How will interest rate movements affect prime office yields in Asia Pacific? - JLL Research Report - The Investor JLL

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How will interest rate movements affect prime office yields in Asia Pacific? - JLL Research Report - The Investor JLL
JLL Research Report

How will interest rate movements affect
prime office yields in Asia Pacific?
How will interest rate movements affect prime office yields in Asia Pacific? - JLL Research Report - The Investor JLL
2   JLL

Executive Summary
JLL expects office yields in most Asia Pacific cities to stay stable over the next
three years so long as financing costs increase by 50-150bps from here, in
line with current expectations.

Prime office yields in most global cities in Asia Pacific have compressed over the last ten years, due both to an abundance of
capital chasing assets as well as lower financing costs.

Yet, we find that the yield compression in Asia Pacific has not fully reflected the decline in financing costs and yield spreads
have widened across the region since 2013. Investors are likely to have been sceptical of the sustainability of low interest
rates and already accounted for a 50-150bps increase in interest rates in their asset pricing. Lending margins have also
narrowed by 50-100bps over the last five years due to new sources of funding and competition.
How will interest rate movements affect prime office yields in Asia Pacific? - JLL Research Report - The Investor JLL
How will interest rate movements affect prime office yields in Asia Pacific? 3

Interest rates likely to rise from here as economic growth improves

Over the last six months, expectations of growth over            Interest rate is one of the components that makes up             This paper aims to answer the following questions:
the next three years have improved significantly. The IMF        total cost of capital, hence is a major consideration for
                                                                                                                                  1. How far have prime yields compressed in major AP office
now expects 2018 global economic growth to hit 3.9%.             property investors. Most investors use leverage by taking
                                                                                                                                     markets in the last decade and did they fully reflect the
As economic growth improves globally, interest rates are         loans or issuing bonds as part of financing requirements
                                                                                                                                     decline in financing costs?
likely to rise. The U.S. Federal Reserve is expected to raise    when purchasing a real asset, be it for owner occupation
interest rates three or four times in 2018. South Korea raised   or investment. Even if investors were to use only their          2. How have property investors’ financing costs changed in
their benchmarking rate for the first time in six years. The     own capital, the required return would still be influenced          the last decade amid quantitative easing and low bond
European Central Bank cut bond-buying from January 2018          by interest rate benchmark movements, thus potentially              yields?
and agreed to revisit monetary policy in early 2018 as the       moving real estate market yields.
                                                                                                                                  3. Based on economists’ consensus estimates of
bloc’s economy continues to grow.
                                                                                                                                     government interest rates over the next three years, how
                                                                                                                                     will financing costs and prime office yields react?
How will interest rate movements affect prime office yields in Asia Pacific? - JLL Research Report - The Investor JLL
4     JLL

Has yield compression fully reflected the decline in financing costs?

Since 2010, total Asia Pacific real estate transaction volumes         Fig 2: Prime office yields in Asia Pacific cities (%)
almost doubled to USD150bn in 2017 due to increasing                   8.5
allocation of capital to real estate and the decline in
financing costs globally. With the weight of capital chasing           7.5
assets, real estate yields have fallen over the last decade.
                                                                       6.5

                                                                       5.5
Fig 1: Asia Pacific transaction volumes
                                                                       4.5
160,000                                                                3.5

140,000                                                                2.5
                                                                                  2008            2009            2010             2011            2012      2013             2014           2015        2016       2017
120,000
                                                                                                      Sydney               Singapore                Seoul          Shanghai             Tokyo           Hong Kong
100,000                                                                Source: JLL estimates. NOI yields except Shanghai yields which are gross yields.

    80,000

    60,000                                                             Fig 3: Financing cost for landlords/investors in Asia Pacific cities (%)
    40,000                                                             10

    20,000
                                                                        8
        0
             2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017     6
       Japan            China       Australia            South Korea
       Hong Kong        Singapore   AsiaPac All Others                  4

Source: JLL estimates
                                                                        2

In key office markets across Asia Pacific, prime office yields          0
compressed significantly over the last decade, with the                        2008            2009             2010             2011            2012       2013          2014               2015       2016        2017
steepest compression of over 200bps in Sydney, Shanghai                                               Sydney               Singapore               Seoul     Shanghai                Tokyo          Hong Kong
and Hong Kong, and the smallest decrease of up to 100bps
in Singapore and Tokyo.                                                Source: JLL estimates
How will interest rate movements affect prime office yields in Asia Pacific? - JLL Research Report - The Investor JLL
How will interest rate movements affect prime office yields in Asia Pacific? 5

One would argue that prime office yields could start to rise      Fig 4: Office yield spread over financing cost in Asia Pacific cities (%)
should interest rates increase. We believe this broad-brush
assumption may not fully hold for all markets and the                                                                                                                                                                       140
                                                                                                                                     + 65 bps
outcome could be more nuanced. While financing costs fell          2.5
significantly from 2013, prime office yields did not fall by                                                                                                                                                                105
as much.                                                                                                     + 44 bps                                                                                         + 66 bps
                                                                   1.5                                                                                                                                                      70
Across Asia Pacific, when cost of financing decreased
sharply from 2013, yield spreads over the cost of debt took                       + 138 bps                                                                  + 103 bps                                                      35
                                                                   0.5
a step up. Yield spreads in 2013-2017 range from 30-240bps,
which are 50-140bps higher than the period in 2009-2012.                                                                                                                                                                    -
This could potentially be due to investors’ scepticism about      -0.5
the sustainability of low interest rates. Investors may have                                                                                                                                                                -35
started to account for higher longer term financing costs in
their asset pricing from 2013. As a result, prime office yields   -1.5             Sydney                 Singapore                    Seoul                 Shanghai                   Tokyo                Hong Kong      -70
did not fully reflect the compression in financing costs. One
could argue that this buffer allows some flexibility for cap                                                                       2009-2012                  2013-2017
rates to stay flat even if financing costs were to rise 50-140
bps over the next three years.                                    Source: JLL estimates. Note: For Shanghai and Hong Kong, cost of debt only fell from 2015 so we use 2008-2014 and 2015-2017 respectively

The exception is Japan, potentially because investors do
not expect interest rates to rise in the foreseeable future.
Prime office yields in Japan were at a 217bps spread above
financing costs in 2009-2012 and this remained unchanged
in 2013-2017.

                                                                                             Yield spreads widened from 2013 due to investors’
                                                                                            scepticism about sustainability of low interest rates
How will interest rate movements affect prime office yields in Asia Pacific? - JLL Research Report - The Investor JLL
6   JLL

How about financing spreads?

Furthermore, while base interest rates or government bond       Fig 5: Financing cost spread over government bond yields in Asia Pacific cities (%)
yields may rise over the next few years, financing costs may
not fully reflect that increase. In 2013-2017, asset owners                    - 90 bps                                                                            - 73 bps
across the region have been able to secure financing at         3.0
a lower spread over base bond yields than in 2009-2012,
as banks reduced their lending margins amid strong              2.5
competition. For this paper, we have used the average
financing cost secured by large landlords or listed REITs
where available.                                                2.0

Listed REITs in the region were also able to diversify their    1.5                                        - 83 bps
sources of funding to include multi-term notes, retail                                                                                                                                                   - 73 bps
bonds in addition to traditional bank loans. On average,
                                                                1.0                                                                                                                          + 13 bps
financing spreads are now 20-200bps above bond yields,                                                                                  - 34 bps
which is about 40-90bps lower than the 60-300bps
spread in 2009-2012. The only exception is Japan, where         0.5
financing spreads have stayed relatively unchanged. While
bond yields may rise over the next few years as central            0
banks raise policy rates, we think it is unlikely for lending
                                                                               Sydney                    Singapore                      Seoul                     Shanghai                    Tokyo     Hong Kong
margins in these developed markets to widen too far out
again. Margins are only expected to increase if the risks
associated with real estate, corporate defaults or bond                                                                      2009-2012                        2013-2017
market dislocations increase.
                                                                Source: JLL estimates. Note: For Shanghai, cost of debt only fell from 2015 so we use 2008-2014 and 2015-2017 respectively

                                                                                 Asset owners have secured financing at a lower spread
                                                                                          over bond yields in the last 5 years
How will interest rate movements affect prime office yields in Asia Pacific? - JLL Research Report - The Investor JLL
How will interest rate movements affect prime office yields in Asia Pacific? 7

What could happen to prime office yields as interest rates start to rise in the
next three years?

Based on economists’ views on government interest               Fig 6: Financing cost in Asia Pacific cities (%)
rates across Asia Pacific in the next three years, we expect
financing cost to rise by 30-130bps, potentially reverting to   10
2012-2014 levels. The exception is Japan, where economists
continue to expect the current low interest rate regime to
persist for the next three years.                                8

We have assumed the highest increase in financing cost
for Australian landlords of about 130bps to 5.5% in 2020,        6
close to 2014-levels, based on the 10-year Commonwealth
Government bond rate rising to 3.5% by 2020 and the
spread between financing cost and bond yields staying            4
at 200bps.

In Shanghai and Hong Kong, we assume financing cost              2
could rise about 100bps to 2013 levels. For Singapore,
we expect financing cost for landlords to rise to 2.95%,
close to 2011-levels but just 40bps higher than 2017 levels.     0
While economists expect US Treasury bond yields to rise to              2008        2009   2010     2011     2012   2013     2014       2015       2016        2017      2018E       2019E      2020E
c.3.5% by 2020, the Singapore 10Y government bond yield
is not expected to exceed 3.0% by 2020 after accounting                                    Sydney      Singapore     Seoul          Shanghai           Tokyo          Hong Kong
for historical spreads and some appreciation of the
Singapore dollar.                                               Source: JLL estimates
8   JLL

Office yields in 2018-2020                                        Fig 7: Prime office yields in Asia Pacific cities (%)
In our view, investors may have fully accounted for this          7.5
magnitude of increase in financing costs. As a result, in
Singapore, Seoul and Tokyo, we forecast prime office yields       7.0
to stay flat or rise only mildly in 2018-2020, after accounting
                                                                  6.5
for financing costs increasing in line with these expectations
(see Fig 7-12).                                                   6.0
                                                                  5.5
For Sydney, we expect prime office yields to increase by c.
50-100bps over 2018-2020 in tandem with rising financing          5.0
costs. For Hong Kong and Shanghai, our analysts expect
strong liquidity to result in mild compression of office cap      4.5
rates in the next few years.                                      4.0
                                                                  3.5
                                                                  3.0
                                                                  2.5
                                                                           2008         2009         2010         2011         2012         2013     2014     2015     2016   2017    2018E   2019E   2020E

                                                                                                     Sydney              Singapore               Seoul      Shanghai      Tokyo      Hong Kong

                                                                  Source: JLL estimates. NOI yields except Shanghai yields which are gross yields.
How will interest rate movements affect prime office yields in Asia Pacific? 9

Fig 8: Forecast prime office yield in Singapore (%)                            Fig 9: Forecast prime office yield in Seoul (%)                                      Fig 10: Forecast prime office yield in Sydney (%)
6.00                                                                           8                                                                                    10
5.50                                                                           7
                                                                                                                                                                     8
5.00                                                                           6
4.50                                                                           5                                                                                     6
4.00                                                                           4

3.50                                                                           3                                                                                     4

3.00                                                                           2
                                                                                                                                                                     2
2.50                                                                           1

2.00                                                                           0                                                                                     0

       2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020   -1 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018E2019E2020E
                                                                                                                                                                    -2
           Office REITs Cost of Debt      Spread          JLL Market Yield              AAA Bank Bond Yield        Yield Spread           JLL Market Yield

                                                                                                                                                                    -4     2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 20172018F2019F 2020F
                                                                                                                                                                                 Mid-point (A vs BBB)              Spread             CBD Prime

Fig 11: Forecast prime office yield in Tokyo (%)                               Fig 12: Forecast prime office yield in Hong Kong (%)                                 Fig 13: Forecast prime office yield in Shanghai (%)
4                                                                              8%                                                                                   10%

                                                                                                                                                                     8%
3                                                                              6%

                                                                                                                                                                     6%
2                                                                              4%
                                                                                                                                                                     4%
1                                                                              2%
                                                                                                                                                                     2%

0                                                                              0%                                                                                    0%
    2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018E 2019E 2020E

            Office REITs cost of debt     Spread          JLL Market Yield     -2% 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018E 2019E 2020E               -2%

                                                                                         Cost of Debt         Spread          Grade A Office Yields - Central        -4% 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018E2019E2020E

                                                                                                                                                                                 Cost of Debt             Spread               Gross Office Prime Yield

Source: JLL estimates
10 JLL

Singapore economy and bond yields
The Singapore economy expanded by 3.6% in 2017, the               bond yields. Consensus amongst economists indicate             Fig 14: 10Y government bond yields in Singapore and US (%)
highest growth since 2013. Unemployment eased in                  approximately 8-10% appreciation of the Singapore dollar
                                                                                                                                  7
4Q2017 and median gross monthly income rose 3% in 2017.           over the next four years and the SGD 10Y bond yield to rise
Consensus Economics forecasts 2018-2019 GDP growth                less than US treasury bond yields over the next three years.    6
of 2.7-3.0% as momentum in both manufacturing and                                                                                 5
exportable services continue.                                     Singapore government bonds had traded at a tighter
                                                                                                                                  4
                                                                  yields than US Treasury bond yields prior to 2012 due to
                                                                                                                                  3
With the Singapore economy and inflation picking up in            expectations of appreciation of the Singapore dollar. After
2018-2020, we expect the Central Bank to revert to a policy       2012, the weaker Singapore economy and moderation of            2
of slight appreciation for the Singapore dollar. This is likely   the SGD by Singapore’s Central Bank have caused the gap         1
to cushion Singapore bond yields from rising US Treasury          to close.
                                                                                                                                  0

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                                                                                                                                                                                       UST             SGD 10Y bond yield

                                                                                                                                 Source: Monetary Authority of Singapore, Thomson Reuters

                                                                                                                                 Fig 15: SREITs cost of debt vs 10Y government bond yield (%)
                                                                                                                                 4.0

                                                                                                                                 3.5

                                                                                                                                 3.0

                                                                                                                                 2.5

                                                                                                                                 2.0

                                                                                                                                 1.5

                                                                                                                                  1
                                                                                                                                        2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020

                                                                                                                                                                                 SGD10Y                                   SREIT cost of debt

                                                                                                                                 Source: Monetary Authority of Singapore, Thomson Reuters
How will interest rate movements affect prime office yields in Asia Pacific? 11

Financing costs for investors                                   Fig 16: Singapore prime office yields vs investors’ financing cost (%)
In 2008-2012, 3-4 year financing costs for Singapore office     6.50
REITs (i.e. CapitaLand Commercial Trust, Keppel REIT and
Suntec REIT) were 100bps above the 10Y SGD government           6.00
bond yield. But this narrowed to 30bps in 2013-2017, and        5.50
40bps currently, as they diversified their sources of funding
to include multi-term notes and retail bonds in addition to     5.00
traditional bank loans. We do not expect financing margins                  1.85        2.55
                                                                4.50
to expand dramatically over the next few years. We think
office REITs’ financing costs could rise 30-50bps over the      4.00                               0.61
next three years.                                                                                              0.68
                                                                3.50                                                      1.05                                                                                   0.84
                                                                                                                                                    1.81      1.25                                     0.89
What could happen to prime office yields?                       3.00                                                              0.91    1.81                          1.06      0.99      0.95

As interest rates fell significantly from 2013, Singapore
                                                                2.50
prime office yields did not fully reflect the compression.
Prime office yields traded on average 80bps above               2.00
financing costs in 2009-2012, but this widened to 120bps                   2007        2008       2009        2010        2011    2012   2013      2014      2015       2016      2017     2018       2019       2020
in 2013-2017. Potentially, investors were sceptical about
the sustainability of low interest rates and accounted                                                    Office REITs cost of debt                  Spread                       JLL market yield
for slightly higher longer term financing costs in their
acquisitions. As financing costs rise over the next three       Source: Singapore office REITs, Monetary Authority of Singapore

years, potentially, the yield spread could normalise to 80-
90bps, moderating the rise in prime office yields.
12 JLL

Korean economy and bond yields
Korea’s GDP grew 3.1% in 2017, the largest gain since 2014.   one or two interest hikes. However, many economists            Fig 17: Five-year government bond yields in Korea and US (%)
Solid export growth and facility investment led to the        forecast only three hikes ahead, unlike the Federal
                                                                                                                             10
firm growth. The Bank of Korea (BOK) economic outlook         Reserve – this denotes the bank will end its tightening at a
                                                                                                                              9
indicated the country’s economy would continue to             benchmark rate of 2.25%. Massive household debt, weak
                                                                                                                              8
expand at a decent pace in upcoming years – growing 3%        inflationary pressure, the appreciating Korean won and the      7
and 2.9% for 2018 and 2019, respectively, as robust export    accommodative fiscal policy will play a role in forcing the
                                                                                                                              6
growth continues and consumer spending improves.              bank to limit its monetary tightening.                          5
                                                                                                                              4
The BOK raised its benchmark rate by 25 bps to 1.5% in        Given the more aggressive interest rate hikes scheduled
                                                                                                                              3
November 2017, a sudden move that signalled an official       in the US – the Federal Reserve aims to end its tightening
                                                                                                                              2
end of the dovish monetary policy era. Since the increase,    cycle at 2.75% of the Federal Fund Rate – overall Korea
                                                                                                                              1
the interest rates of government bonds across maturities      yields are predicted to trade lower than the US yields
                                                                                                                              0
continue to ascend, already pricing in an additional          over the next few years. By adding 2.25%, the maximum

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                                                              benchmark rate at the end of the current interest hike cycle
                                                              to 40 bps, a historical spread between the BOK benchmark                                  5Y korean gov’t bond yield                                                   UST 5 years
                                                              rate and five-year government bond yield in the previous
                                                                                                                             Source: Dongbu Securities, Oxford Economics
                                                              interest rate hike cycle, we think that, at the end of the
                                                              current cycle, the Korea five-year government bond yield
                                                              could increase to the 2.65% mark, 65 bps up from the           Fig 18: Five-year AAA bank bond vs. five-year government
                                                              average 2017 yield.                                            bond yield (%)
                                                                                                                             6

                                                                                                                             5

                                                                                                                             4

                                                                                                                             3

                                                                                                                             2

                                                                                                                             1

                                                                                                                             0
                                                                                                                                  2010          2011          2012          2013          2014      2015          2016          2017 2018E 2019E 2020E

                                                                                                                                                       5Y AAA bank bond                                               5YR Korean gov’t bond yield

                                                                                                                             Source: Dongbu Securities, Oxford Economics
How will interest rate movements affect prime office yields in Asia Pacific? 13

Financing costs for investors                                       Fig 19: Korea prime office yields vs. AAA bank bond yield (%)
Since the cost of debt is not publicly available in Korea due to     8
its relatively small REIT market, we have chosen the five-year
AAA bank bond rate as a proxy for the cost of debt. Financial        7
institutions refer to the bank bond rate as their cost of funding                                  1.37
and employ the bond rate as a benchmark in setting their             6     0.61                               1.50
lending rate. Since 2010, the spread of the bank bond yields                                                              1.81
                                                                     5
over government bond yields has narrowed and stabilised at                                                                       2.23
around 20 bps. We believe the low interest rate environment                                                                             2.06
                                                                     4                                                                            1.99
coupled with the sanguine economic outlook ahead would                                                                                                      2.60                 2.29
                                                                                                                                                                      2.89
encourage yield-hungry bond investors to continue to                 3
purchase bonds, preventing the spread from widening.
Thus, we expect bank bond yields to increase in tandem with          2
government bond yields in 2018-2020, i.e. by around 65bps.
                                                                     1
What could happen to prime office yields?
                                                                     0
The Korea prime office yield hovered on average 170 bps                                0.41
above the bank bond in 2009-2012. Over the subsequent five          -1
                                                                          2007        2008        2009        2010       2011    2012   2013      2014     2015      2016       2017      2018E     2019E 2020E
years, the spread extended to 237 bps on average. Looking
closely at the historical spreads, they are well tied with                                                   AAA Bank Bond Yield               Yield Spread                  JLL Market Yield
two dominating forces: overall economic conditions and
liquidity. Excluding the period between 2007 and 2009 when          Source: Korea Financial Investment Association, JLL Korea
spreads became abnormal due to a sudden spike in bond
yield caused by the financial crisis, 2011, 2014 and 2017
stand out as years with low spread – they all feature resilient
economic growth and ample investment volumes.

We expect spread of office yields over financing cost to narrow
in 2018-2020, due to the solid economic outlook, strong
liquidity and the heightened interest from international and
domestic investors. We think the market is poised to test the
previous historical lows in the post-crisis period going forward
– this indicates the yield spread would shrink to around
180-200 bps. Therefore, prime office yields are expected to
increase marginally by around 5-10 bps per annum.
14 JLL

Japan economy and bond yields
The Japan economy is expected to have expanded by 1.6%
in 2017, marking the sixth year of positive growth after the   The unemployment rate for December 2017 was 2.8%.               Fig 20: 10Y government bond yields in Japan and US (%)
Great East Japan Earthquake. While growth was moderate,        While it crept up for the first time in seven months, the job
the trend of increased corporate investment continued,                                                                          7
                                                               offer ratio has increased for the third consecutive months
and private consumption also picked up. The Tankan             by 0.03 to 1.59. This reflects a serious labour shortage,        6
Diffusion Index which measures companies’ sentiment and        amid a gap between the personnel required by corporates          5
confidence in the economy rose to 25 point in 4Q17. This       and job seekers’ abilities. The Japanese government bond
marks the fifth consecutive quarter of improvement, and        yield has stayed at zero for a year, due to monetary easing      4
shows market confidence has recovered to a level similar       by the government.                                               3
to 11 years ago. The strong performance of corporate
                                                                                                                                2
performance against the backdrop of a solid global
economy boosted the business climate.                                                                                           1

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                                                                                                                                                                                          UST                            JP 10Y bond yield

                                                                                                                               Source: Oxford Economics, Thomson Reuters

                                                                                                                               Fig 21: JREIT cost of debt vs 10Y government bond yield (%)
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                                                                                                                               0.50

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                                                                                                                                                                                          JGB 10Y                        JREIT cost of debt

                                                                                                                               Source: Oxford Economics, Thomson Reuters
How will interest rate movements affect prime office yields in Asia Pacific? 15

Financing costs for investors                                 Fig 22: Japan prime office yields vs investors’ financing cost (%)
In 2009-2012, the average cost of debt for Japan office       4.50
REITs (i.e. Nippon Building Fund, Japan Real Estate
Investment, and Mori Hills) was 57bps above the 10Y           4.00
Japan government bond yield. But this widen to 70bps          3.50
in 2013-2017. We do not expect financing margins to
expand dramatically over the next few years, unless there     3.00
                                                                                                2.25          2.09   2.16
are changes in the current monetary policy.                                                                                 2.31
                                                              2.50                  2.06                                           2.40
                                                                        1.71
                                                                                                                                             2.19
What could happen to prime office yields?                     2.00                                                                                      2.06      2.15      2.14
As interest rates fell significantly from 2013, Japan prime   1.50
office yields mirrored the compression. Prime office
yields traded on average 220bps above financing costs in      1.00
2009-2012 and this stayed at 219bps in 2013-2017. Unlike
                                                              0.50
other Asia Pacific office markets, office yield spreads
over financing costs did not widen, potentially because           0
investors did not expect interest rates to increase in the              2007       2008        2009           2010   2011   2012   2013      2014      2015      2016       2017     2018E 2019E 2020E
foreseeable future.
                                                                                                       Office REITs cost of debt             Spread                  JLL Market Yield
Based on forecasts by Oxford Economics, the 10Y JGB
yield is expected to stay close to zero, keeping financing    Source: JLL, Each J-REIT’s Public Information
costs relatively stable over the next three years. We
expect prime office yields in Japan to stay at around 2.9%
over the next three years amid flattish financing costs.
Amongst Asia Pacific cities, Tokyo office yields’ spread
over financing cost is the widest, potentially due to low
expectations for growth. If these expectations change,
there is some potential for a structural change in office
yield spreads in Japan.
16 JLL

Australian economy and bond yields
The Australian economy expanded by 0.6% in 3Q17,                  The RBA is acutely aware of the economy’s transition after          Fig 23: 10-year Australian Treasury Bond yield vs US Treasury (%)
following an upwardly revised 0.9% in 2Q17. While growth          the mining boom to more broad based drivers, and has
                                                                                                                                      7
was marginally below market expectations (0.7%), y-y              maintained a stimulatory monetary policy stance so as
growth rebounded to 2.8% and continues Australia’s 26-year        to support this transition. Low wage growth and benign              6
run of uninterrupted economic expansion.                          inflationary pressures have also supported this policy.             5
                                                                  However, with the transition almost complete, and with
                                                                                                                                      4
The national jobs boom has maintained momentum                    economic growth, most economists expect that the cash
through 2017. Total employment increased by 3.3% in 2017          rate will be lifted during 2018.                                    3
and full-time employment growth accounted for 75% of                                                                                  2
total job creation in 2017. The labour force participation rate   The futures market expects a 25 bps rise in late 2018 and a         1
pushed to a seven year high of 65.7%, as better employment        further 25 bps by June 2019. If this eventuates, this will move
                                                                                                                                      0
prospects encouraged more people to try to enter the              the cash rate to 2.0%, which will be the highest rate in more

                                                                                                                                              2000
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                                                                                                                                                                                                                                                2014
                                                                                                                                                                                                                                                       2015
                                                                                                                                                                                                                                                              2016
                                                                                                                                                                                                                                                                     2017
                                                                                                                                                                                                                                                                             2018E
                                                                                                                                                                                                                                                                                     2019E
                                                                                                                                                                                                                                                                                             2020E
workforce. Nevertheless, wage growth remains subdued,             than three years. Bonds yields trended down in the December
suggesting there is still excess capacity in labour market.       quarter. The 10-year inflation-indexed Commonwealth                                          10-year US treasury bond yield
                                                                  Government bond rate fell to 0.93% in December (from 1.15%                                   10-year Australian Commonwealth Treasury Bond yield
The RBA has suggested full employment is consistent with          in September), but has moved back up to around 1% in
                                                                                                                                      Source: RBA, JLL estimates
an unemployment rate of around 5% and that a further              January 2018. This highlights the pressure on bond yields as
decline of 0.5% from the current 5.5% should see wages            some central bank, particularly the US Fed, start to unwind their
grow more substantially.                                          very large balance sheet expansion since the GFC. However, to       Fig 24: Estimated Australian REIT cost of debt vs bond yield (%)
                                                                  date, the process has been very gradual and orderly.
                                                                                                                                          5
With the headline inflation rate persistently below the
Reserve Bank’s target band of 2% to 3%, the monetary                                                                                      4
authorities left the overnight cash rate at 1.5% at their
February 2018 meeting, unchanged since August 2016.                                                                                       3

                                                                                                                                          2

                                                                                                                                          1

                                                                                                                                          0

                                                                                                                                                2007

                                                                                                                                                            2008

                                                                                                                                                                     2009

                                                                                                                                                                                 2010

                                                                                                                                                                                          2011

                                                                                                                                                                                                      2012

                                                                                                                                                                                                               2013

                                                                                                                                                                                                                           2014

                                                                                                                                                                                                                                    2015

                                                                                                                                                                                                                                                2016

                                                                                                                                                                                                                                                          2017

                                                                                                                                                                                                                                                                     2018E

                                                                                                                                                                                                                                                                                 2019E

                                                                                                                                                                                                                                                                                              2020E
                                                                                                                                                            Estimated REIT/Landlord Cost of Debt
                                                                                                                                                            Hong Kong Exchange Fund Note (10 Year)

                                                                                                                                      Source: RBA, JLL estimates
How will interest rate movements affect prime office yields in Asia Pacific? 17

Financing costs for investors                                    What could happen to office yields?                               benchmarks. The spread between Sydney CBD prime
                                                                                                                                   yields and the real risk-free rate is currently 398bps, or
Given that a number of Australian REITs (A-REITS) have S&P       Sydney CBD prime office yields are currently in unchartered
                                                                                                                                   33bps wider than the historical average benchmark of 365
credit ratings ranging from BBB+ to A-, we have adopted a        territory with the prime yield high-low range compressed
                                                                                                                                   bps. JLL believes that the Sydney CBD yield compression
midpoint between A-rated and BBB-rated 10-year Australian        to just 37bps, at 4.63% - 5.00%. The strong rental growth
                                                                                                                                   cycle is approaching its end. However, current momentum
corporate bond yields as a proxy for the cost of debt. The       assumptions being priced in by investors coupled with
                                                                                                                                   from global capital markets and strong local market
average spread between the estimated cost of debt for            record low Commonwealth Treasury bond yields have
                                                                                                                                   fundamentals are expected to persist in the near term,
AREITS and the 10-year Australian Commonwealth Treasury          resulted in compression of both the upper and lower bound
                                                                                                                                   creating modest scope for further prime yield compression.
bond yield has been 258 bps over the last 10-years which         of the prime CBD office yield.
                                                                                                                                   The tighter end of the prime yield range is expected to reach
of course includes the volatile 2008-2010 period. This
                                                                                                                                   4.50% by the end of 2018, with a gradual decompression
spread has however reduced to 204bps bps over the last           Although yields are at unprecedented levels, the spread
                                                                                                                                   cycle to commence in 2019.
5-years. The decline in the spread is largely due to increased   between Sydney CBD office yields and the real risk-free
demand for higher yielding corporate debt issuances,             Government 10-year bond rate remains wider than historical
and the current lower-for-longer global financial returns
environment.                                                     Fig 25: Sydney CBD prime office yields and 10-year Australian corporate bond yield (%)

The recent reduced spread is expected to remain in the near      12
term as regulatory bodies slowly unwind fiscal stimulus
                                                                 10
policy as the domestic and global economy improves. As
domestic interest rates move out, the estimated AREIT cost
                                                                  8
of debt is expected to move out accordingly. Many rated
A-REITs have accessed debt funding from the liquid US             6
markets. Hence, investment hurdle rates in the local market
are not determined entirely by domestic factors. These            4
lower US rates and hedging costs are not taken into account
in the above AREIT cost of debt estimation.                       2

                                                                  0

                                                                 -2

                                                                 -4    2007        2008      2009    2010    2011    2012   2013     2014      2015       2016      2017      2018E      2019E 2020E

                                                                                                    AREIT Cost of Debt                 Spread                  JLL Prime Yield
                                                                 Source: JLL Research, RBA
18 JLL

Hong Kong economy and bond yields
Supported by strong global trade and higher-than-expected       strengthening Renminbi, inflation is set to quicken from           Fig 26: 10-year Exchange Fund Note vs US Treasury (%)
economic output from mainland China, Hong Kong’s                1.5% in 2017 to return above 2.0%, albeit still well below the
economy grew by 3.8% in 2017, a significant improvement on      annual average of 3.3% recorded over the previous 10 years.         8
the 2.0% recorded in 2016 and the strongest year of expansion                                                                       7
since 2011. Yet growth is likely to ease as we head into        Ample liquidity in the local money market and strong                6
2018. With domestic demand forecasted to weaken against         demand for fixed-income securities has contributed to 10-           5
moderating growth on the mainland, rising interest rates        Year Exchange Fund Notes issued by the HKMA trading at              4
and an elevated property market, the consensus view is for      yields below US 10-Year Treasuries since 2004. More recently,       3
economic output to slow to 2.8% in 2018 and 2.6% in 2019.       the tighter yields also reflect the lower default risk perceived
                                                                                                                                    2
                                                                by investors. US government debt to GDP has ballooned by
                                                                                                                                    1
The labor market continues to be near a state of full           more than 55% over the last 10 years and stood at about
                                                                                                                                    0
employment with the seasonally adjusted unemployment            105% in 2017. In contrast, JLL estimates that Hong Kong

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                                                                                                                                                                                                                                                                2017
                                                                                                                                                                                                                                                                        2018E
                                                                                                                                                                                                                                                                                2019E
                                                                                                                                                                                                                                                                                        2020E
rate tightening to 2.9% between October and December,           government debt (including HKMA’s Exchange Fund Notes)
a 20-year low. Despite the expectations of slower growth        amounted to only 40% of GDP in 2017. Bond yields have                                  US 10 Year Treasury
ahead, results from an array of business sentiment surveys      been steadily rising in tandem with the tightening in US                               HK Exchange Fund Note (10 Year)
suggests that the private sector remains upbeat about           monetary policy since 2016.
                                                                                                                                   Source: Oxford Economics, JLL estimates
the city’s business prospects in 2018. Coupled with a
                                                                                                                                   Fig 27: Estimated Hong Kong REIT/Landlords Cost of Debt
                                                                                                                                   vs US Treasury (%)
                                                                                                                                     5

                                                                                                                                     4

                                                                                                                                     3

                                                                                                                                     2

                                                                                                                                     1

                                                                                                                                     0

                                                                                                                                          2007

                                                                                                                                                       2008

                                                                                                                                                               2009

                                                                                                                                                                            2010

                                                                                                                                                                                    2011

                                                                                                                                                                                                 2012

                                                                                                                                                                                                          2013

                                                                                                                                                                                                                      2014

                                                                                                                                                                                                                               2015

                                                                                                                                                                                                                                           2016

                                                                                                                                                                                                                                                    2017

                                                                                                                                                                                                                                                                2018E

                                                                                                                                                                                                                                                                           2019E

                                                                                                                                                                                                                                                                                        2020E
                                                                                                                                                       Estimated REIT/Landlord Cost of Debt
                                                                                                                                                       Hong Kong Exchange Fund Note (10 Year)
                                                                                                                                   Source: Oxford Economics, JLL estimates
How will interest rate movements affect prime office yields in Asia Pacific? 19

Financing costs for investors                                    2016. Investor expectations for further rental growth—the
                                                                 vacancy rate in the Central Grade A office market stood
Owing to Hong Kong’s relatively small market for
                                                                 at just 1.7%—and still low borrowing costs should also
government bonds and the currency peg between the
                                                                 continue to weigh on yields.
Hong Kong dollar and US Greenback, corporate bond
yields generally benchmark against a spread over HIBOR.
                                                                 Still, JLL believes that the current yield compression cycle
However, there is no complete historic data on spreads
                                                                 is nearing its end. After reaching a low in 2018, Grade A
and anecdotal evidence has shown that it is not stable.
                                                                 office yields expected to flatten out before steadily rising
As such, JLL has taken the average corporate bond yield
                                                                 from 2020 onwards. In Central, yields are likely to remain
of Hong Kong’s major REITs and landlords to estimate the
                                                                 at a lower level for a slightly longer period owing to strong
cost of debt.
                                                                 demand from mainland Chinese investors targeting trophy
                                                                 assets in the city’s CBD.
Strong capital inflows, along with the commencement of
the Mainland-Hong Kong Bond Market Connect, which
allows for cross-border bond trading between the markets,
has kept the local money market awash with liquidity.            Fig 28: Hong Kong Grade A Office Yields vs Financing Costs (%)
Consequentially, the cost of debt has plummeted to below         7.0
2.0%. Notwithstanding, JLL expects financing costs to
steadily rise in line with US interest rates. However, owing     6.0
to strong capital inflows any increase in financing costs will             2.08
likely be moderate; up by about 80bps over the next three        5.0
                                                                                                    0.39
years.                                                                                 1.27
                                                                 4.0
                                                                                                                             0.01        0.32
What could happen to office yields?                              3.0                                        1.01
                                                                                                                      1.14                          1.28       1.68       0.97
Despite reaching unprecedented lows, JLL believes that           2.0
Grade A office yields still have room to compress further
even as interest rates start to rise. Investment into the        1.0
Grade A office market reached a record USD 16.5 billion             0
in 2017, up about 50% from a year earlier. Mainland
Chinese buyers returned to the market in the second half         -1.0     2008        2009          2010   2011       2012   2013       2014       2015       2016       2017      2018E       2019E      2020E
of 2017 and were again prominent in the city’s biggest
transactions. The uptick in activity is a reversal of the drop                                         Cost of Debt                 Spread                   Grade A Office Yields - Central
we observed following China’s implementation of capital
                                                                 Source: Bloomberg, JLL estimates
controls on outbound real estate investments in late
20 JLL

China economy and bond yields
China’s GDP rose to RMB82.7 trillion in 2017 as growth        The People’s Bank of China (PBoC) made no changes to              Financing costs for investors
accelerated to 6.9% y-o-y compared to 6.7% in 2016, beating   benchmark interest rates in 2017, leaving the one-year
                                                                                                                                Since the cost of debt is not publicly available in China, we
expectations. Most of the economy’s resilience can be         benchmark lending rate flat at 4.35% since Nov. 2015. Most
                                                                                                                                have chosen the weighted average of interest rates of bank
attributed to the services sector, whose growth accelerated   economists agree that China’s government will eventually
                                                                                                                                loans to non-financial institutions and other sectors as a
to 8.0% y-o-y, up from 7.7% in 2016.                          need to raise rates to deal with risks that rising leverage may
                                                                                                                                proxy for the cost of debt. The rates decreased significantly
                                                              pose to the country’s banking system.
                                                                                                                                by 190 bps between 2014 and 2016 and picked up in 2017 by
                                                                                                                                49 bps to 5.76%.
                                                              However, there remains a possibility that the timing for
                                                              rate increases could be delayed, as the leadership recently
                                                                                                                                It is worth mentioning that real estate financing in China
                                                              showed signs of wariness that applying tightening measures
                                                                                                                                currently stands at a crossroads, especially for Chinese
                                                              too rapidly could produce a sharper economic slowdown
                                                                                                                                domestic investors, who are playing an increasingly
                                                              than the government is willing to tolerate.
                                                                                                                                important role in the investment market. They have started
                                                                                                                                to combine traditional approaches of securing financing
                                                                                                                                (such as bank loans) with newer methods. For instance,
                                                                                                                                as China relaxed rules for the sale of mortgage and asset-
                                                                                                                                backed securities, securitization, which is still in its nascent
                                                                                                                                stage in China, hold considerable potential for developers
                                                                                                                                and investors. Such new methods will help investors to
                                                                                                                                diversify their sources of funding.
How will interest rate movements affect prime office yields in Asia Pacific? 21

What could happen to prime office yields?                        Fig 29: Shanghai Gross Office Yields vs Financing Costs (%)
Due to the robust net take-up in the office leasing market         10
and strong investment interests from a wide range of
investors, gross market yield compressed 31 bps over the
past three years in Shanghai. Going forward, we expect               8
prime office yield to compress mildly by 8 basis points in
2018-2020. This is based on the following factors: 1) leasing        6
demand will remain strong as the city is in the process of
building into a global city; 2) rental outlook for the mid- to
long-term is very positive; and 3) investors will become more        4
diverse including Chinese insurance companies, the rapidly
growing ABS/CMBS market and foreign core investors.                  2

                                                                     0

                                                                    -2

                                                                    -4    2008        2009          2010     2011     2012   2013       2014       2015       2016        2017      2018E      2019E      2020E

                                                                                                           Cost of Debt               Spread                    Gross Office Prime Yield

                                                                 Source: Bloomberg, JLL estimates
22 JLL
How will interest rate movements affect prime office yields in Asia Pacific? 23

Authors

Regina Lim                                         Denis Ma
Head of Capital Markets Research, Southeast Asia   Head of Research, Hong Kong
Regina.Lim@ap.jll.com                              Denis.Ma@ap.jll.com

Takeshi Akagi                                      Sungmin Park
Head of Research, Japan                            Head of Research, Korea
Takeshi.Akagi@ap.jll.com                           Sungmin.Park@ap.jll.com

Andrew Ballantyne                                  Joe Zhou
Head of Research, Australia                        Head of Research, China
Andrew.Ballantyne@ap.jll.com                       Joe.Zhou@ap.jll.com
24 JLL

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