic lows in both commercial and residential property. This, in part, reflects current global monetary conditions, but could also indicate that capital values are too far ahead of rental growth, that rents have yet to catch up with capital values, that lower income returns are the new norm, or any combination of these factors.

Office occupier yields

Our simple measure of small office occupier costs in world cities shows that occupier yields (rents paid by tenants as a percentage of capital value) fell after 2009 (see fig. 4). Yields on creative/digital properties (usually fringe locations, alternative buildings are less favoured by institutional investors) have recently stabilised, despite rental growth. Yields on financial district buildings that suit small-scale financial occupiers have continued to move in. These prime locations are becoming increasingly favoured by investors, pushing values up and cap rates down.

This means that although rents may be rising, occupiers are paying less for their property each month as a proportion of the capital cost of their building.

Figure 4

FIGURE 4World city office occupier yields compared

Source: Savills World Research

Office investor yields

Yield measures vary substantially around the globe. Headline market yields are often quoted in the office markets but they don’t take hidden costs and rental discounts into account.

Recent research by Savills, in conjunction with Deakin University in Australia (see fig. 5), looked at how tangible income returns to grade A office investors differ from quoted market yields in cities around the world. It found that a combination of investor costs and tenant incentives, such as rent-free periods or rebates, reduce the income return that an investor actually receives, in some cases quite considerably. The table opposite compares this ‘net effective yield’ with quoted market yields in our 12 cities.

Figure 5

FIGURE 5NOBEY (net of bonds effective yield)

Source: Deakin University / Savills World Research

Net effective yields in our 12 cities are, on average, 100 basis points below quoted market yields. In Sydney and downtown Los Angeles, the difference is much greater, while Tokyo, Hong Kong, Singapore and London show the greatest similarity between quoted market rents and income receivable by the landlord (see fig. 6).

Investor returns, measured by this method, are less than varied market yields. Heavily invested cities, such as London, Hong Kong, New York, Tokyo and Paris, are yielding in the region of 2.5% to 3.5%, while cities with lower rates of big-ticket international investment, such as Sydney and Shanghai, are being priced at around 4% to 4.5%. Mumbai is a clear high-risk outlier at an estimated 7.6%.

We have also subtracted the prevailing rate on 10-year government bonds to show the return investors receive over a local ‘low risk’ bond investment.

The average net of bonds effective yield currently exceeds 10-year government bonds by just 90 basis points (see fig. 5 and fig. 6). This gives some indication of how much further yields can move in. Cities with property yields that show lower returns in excess of bonds might be deemed more fully valued than those that offer investors a bigger surplus.

Figure 6

FIGURE 6June 2015 market yields and net effective yields compared

Source: Savills World Research

That said, a higher surplus might be expected in countries where the capital value of real estate depreciates faster – Japan, for example. Alternatively, a lower NOBEY might be expected in jurisdictions where rental growth is high, or is expected to be high, where bond yields are expected to move in further, or even where bonds may be perceived as being riskier than real estate.

World city yields would seem to be on the low side, having moved in, on average, 26 basis points over the past 12 months.

There are sometimes significant differences in yields within the same city. These are particularly striking in New York, for example. A Midtown investment will currently yield a net income of 2.8%, while a Downtown one will yield 3.2%. Differing investor expectations of the two markets are clearly at play here, but it tends to support our view that investors seeking income may be better off exploring secondary locations and second-tier cities, unless they believe in strong rental growth prospects within low-yielding markets.

Looking forward, it would appear that substantial rental growth will be needed in most of the world city office markets covered in this report, especially if the expectation is that gilt rates will move out as base rates rise. We expect to see office yields start to stabilise in 2015-16 and they have already started to move out slightly in Sydney and Shanghai.

Further inward movement is still possible in some cities where GDP growth and job creation increases demand, speculative office building has been minimal and vacancy rates are low. In these cities, current cap rates appear sustainable – both now and in the foreseeable future – provided rental growth continues.

Mumbai offers a high risk/reward investment

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