16 November 2019
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Find the Gap, don’t mind the gap

Ross Lees
5 November 2019

Following two cuts in interest rates in June and July this year, the Reserve Bank of Australia’s (RBA) decision to keep the official cash rate on hold in August and September  was widely seen as a positive sign. In his speech, Governor Lowe pointed to an Australian economy that’s gradually strengthening, highlighting the fact that unemployment rates are low and the labour force participation is at a record high. At the same time, a 0.75% official cash rate is an historic low and low rates globally have seen long-term bond yields also fall to record lows in many countries, including Australia. Global synchronised monetary policy easing seems to be the new world order – which means that ‘lower for longer’ is where rates are likely to stay.  

Low interest rates are welcome news for homeowners with mortgages but for investors seeking to grow their wealth, low rates present a real challenge. Additionally, those close to or in retirement need income returns they can live on – and in the current economic landscape, fixed interest and cash investments may not provide that. In fact, according to BlackRock’s head of fixed interest, nearly 30% of developed market global government bond debt is negative yielding, and almost 80% yields less than 2% a year.

At the same time, according to a recent global survey of individual investors, many investors’ expectations around return and yield are higher than professional investors believe is realistic. Global financial professionals say an active investment strategy could achieve 5.5% a year above inflation, whereas investors themselves expect 11.7% a year above inflation. In Australia, professional investors say 6.4% above inflation is a strong, yet realistic expectation, whereas individual investors are looking for 11.9% above inflation – an expectation gap of 85%.

However, regardless of which of these return expectations we consider to be realistic, they are all substantially higher than the returns on offer from fixed interest or cash, which are currently sub-2% a year, and could go lower still.

Why is yield much more important now?

Yield is particularly important now for several reasons. Firstly, because interest rates are so low that income is hard to find but also because the changing face of the global economy means that demand for income is outstripping supply. Not only is our population ageing but the move away from a manufacturing-based economy to a service-based economy in countries like the US and Australia means we are not producing income in the way we did in the 1980s and 1990s – when companies were issuing debt in order to fund activities in capital-intensive industries.

For investors today looking for a consistent, stable income stream they can live on, there is a shrinking pool of investment strategies available.

So what options do investors have?

The fact is that relying on bonds and cash to provide them with an income stream is often no longer enough. Some investors are considering other assets, like real estate, which has the potential provide stable and predictable income over time, as well as the possibility of a capital gain in the longer term.

How do yields from property compare with fixed interest, cash and term deposits?

Yields from Australia’s listed property sector (A-REIT) compare very favorably with yields from 10-year Government bonds, as shown in the graph below. The value of an AREIT will move in value daily in line with the broader share market.

Chart 1: AREITS Earnings Yields Compared to Bond Yields

Source: RBA, UBS (2019)

If we look at term deposits or cash, currently the best investors can realistically expect is around 75 basis points above the official cash rate, in other words, 1.50% a year. When we look at unlisted property funds, these are currently yielding on average 6% a year. It’s a yield differential that makes the case for cash hard to justify.

Australian commercial property

Despite some weakness in the economy, the outlook for commercial property, including office and industrial looks very robust. Australian office markets still offer superior yields and the prospect of rental growth in the medium term, when compared with other markets in the APAC region. In addition, relatively new real estate sectors are likely to continue to grow and perform. Healthcare, for example, is one area where we see strong growth potential. Healthcare expenditure is one of the largest contributors to Australia’s GDP at 10.3%, and healthcare real estate is already performing strongly. It has tended to produce higher total returns compared with traditional real estate sectors and is underpinned by fundamentals from Australia’s growing and ageing population, longer life expectancies and an increased focus from the Federal Government on preventative care. Institutional investors have already invested substantially in healthcare real estate based on its expected growth trajectory, as well as the stable, recurring revenues it can offer.

What’s the conclusion?

Investors looking for stable yields to enhance their income streams and support them in retirement are now faced with a real conundrum. Traditional, safe sources of investment income, from cash, term deposits or fixed income are simply not performing in the current economic environment where low interest rates show no sign of rising substantially in the short to medium term. Investors may want to look further afield and consider other asset classes which can provide better outcomes for them.

Real estate is one such option – the yield differential between listed and unlisted real estate is attractive in today’s investment universe, and unlikely to narrow substantially looking forward.

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