With the U.S. Fed Reserve continuing along a path of steady interest rate hikes, it’s interesting to take a look at how markets in the Asia Pacific are being affected. While most central bank in the region have been relatively quiet over the past six months, the Bank of Korea lifted their base rate by 25bps in November, and the People’s Bank of China (PBOC) lifted their 7-day and 28-day reverse repo rates in December.
Despite relative stability in the shorter-term rate markets in Asia Pacific, there has been much more movement at the long end of the benchmark curves. Almost all prime APAC markets have seen their swap curves lift over the past six months, albeit by varying levels. Hong Kong has seen the largest movements across the curve given their inherent link to the U.S. rate market. Singapore and Korea have also experiences some modest movements, while Australia has been slightly more muted. Japan is the outlier in the region and a long-way back in the rate cycle with the Bank of Japan stating they remain committed to their asset purchase program and yield curve controls.
These rates movements are having an impact on regional commercial real estate markets in a number of ways. These benchmark curves are used for interest rate fixing costs so we are seeing some upward pressure on rate fixing. Certainly there is the anticipation that we are entering into an interest rate cycle and therefore investors are looking at the spreads between their cap rates and financing cost.
Underwriting deals will also need to focus more on income growth rather than an assumption around cap rate compression. On the cap rate front, investors have been more disciplined in this cycle and have allowed the spread between cap rates and benchmark rates to widen. This spread is being compressed due to upward pressure on benchmark rates however the margins remain wide relative to the previous cycle.
On a positive note, the underlying drivers of short-term interest rates are highly correlated to the same drivers of commercial real estate income streams. Indicators like employment and consumption growth are positive indicators for office and retail markets – and of course put pressure on aggregate demand and therefore inflation and interest rates.
We have undertaken a study on the correlation between office market rents and short-term interest rates in the Asia pacific region and have found there is a strong correlation. During periods of rising short-term interest rates, office market rents are consistently in growth mode which over the long-run can help to offset cap rate decompression. The below chart shows the one year change in short-term interest rates relative to the one year change in office rents. Both indicators are weighted to AP market size (rental growth is lagged 2 quarters).
Rental growth is correlated to short-term interest rates (2000-2018)
Finally, the recent movement in global interest rates is having an impact on foreign exchange markets. FX has been more volatile than usual and the interest rate differential between various markets is shifting more rapidly. One example of this has been the relative interest rates between Australia and the US. For the first time in 16 years, interest rates in the U.S. are now above that of Australia (both short term interbank rates as well as longer dated swaps and government bonds).
This is extremely important from a currency hedging standpoint. Interest rate differentials are the key pricing input of forward swap contracts and other FX hedging derivatives. There are some other idiosyncratic characteristics that go into hedge pricing but the key deterrent for hedging into market like Australia has often been the high interest rate structure.
As this is no longer the case relative to the USD, the forward points for the AUD/USD contract have recently turned positive – again for the first time in over 15 years. This makes cross-border investing into Australia much more digestible for USD based investors. This also opens up new opportunities for debt investors into Australia who can take advantage of the high lending margins on offer without having to lose the gain on FX hedging.