Global deflation and its effect on Singapore real estate
By Alan Cheong
/ Savills, The Edge Property |
This may seem like heavy reading, but it is a topic that needs to be addressed before it develops into a major issue. After the global financial crisis (GFC), real and financial economic markets have been performing much less ideally than expected by many central banks. Wild swings in global financial markets and commodity prices have left people looking for answers. In the fixed-income space, warnings abound that the market is facing the danger of illiquidity (arising from the US Federal Reserve’s purchases of Treasuries) rather than the common understanding that there is too much liquidity. Markets are becoming stranger by the day.
Now, there is increasing talk of deflation. Since the prices of oil and commodities came off sharply in late 2014 (Chart 1), this inversion from inflation to deflation has become a more commonly heard line among global fund managers and in IMF publications as well.
Chart 1
Source: IMF
On top of this, there are strong top-down (normalising interest rates, fanning expectations of rising interest rates and so on) and bottom up (so-called prudent controls on credit and increased regulations to restrain exuberance in credit growth worldwide) measures, making for a plausible disinflationary scenario in the short term with a high risk of deflation in the medium term (if these top-down and bottom-up measures are overdone). The top-down factors keep the monetary base restrained, while the bottom-up factors discourage the speeding up of the velocity of money circulation.
China’s recent devaluation of the renminbi has also not helped the cause of keeping export prices stable in the world’s manufacturing engine.
While global financial markets have been plagued by these three issues, the real estate industry has been carrying on as normal — partly because these developments only came to a head recently when the Chinese economy started to decelerate and with it came the chill of a liquidity winter. Despite the outbreak of a crisis in Europe and the US economy still languishing, Asia brushed these aside and commentators have been quick to opine that Asia is still the engine of growth. In countries in which the real estate markets had experienced long-term rental and capital appreciation, the risk is that of unexpected deflation. Should deflation trades become an entry in global money managers’ new playbook, how will real estate prices behave as the reactions in the financial markets spill over to property?
What happens in deflationary environment?
We have been indoctrinated with the adage that real estate is a hedge against inflation, never asking what happens if the environment is deflationary rather than inflationary. What happens when things are in reverse gear?
The income capitalisation formula can provide some insights. In this math, future income growth is deducted from the yield (r - g) to give us the capitalisation rate (r is the required rate of return and g is the rental growth rate). However, in a deflationary environment, that growth turns negative and will therefore be added back to the yield factor. This means that in a deflationary environment, yields should be higher. Does this financial math pan out on the ground? Let us use Japan as a case study.
Chart 2 shows that when deflation was pronounced in the early part of the last decade, real estate yields in Japan remained high. When deflationary pressures began to ease towards 2006, yields fell. In 2008, when inflation spiked, yields came down to a trough before rising significantly in 2009, when deflation returned. Lately, when inflation in Japan stood well above zero, yields began to come off.
Chart 2
Source: World Bank, Savills Japan, Various stockbroking houses
In practically all countries excluding Japan, inflation ruled and it was hard to ascertain how yields would behave when deflation set in. Previously, this did not really matter because Japan seemed like an isolated case. Now that deflation is increasingly being floated among global money managers, we should be more wary of how real estate returns would function in such an environment. Looking at how Japan’s real estate performed in the last decade may provide the best indication of how our real estate market will function if deflation does set in.
Yield in real estate is defined as annual income divided by the capital value. This yield or capitalisation rate has two components: the current rental element and future growth in rents. Therefore, if we say that the yield of Grade A offices here is 3.75%, it is a percentage that has taken into account the future rental growth. If the average long-term rental growth is 4% a year, then yield under zero rental inflation should be 7.75% (3.75% + 4%). This 7.75% represents the required rental return for Grade A offices where there are no rental increases. Most of the time, we take yield for granted, forgetting about the return if no positive lease reversions occur. However, when deflation is in play, this number becomes important because it becomes the base from which to ascertain what the yield or capitalisation rate should be if rental growth reversions are zero or negative. To illustrate, if rental deflation is 1% a year, then instead of subtracting this from 7.75%, it should be added to it, giving us an 8.75% yield or cap rate.
Inflation and yields
With the technical bit behind us, we now have a clearer understanding of why, in a deflationary environment, yields increase. Empirically, we saw that being played out in Japan. The explanation is that when there is negative rental growth, one would require a higher present yield to offset future reversionary losses. It must be pointed out that other factors are also at play in determining yield. These factors include interest rates, politics and specific factors pertaining to the type of real estate, such as its age and tenure. Nevertheless, it is undeniable that in the case of Japan, inflation and its reverse affect yields.
Returning to Grade A offices here, we find that the 10-year average net yield from 2Q2003 to 1Q2013 was 5.3%, with rents growing at 4.5% a year. From 2Q2005 to 2Q2015, net yields averaged 4.9%. However, with lower yields came higher rental growth, which averaged 6.6% a year. In some way, this gives a hint that the net yield compression effect being a trade-off for higher rental growth also applies to Singapore’s Grade A offices.
If we take the analysis a step further by removing the impact of interest rates — that is, we take the difference between office yields and the 10-year government bond — the result does not change (see Chart 3). From 1990 to 2Q2008, office rental growth in the Central Area was flat. In 2007, anyone building a spreadsheet would have used the previous 10- to 15-year negligible rental growth to input into the capitalisation rate. This probably explained why the yield spread from 2000 to 2Q2008 had been generally higher than in the last couple of years. From 3Q2008 to 2Q2015, the rental trend line was positive and we see the yield spread falling.
Chart 3
Source: URA, Savills Research & Consultancy
The relationship between yield and capital value is an exponential decay function — as yield increases or decreases from a low base, capital value falls and increases fast respectively. The sensitivity of capital values to net yield changes becomes especially pronounced when the latter are at very low levels. A small increase or decline in yields will exacerbate value changes down and up respectively.
Singapore’s office net yields are currently hovering in the lower end of the historical 15-year range and that is not a very comforting zone to be in because if long-term rental deflation (or even disinflation) becomes the baseline scenario, its effect on capital values will be significant and in a direction that many will find discomforting. Although, for an open economy like Singapore, it is hard to sterilise the economy entirely from externalities such as inflation, there are several paths within the real estate sector that players can manoeuvre to mitigate any ill-winds of deflation.
Measures to counter rental deflation
For the office sector, one measure that could be taken to dampen the negative effect of rental deflation is restricting the supply of government land sales for commercial developments. Instead of offering large blocs, consider offering smaller office developments that cater to businesses that require less space. The other measure may be to tighten the definition of what is allowed in a business park space to reduce demand seepages from traditional office space users. Another control, which affects lower-grade office space, is to increase enforcement against the illegal use of industrial spaces. Other broader strategies include a relook at the necessity of developing large regional centres.
For landlords of buildings with large floor plates who believe their properties face medium- to long-term negative rental reversions, exploring ways to subdivide the space may be a viable option. Having said that, the latitude a landlord has to combat negative rental reversions is less than that available to those who make macro policy decisions.
Real estate professionals are used to working in an environment where the assumption of a long-term increase in both price and rental is a given. Should the reverse occur, it will certainly throw seasoned players off balance because the existence of loans and legal covenants does not facilitate a seamless symmetrical shift to reverse gear. There shall be great angst. The industry may not be thinking about this seriously because spreadsheets are still constructed assuming positive rental reversions and institutions of higher learning continue to explicate the view (not incorrect, though) that real estate is a hedge against inflation. For lenders, they are lending based on valuation methods that either assume the existence of inflation in a discounted cash flow analysis or, if adopting a market comparable approach, a strong inflationary bias.
To be honest, whether deflation occurs in our real estate market is moot. Policymakers may reverse their actions and reopen the credit spigots again. Cooling measures could be lifted or rolled back. Even if deflation does exist in the consumer market, it is not clear how it will affect the various real estate sectors. The office sector may be driven by its own set of determinants. However, for certain sectors such as retail, there are definitely price pressures. The proliferation of online shops is driving down prices. This price decline is largely owing to a structural change in the business of retailing.
Nevertheless, deflation may not be entirely bad, as new opportunities will appear. For example, in the retail real estate sector, the burgeoning online market spurs demand for logistics space. For the private residential leasing sector, lower rental-paying capacity will increase the attractiveness of multi-room abodes that are let out to multiple tenants. Still, in these strangest of times, the level of vigilance must be increased. Those in the real estate and related industries should start looking hard into this issue of what if we don’t have rental increases.
Alan Cheong is head of research and consultancy at Savills Singapore. He can be reached at alan.cheong@savills.com.sg.
This article appeared in The Edge Property Pullout of Issue 694 (September 14) of The Edge Singapore.
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