The big squeeze
Are rising interest rates and low capitalisation rates making you nervous?
Owen Cooney from OC Consulting advises investors on how to withstand “yield squeeze”.
Photo Jahl Marshall
Commercial property has been a passion of mine for decades, but the economic environment we are all accustomed to operating in is changing.
For as long as I can remember, there has been a differential between the interest rate paid on mortgage debt and the yield (or capitalisation rate) received from a property. However, with interest rates now rising, the cost of debt will soon be similar to, if not greater, than the capitalisation rates a commercial property can reasonably generate.
In recent years it has been common to use debt to increase yield to an investor because that debt was so cheap. But thanks to inflationary pressures and rising interest rates, investor yields are being squeezed – and will continue to be squeezed until the market adjusts.
These comments are, of course, a generalisation. There are always markets where some purchasers will happily accept a very low capitalisation rate for a particular property. It’s also worth pointing out that investors who don’t need to take on debt to purchase a commercial property will not feel that same squeeze!
But the investor collectives we help set up at OC Consultancy Ltd do use non-recourse debt and will continue to do so. Instead of leveraging a property at 45 percent to 50 percent of LVR, we now intend to leverage at around 30 percent to ensure the smoothest path forward as New Zealand’s Reserve Bank battles to bring inflation back under control.
In our post-pandemic climate, there’s no escaping yield squeeze for the foreseeable future. But our message to investors is this – yields are only one factor that should be considered when making an investment decision.
You may be familiar with the advice of Warren Buffett regarding investment as a long-term game. Buffett famously said, “If you aren’t willing to own a stock for 10 years, don’t even think about owning it for 10 minutes.” Unfortunately, in our recent bull market, this message has been forgotten by many.
In the commercial property context, our focus is on securing long-term leases with good quality tenants and covenants. This, coupled with robust rent review mechanisms, is the best way to protect your investment from the effects of inflation and yield squeeze.
To be a successful property investor, you must look beyond what’s happening right now and see what is most likely to occur in the future.
We are confident that good commercial property will stand the test of time and be resilient. Just like any other investment, you must be prepared to weather the ups and downs of each economic cycle and keep your eyes firmly on the horizon of what’s to come.
The right building, with the right tenant and the right lease arrangements in place, will always be profitable in the long run.