Why Australian real estate investors should be watching bond market yields
Updated: Apr 18
Australian real estate is currently a hot asset class with residential price growth the fastest since 1988. Auctions are well bid. Real estate is an essential good, however in an era of global capital mobility, large fiscal stimulus programs and prolonged unconventional monetary policy valuation disciplines in this asset class have understandably come under pressure.
House price growth is due cheap debt and household sentiment
Regulators in Australia (APRA and RBA) have both recently reassured the market that lending standards have not fallen, meaning banks are not lending more than their policy documents say is appropriate based on the borrower. We know Australian wage growth is minimal and immigration has been severely curtailed. This means that recent house price increases is due lower interest rates and resulting increased household appetite to borrow.
Real estate involves leverage on leverage
Residential real estate investors in Australia generally are required to utilise leverage to enter the asset class, which perhaps is akin to giving every 16 year old a credit card in that bank debt is a part of everyday life. Many households also concentrate their investments into this single asset class building leverage on leverage via a process George Soros termed Reflexivity.
Australia is a bank dominated market meaning leverage is often opaque. Banks lend many times their capital. This means that Australian banks have their own leverage and that is primarily to residential mortgages. I want to be clear that Australian regulations are very robust, and our banks are exceptionally skilled at managing risk, however the leverage is there and that means Australian real estate involves leverage on leverage, a structure which does very well when the price of the underlying increases.
Real estate is akin to a blend of bonds and shares
Real estate has investment characteristics similar to a blend of bonds and shares:
Bonds because it has relatively predictable cashflows, and
Equities because there is generally assumed to be some growth in cash generation and there is a terminal value (worst case land, but generally a share-like perpetuity).
Shares, bonds and real estate valuations are all sensitive to interest rates
Like any objectively valued financial asset the underlying value of real estate is the present value of its future cashflows. The discount rates used in deriving that valuation fluctuate with market interest rates.
When we incorporate the lack of diversification, and the use of leverage, it is no surprise real estate portfolios are sensitive to interest rates. This is apparent from the extensive gains real estate has experience in recent years despite limited growth in wages. Because of this sensitivity real estate investors who seek to measure how much risk they are taking for their projected returns should be keeping a very keen eye on both bond markets and interest rate futures in order to monitor their concentrated risk to interest rates.
Real estate has a cycle too
Australians perhaps more than any other country need to remember that real estate over history has experienced cycles, generally as credit availability has waxed and waned. Regulators and credit providers historically have been pro-cyclical, driving booms into manias (Reflexivity) and pull-backs into busts. Perhaps Australia's most poignant reminder is that 1991 followed 1988.
Risk management in this asset class needs to consider decades long timeframes
Investing in a long tenor bond involves substantially more interest rate risk than short tenor bonds. One of the main reasons is the present value of the return of principal; the more the valuation of the bond relies of the return of principal the more sensitive the bond is to interest rates. Bonds that do not pay interest, known as zero coupon bonds, are the most sensitive to interest rates. Consider how similar a zero coupon bond is to an owner-occupier house which is intended to be sold at some point many years into the future.
Real estate investments, and the mortgages which fund those investments, are decades long commitments which means risks should also be managed over those timeframes. Insurance companies' asset-liability management takes this approach for good reason.
The image below is from the RBA and shows very short tenor interest rates in Australia are now so low they do not even compensate for consumer price inflation. The image shows that interest rates have been consistently favourable to real estate investors in recent decades. Whether its realistic to expect that tailwind to remain in coming decades, given short tenor rates are now close to zero, is far less clear.
What drives interest rates?
Perceptions of risk drive required returns as expressed in interest rates. Those risks include inflation and default risks as well as opportunity costs. For less liquid asset classes like real estate liquidity risks are also present.
What are some of the risks worth monitoring at present?
Tax increases - the US and UK have both flagged these are being considered
Cost pressures flowing into inflation - shipping freight rates, commodity prices and semiconductors are examples - lenders will want to be compensated for inflation with higher rates
Geopolitical risks - Australia bears a concentrated exposure to deteriorations in relationships between developed democracies and China
Coronavirus - infection rates continue to grow in many countries and new variants continue to emerge
Unwinding of leverage. 2008 (offshore, not in Australia) demonstrates what happens when the value of the collateral banks have based their loans off falls. Credit Suisse’s $4.7 billion hit from Archegos Capital Management is a pertinent reminder that bank lending is opaque and generally we will not see bank lending risks accumulating nor have much time to manage that risk as the whole market will scramble to hedge when word does emerge.
Credit spreads. Leverage metrics are high. According to Moodys net debt to EBITDA ended 2020 near 6 times. Even if government bond yields stay low rising credit spreads can increase the cost of debt.
Defaults. The number of 'fallen angels' rose quickly during the pandemic and several industries continue to be impacted into 2021. Standard & Poors expects bond default rates to continue climbing over 2021.
Hopefully none of these risks de-rail anything. I remain incredibly optimistic about Australia and our long term prospects. However hope is not a strategy; risks need to be monitored and managed.
As I wrote in the March blog rising long term interest rates (see here) in the bond market is our canary in the coalmine.