With recent interest rate cuts, we will continue to witness capital piling into higher yielding asset classes, property included, as people seek arbitrage opportunities to try and obtain a real return on their money. Cash rates at 2.00% mean that monies on deposit are going backwards in real terms (after inflation) and thus it is no surprise that the market continues to seek out alternative investment destinations, property in particular.
Over the last few years, property yields have chased the interest rate curve down. This has seen prices for property increase significantly in an environment where the broader property fundamentals are either benign or negative. Yields following the interest rate curve is not a new phenomenon, however the extent to which it has occurred over the last two years has meant that broader property prices are starting to look expensive.
We have heard a number of arguments that current pricing is reasonable given that the risk premium (the return obtained over the 10 year bond rate) has largely been preserved. Whilst this is true in some ways, it assumes that property investing is based solely with reference to the cash rate. This is simply baseless. It can be a dangerous game to invest on a relative basis to other metrics – property pricing should be a function of property fundamentals, not a function of interest rates (or relative pricing to other investment sectors).
Relative investing in property was what drove the sector pre GFC. Money flowed into property chasing yield, and the resultant growth was a boon for all involved. However, it went too far and after a while the only thing supporting the market was momentum – the market had fundamentally surpassed the traditional metrics which represented sound pricing.
The other argument supporting the tightening in pricing is the weight of money coming from offshore, in particular, Asia. This was the same argument mounted pre GFC off the back of foreign institutional capital flowing in. Much like the Japanese foray into Queensland in the 80’s, such capital inflows only distort markets beyond their fundamental pricing. Eventually property prices revert to the mean but the necessary rationalisation of the sector hurts many.
Ultimately, over the long term markets follow particular investment based outcomes. When acquiring income producing property on tight pricing, you are reliant on interest rates to remain where they are in order to preserve margins. Given the cash flow is generally fixed for a predetermined period, any increase in interest rates will slash investment margins and therefore result in a concomitant softening in yields, a sharp fall in values and arguably a significant change in sentiment.
Beware of investing on a relative basis – it might seem attractive in the short term, but long term it can be your downfall.