Because interest rates have remained low, commercial property may afford investors a comparatively attractive income stream.
What’s Inside?
A dearth of income opportunities exists in the present environment of very low interest rates. Commercial property may be the exception, but investors need to perform due diligence.
How Is This Research Useful to Practitioners?
The Great Recession of the past several years has led central banks to keep interest rates low in an effort to jump-start economic growth. These circumstances have been challenging for investors; even high-yield bonds have yielded lackluster returns.
Properly vetted, select commercial properties may offer comparatively attractive yields. The author explores the dynamics of the relationship between rental yield and investors’ cost of financing. Ample yields cover financing costs, with capital gains being a bonus. But high financing costs in the form of property maintenance and high vacancies can narrow this gap, resulting in meager returns.
The author examines UK property returns and rental yields from the Investment Property Databank beginning in December 1987. By comparing monthly rental yields with base lending rates (as a proxy for financing costs) and then studying the total return from property over the following year, the author finds that the wider the gap between rental yields and base rates, the more robust the property returns. The converse holds as well.
Users of this metric need to remember several caveats. Return data are not equally reliable across all property markets, property is illiquid, transaction costs can be significant, and low rates may not immediately translate into cheaper financing because of banks’ reluctance to extend credit at the same rate as they did during the economic boom. In addition, softer economic growth may translate into fewer rental opportunities.
Real estate investors and practitioners in the alternative asset class space may find the author’s conclusions worthy of further consideration, although they may well be familiar with the yield/finance cost dynamic.
Abstractor’s Viewpoint
Investors are facing a lack of income opportunities, but the author identifies one that appears to have merit. As with any potential investment, research and due diligence are necessary. Investors need to understand possible macroeconomic outcomes and how the proposed strategy could play out. Only a deflationary scenario would not seem to bode well for this strategy.