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April 6, 2016 CBRE Research © 2016 CBRE, Inc. |

VIEWPOINT

Global Office

Real estate in a world of negative interest rates

• The European Central Bank and the Bank of Japan—two of the world’s four most important monetary institutions—along with several smaller central banks, are pushing their nominal interest rates negative in an effort to stimulate spending and stave off the threat of deflation.

• The policy will probably have some success—particularly if the U.S. Federal Reserve delays its planned monetary policy normalisation for a while. The big structural factor that underlies deficient demand and very low inflation, however, is excess savings—and changing this would require policy changes well beyond the reach of even the most powerful central banks.

• Overall, negative interest rates are good for property values—particularly on prime assets, which, even at low capitalisation rates, offer a good income at a relatively low risk. Investors will take advantage of this by increasingly allocating greater shares of their portfolios to real estate.

WHAT IS HAPPENING?

On 10 March, the European Central Bank (ECB) initiated a new round of monetary stimulus, which included lowering the main deposit rate 10 basis points (bps) to -0.4%. It is not the only major central bank pursuing a negative interest rate policy; so also is the Bank of Japan (BoJ).

Between them, the ECB and the BoJ have $6.7 trillion in assets—nearly 30% more than the U.S. Federal Reserve’s $4.5 trillion, but less than the People’s Bank of China’s (PBOC) $11.1 trillion. In essence, two of the four most important monetary institutions in the world are attempting to drive nominal short-term interest rates even deeper into negative territory. Other, smaller central banks—including Denmark, Sweden and Switzerland —are pursuing similar policies.

Richard Barkham, Ph.D., MRICS Chief Economist, Global Research Dennis Schoenmaker Economist, Global Research

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VIEWPOINT GLOBAL OFFICE

Figure 1: OECD Real Interest Rates

Source: CBRE Research, Q1 2016.

One of the great fears of central banks is that the general level of prices will start to fall, moving us from a world of inflation and generally rising prices, to a world of deflation. Deflation has some very serious consequences and is probably more disruptive to the real economy than inflation—even at high levels.

Deflation pushes up real interest rates. Real interest rates are the nominal interest rates we see quoted every day in the marketplace, minus expected inflation (or deflation). If expected inflation is, say, -1.5%, even a low nominal interest rate like 0.5% becomes a high real interest rate—2%.

High real interest rates are highly contractionary: they compel consumers and businesses to pay off debt, while discouraging the use of credit for purchasing consumer goods and investment. Moreover, if prices are falling, consumers tend not to spend money, preferring to wait for better deals in the future.

All in all, deflation and high real interest rates cause demand to contract relative to supply, and this magnifies the deflationary cycle. This is one of the problems that Japan has had since the end of the 1980s. Once deflation becomes entrenched, it is hard to eradicate. Right now, central banks are very fearful that it is about to happen—particularly in Europe.

HOW DID WE GET HERE?

A simplistic explanation is that the Eurozone—similar to Japan in its post-bubble era—has failed to pursue sufficiently vigorous economic policies to boost demand and reduce unemployment. As a consequence, the demand for goods and services is well below the potential supply, so prices are stable at best and declining at worst. Some would argue that the Eurozone’s private sector is also hampered by excessive regulation and taxation, so innovation and entrepreneurship are stifled.

This situation—the weak growth of prices—has recently been exacerbated by price declines in commodities and oil. Theoretically, this is only a temporary effect, but it seems to be creating an expectation among consumers and businesses that prices will continue to decline, and this is becoming a self-fulfilling prophecy. The ECB is therefore pursuing—somewhat late in the day—a highly stimulative monetary policy, to boost growth and reduce the chance of dangerous deflation. Very late in the day, the Bank of Japan is doing the same.

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The more complicated answer is that interest rates, in real and nominal terms, have been declining for 30 years. Nominal interest rates have declined because inflation and inflation expectations have declined. Real interest rates have declined because households, businesses and governments are collectively saving more money, year to year, than is required by governments or businesses for investment. These “excess savings” have been channelled into safe financial assets like government bonds, so the yield spread against inflation—namely the real interest rate—has fallen steadily. In fact, the real interest rate in the world’s most developed economies has been negative for the past six years. Now, the nominal rate of interest has gone negative as well.

Though the savings glut—as it is called—is a global phenomenon, certain parts of the world contribute more to savings than others. Germany, Japan, China and, until recently, the oil-producing nations are key generators of savings at a global level. Moreover, it is not always households that save more than they spend—sometimes it is the corporate sector that sits on cash, as in Japan.

Why do situations of excess savings arise? There are a number of reasons. Household income may surprise on the upside for a period of time and be saved rather than spent. This is the case in China, where, due to lack of state provision, saving is also motivated by a need to prepare for old age, ill health or other contingencies. In some countries, like Germany, there is a marked cultural aversion to debt, so households spend less than their disposable income. In the corporate sector, revenue may be retained rather than invested because of uncertainty about future demand, or for reasons of tax efficiency, as in Japan. Governments contribute to the global pool of savings when there is excess revenue from tax after having met current spending requirements.

Most of the OECD governments are in fiscal deficit, so they are calling on savings rather than contributing. However, until the recent collapse of oil and commodity prices, Norway, Saudi Arabia Canada and others used their fiscal surpluses to create, among other things, sovereign wealth funds (SWFs) to invest for the longer term. The recent rise in influence of SWFs is due in part to high levels of savings in resource-rich and export-oriented economies.

Excess global savings doesn’t just depress real interest rates; it also creates a situation of weak global demand for goods and services. Insufficient spending (demand) relative to the capacity of the global economy to supply goods and services means downward pressure on prices. This brings on the threat of deflation, and it is why central banks are cutting interest rates—to deter savings and boost spending so as to generate growth.

WILL THE POLICY WORK?

The ECB’s cut in the main deposit rate of interest to -0.4% (charging banks to deposit cash) was only one part of a package of measures that also include:

• provision of loans to the banking sector, also with a negative rate of interest (paying the banks to borrow);

• expansion of the government bond-buying program (quantitative easing, or QE) from €60 billion to €80 billion per month; and

• inclusion of investment-grade corporate bonds in the QE program for the first time.

This is a very substantial program of monetary easing, and it should—if the experience of the U.S. and the U.K. is anything to go by—have a positive impact on growth, via increased bank lending to consumers and

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businesses, a lower cost of capital to the business sector and a boost to sentiment. As 38% of world trade originates in the European Union, a boost to growth will be beneficial for the global economy.

There is a slightly bolder question mark on the potential of the negative interest rate policy pursued by the BoJ—in particular, the -0.1% rate on bank balances between 10 and 30 trillion yen. Although the measure is stimulative, it is not clear that it will, on its own, force Japanese corporations—which save “too much”—to invest more or to pay out higher proportions of their revenue in wages. Further structural reform, including a change in the taxation of retained profits to reduce the incentives for corporations to save, is probably required.

The negative interest rate policies currently being pursued by the central banks of Sweden, Denmark and Switzerland are not as globally significant as those of the ECB and the BoJ, nor are they directly related in the near-term to deflation. These are good, well-run economies that have faced a strong inflow of capital due to monetary easing in the Eurozone. As such, the value of their currencies has risen relative to the Eurozone—their main trading partner. Pushing interest rates into negative territory is an attempt to hold down the value of their currencies—one that has been moderately successful.

Figure 2: EMEA Prime1 vs. Secondary2 Market Yields


1 As prime markets, we use Helsinki (Finland), Amsterdam (the Netherlands), London (UK), Hamburg and Frankfurt (Germany), Paris (France), Madrid (Spain) and Stockholm (Sweden).

2 Secondary markets include Tampere (Finland), Rotterdam and Utrecht (the Netherlands), Birmingham, Glasgow and Manchester (UK), Cologne and Dusseldorf (Germany), Lille and Marseille (France), Valencia and Malaga (Spain) and Gothenburg (Sweden).

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Figure 3: UK Prime vs. Secondary Market Yields


The broad, medium-term conclusion is that the policy is appropriate and necessary. The global economy still requires monetary stimulus to maintain growth in output, and it would be a disaster if it fell into a generalized deflation like that which Japan has experienced over the past 25 years.

However, it will take more than negative interest rates to fully eliminate excess savings and its reciprocal, deficient demand in the global economy. Here, the fall in oil prices is a big plus. It represents the transfer of approximately $1 trillion from governments, which were largely savers, to consumers, who are largely spenders. Oil-producing nations account for only 40% or so of the global savings glut, though; China, Japan and Germany account for a good proportion of the rest. For the global savings glut to come to an end, some very profound changes to economic management need to occur, including the transformation of China to a consumer economy.

WHAT ARE THE IMPLICATIONS FOR REAL ESTATE?

One of the features of the post-Global Financial Crisis economic landscape has been investors’ relative preference for prime real estate. We have good data on this in the U.K. and Europe, and we can see this preference in the spread between yields on prime and secondary real estate (see Figures 2 and 3). In the U.K. this spread has diminished, but it is still higher than in 2008. This preference for prime real estate is not just a preference for lower-risk assets; our charts show that rent growth, though weak, has been higher in prime real estate (see Figures 4 and 5).

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Figure 4: EMEA Prime vs. Secondary Market Rental Growth


Figure 5: UK Prime vs. Secondary Market Rental Growth


As the world economy works its way through this soft patch, we expect to see this preference for prime real estate reassert itself a little bit. As growth picks up again in the second half of 2016, investors’ preferences will shift again toward secondary and value-add real estate situations.

More broadly, growth—even sub-par growth—alongside low interest rates is a good environment for real estate. The income returns provided by real estate will continue to attract investors.

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The fact that the ECB and the BoJ are now pushing deeper into negative interest rate territory surely puts a brake on the pace at which the Fed can raise interest rates, despite the fact that core inflation (CPI or PCE) is picking up a little.

The bottom line is that negative interest rates are likely to be good for real estate, due to portfolio effects in the first instance and to economic growth over the medium term.

That said, negative nominal interest rates are indicative of a global economy that is not functioning quite as it should. Globally coordinated demand-side policies are the only answer, but politics is against this happening.

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CONTACT

Richard Barkham, Ph.D., MRICS Chief Economist, Global Research + 44 20 718 22665 [email protected] Dennis Schoenmaker Economist, CBRE Global Research +44 20 718 22457 [email protected] Elizabeth Brotchie Client Services, Global Research, Econometric Advisors +1 617 912 5224 [email protected] Mary Suter Client Services, Global Research, Econometric Advisors +1 617 912 5251 [email protected]

To learn more about CBRE Research, or to access additional research reports, please visit the Global Research Gateway at www.cbre.com/researchgateway.

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