Impact of the Term Structure of Interest Rates on Property Yields

Jarek Morawski and Anthony De Francesco

ERES from European Real Estate Society (ERES)

Abstract: Significant amount of research has been dedicated to explaining property yields. Long term interest rate is usually identified as one of the key determinants, and property yields are often benchmarked to long term government bonds, which are considered to represent the closest alternative to property investments. However, empirical evidence provides a mixed picture indicating that the link is less than straightforward even when allowing for a time-varying risk premium. We argue that the relationship between interest rates and property yields is not just contemporaneous and expectations about future interest rates need to be accounted for in order to fully understand the link between these variables. Since real estate is illiquid and involves significant transaction cost, investors are effectively locked in for many years once they commit to a project. An interest rate increase during that period would expose them to a valuation risk. Moreover, when benchmarking to liquid bonds, the opportunity cost is not only the interest they can earn today but also the interest they could expect in the near future. Fundamentally, the term structure of interest rates (yield curve) contains information about the expected future interest rate. Therefore, we would expect that a steeper curve should result in higher property yields. We test this hypothesis using prime office yields in the key centres in Europe and Australia and find convincing evidence that the shape of the yield curve indeed affects property yields.

Keywords: Interest rates; Property Yields; Real Estate Investment; Yield Curve (search for similar items in EconPapers)
JEL-codes: R3 (search for similar items in EconPapers)
Date: 2019-01-01
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Persistent link: https://EconPapers.repec.org/RePEc:arz:wpaper:eres2019_286

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