By guest contributor Lev Driker, Analyst, Atchison Consultants
Australian direct property is an attractive investment asset class to hold in the current low interest rate environment as it still offers relatively attractive yields. Low domestic interest rates and strong investor demand have placed downward pressure on capitalisation rates resulting in rising capital values. Some markets including Sydney and Melbourne have seen yields tighten considerably providing little room for further contraction. However, with improving economic conditions there is upward pressure on rents providing some room for capital growth.
Figure 1 compares the 10-year government bond yield with the market cap rate over 20 years to 30 September 2017.
Capitalisation rate (cap rate) spreads, which can be used as a proxy for yield spreads, continue to remain wide and attractive relative to 10 year government bond yields, with the spread currently sitting at around 3%.
Figure 1: 10 Year Government Bond Yields vs. Australian Commercial Property Capitalisation Rate
Major banks are increasing lending rates for commercial property borrowers. As the spread in yields narrows between property yields and debt interest rates, we expect this will have a moderating effect on investor demand for property. Capitalisation rates (yields) will flatten and possibly soften, leading to a stabilisation in capital values during the medium term (three to five year period).