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Do Yields Reflect Property Market Fundamentals? Tony McGough (City University Business School) Sotiris Tsolacos (Jones Lang LaSalle) Real Estate Finance and Investment Research paper No. 2001.01
March 2001

ISBN 1-903834-06-6

Do yields reflect property market fundamentals? Abstract

Property yields are a significant input in property valuations, property development decisions and other functions in real estate analysis and consultancy. Trends in property yields are also a means to study investment behaviour and attitudes within the property market. The construction of models that track the historical variation in property yields improves our understanding of the determinants of yields and provides the basis for their forecasting. The usefulness of such research is of significance to real estate analysts and professionals. Current work in Europe has paid little attention to the empirical investigation of yield movements. A UK study by Tsolacos, Keogh and McGough (1998) modelled yields but the authors identified significant econometric difficulties compared with the modelling of rents and new construction. In other European countries the subject has not been researched but the major property consultancy companies do attempt yield analysis and modelling. The US literature has examined this issue in more detail. A number of studies have provided significant insight on the determination of yields and the relative importance of property and capital market factors (Sivitanidou and Sivitanides, 1999; Jud and Winkler, 1995). The present study aims to model property yields in the UK at the national level. It focuses on office property yields. A theoretical model of office yields is constructed in which the investors target rate of return and expectations about rental growth are key elements. Within this model the relative importance of the property market factors and wider capital market influences is examined. This is an important task since the empirical investigation will show the extent to which property market fundamentals underlie yield movements in the UK. At a second stage the study evaluates the forecast performance of the model. This is a task that has been overlooked in the existing literature. The study also aims to identify other more qualitative and institutional factors that have an effect on property yields and examine their relevance in forecasting. Keywords: property yields, property and capital market influences, econometric modelling, forecasting

Do yields reflect property market fundamentals?

1. Introduction In the past decade, there has been a rise in the amount of econometrical analysis of the property markets throughout Europe. This advancement in the technical understanding of the workings of the market itself, its cycles and interactions with countries overall economic well being has concentrated mainly on the modelling and forecasting of commercial properties rental growth. This has led to a detailed understanding of the area, and with the use of more sophisticated econometric techniques, the development of these models have brought forward the clear linkages within the property market and the economy as a whole. However, rental growth is only one part of the driver to propertys total performance as an investment asset. Although we have much information of what affects yields and how yields are constructed, empirical investigation has not reflected this. Work on understanding, modelling and, in particular, forecasting of property yields is an area which has received minimal analysis within Europe. This paper presents an initial analysis of yields, in the hope that it will help investigate the relationship and links between capital markets and property markets. In particular the paper looks at the drivers of yield movements to answer the question is the underlying property market responsible for movements in yields or is it the wider investment market. Thus, this paper will look at the general property market, as measured by IPD initial yield to obtain a general insight into the drivers of yields. This study also hopes to attempt to forecast yields and tests the forecasts stability to see if this is a practical aim within the field. It is interesting to observe that forecasting is completely absent from the existing empirical work. The main implication of this is that we do not know to what extent more complicated models, which are based on several series, perform in relation to simpler models. This paper will now take the following format. In section 2, we discuss the existing literature in this area. Section 3 discusses the modelling methodology used in this paper. Section 4 presents the results of the different econometric techniques attempted, whilst section 5 considers the forecasting performance of the selected models. Section 6 concludes the paper

2. Existing models and results Within the UK and Europe as a whole there is minimal work in this area. The RICS report, The Property Cycles (1994) presented a modelling approach to yields. It looked at forecasting the Hillier Parker all property yield and for each sector, the yield gap that is the difference between the sector yield and all property yield- over the period 1964-1992 and across regions. Though there were limited test statistics, the results provided very high levels of explanatory power (up to 96%). There was an attempt in these models to bring in the financial elements, and for the All Property yield, the main drivers were found to be lagged yields and a mixture of macro and property variables including inflation, interest rates, long bond yields, commercial orders, net property investment and returns. The yield gap was explained by its lags, and capital value or returns with a lead of 1 year.

This was seen as explaining the market well, as at the national level it was felt yields were driven by more than purely property variables, whilst regional/sector differences were more likely to be explained by expected future performance. As such, the models seemed intuitively correct. No analysis was made of the forecasting ability or stability of the models over the period. In Keoghs model (Keogh 1994) and Tsolacos et al (1998) it is argued that yields reflect conditions in the property investment market that will affect development. In the latters model, yields were implicitly incorporated into the models used but there were no explicit forecasting of the yields themselves. In the US there has been more extensive analysis of the yields. These can be generally divided into 2 camps, those that investigate the links to national economic variables and that analyising the locational influences. Of the former, Nourse (1987) compared changes to capitalization rates in relation to changes in tax regimes, whilst Froland (1987) looked at the effects of such things as corporate earnings:price ratios and treasury rates, but using cross-sectional not time series in the analysis. Chandrashekaran and Young (2000) use the S&P 500, inflation measures and inflation and default spreads to create sector models which are then used to test predictive power, though their results are disappointing at present. Sivitanidou and Sivitanides (1999) looked at office capitalization rates across metropolitan locations. It finds that there are local effects, time variant local effects and national economic effects. The local effects include the office employment base and the tenant mix, whilst the time variant effects include office space absorption and vacancy rates. Ambrose and Nourse(1993) also find a regional effect (North, South ...) as well as a sectoral effect on top of the standard national economic variables. Both the data availability and more advanced nature of research in the US have facilitated a more extensive analysis of the data than at present in the UK. Whilst this paper does not propose to consider the full nuances analised in the papers above, it will attempt to consider the macro effects on UK property yields, and also produce forecasts to consider the strength and stability of these models. 3. Methodology Yield determination The theoretical analysis of yield determination presented in Fraser (1994) and Brown and Matysiak (2000) is adopted to construct a model of yields that will dictate the empirical specification of property yield determination (in the property pricing model of Fraser and the periodic growth model presented in Brown and Matysiak). The rental income yield (expressed in percentage terms) for a freehold rack-rented property that accrues a fixed income is
Y= RENT x100 P

(1)

where Y is the rental yield, RENT is the fixed rental income and P is the market value of the property.

As it can be seen in the analyses of Fraser and Brown and Matysiak, the basic discount cash flow model can be stated as follows in the case of properties that are let on long leases and are subject to rent reviews periodically: P0 =
T T RENT RENT (1 + g ) T RENT (1 + g ) 2T + + + .... m (1 + r ) T +m (1 + r ) 2T + m m =1 (1 + r ) m=1 m =1 T

(2)

where P0 is the present value of the future rental stream, T is the period between rent reviews, g is the constant growth rate in the rental income each period (f.i.each year) and r is the discount rate that is assumed to remain constant through time. In equation (2) the term RENT(1+g)T represents the discounted rental growth. This according to Fraser simplifies into:

P0 =

RENT (1 + g ) T 1 r r (1 + r ) T 1

(3)

and given equation (1) the following rental yield formula is derived: (1 + g ) T 1 Y = r r (4) (1 + r ) T 1 Therefore equation (4) suggests that yields are a function of the rental growth rate g, the required or discount rate r and the time interval T between rental reviews. An empirical investigation of the relationship of yields and these variables can take place within the framework of equation (5): Y = ( g , r ,T ) + t where t allows for random and independent shocks. The term g can be measured in different ways. Long-term average growth rates can be used or the more recent growth rates or predictions of rent growth rates. The discount rate can be proxied among other measures by short-term interest rates, yield on government or corporate bonds and the dividend yield. Models (i) Vector autoregressions with error correction mechanisms The main methodology in the existing literature to examine this relationship is regression analysis. As it was shown in the previous section authors have conducted work with different discount rates and rental income growth rates. (5)

This study aims to model all property yields and investigate the relationships between yields ant these variables as shown by equation (5) based on three different methodologies. The first methodology examines the possibility of long-run relationships between yields and the variables that explain yields. Economic theory often suggests that a group of economic variables should be linked by some long-run equilibrium relationship. Although these variables may drift away from their long-run path, economic forces are expected to restore equilibrium. In the case of a long-run relationship a vector error correction model (VECM) of yields will be formulated in order to model and forecast property yields. If yields and other variables are integrated of the same order and cointegration tests identify long-run relationships between property yields and the rental growth rate and the required rate of return then the estimated VECM will take the following general form:

The unrestricted VAR model can be written as a vector error correction model (VECM):
Yt = A + i Yt -i + ECM t 1 + ut
i =1 m

(6)

where the vector Y is a vector which includes the variables that cointegrate and the ECM is the error correction mechanism term. The tests for cointegration are based on Johansens approach (Johansen, 1988 and Johansen and Juselius, 1990) which establishes the presence of distinct cointegrating vectors in non-stationary time series. In addition the Engle and Granger (1987) procedure is also applied as a further test of cointegration. Cointegration is accepted only if both procedures indicate so. In the case that variables do not cointegrate, a vector autoregression model will be formulated with stationary variables. The general form of this model is similar to that presented in equation (6) without the error correction term. (ii) ARIMA model The ARIMA methodology aims to identify and estimate a model that might have generated the series of interest using the available data. The series is then modelled as a combination of both autoregressive and moving average components (AR and MA components). If a series follows a k thautoregressive stochastic process then its value at time t depends on its values k periods in the past and a random term. The MA component captures the effects of past random shocks or error terms on the series. Therefore in ARIMA terms the time-series is a linear function of past actual values and random shocks. The objective is to model the series so that the residuals are white noise. In an ARIMA (p,d,q) specification, p refers to order of autoregression, q to the order of moving average and d indicates the order of integration. If a time-series is stationary (I(0)) then the ARMA notation is used instead of ARIMA which denotes integrated time-series. Applying the general ARIMA process in the case of yields the following model is estimated in the present Study:
Yt = a + 1Yt1 + 2Yt 2 + ... + Yt + 1u t 1 + 2 ut 2 + ... + q ut q + t

(7)

where Y is property yields and ut-i represent the past shocks that affect yields at time t. The inspection of the autocorrelation and partial autocorrelation coefficients guides the order of AR and MA terms to be tested in (7) and the final order of the ARIMA is based on the minimisation of the Schwarz criterion.

(iii) The regression model The third specification is a regression model of yields. This model assumes that the main driver of yields is rental values. Given the characteristics of the yield series it is also assumed that current yields are partially determined by their past values. This simple regression model takes the following form:
n m

Yt = a 0 + i RENTt i + jYt j + t
i =0 j =1

(8)

These three methodologies are then used to forecast monthly yields six months ahead. Ex post forecasting analysis is made for two six-month periods: 1999:4 to 1999:9 and 1999:10 to 2000:3. The predictive performance is then evaluated by the commonly used tests the mean absolute per cent error and the root mean squared percent error. Following the ex-post forecasts and their evaluation, ex ante forecasts are presented for the period 2000:4 to 2000:9. Data series description The property yield data used in this study refer to the initial yields published by IPD in their monthly index. The rental data are also IPD data. The rental growth is measured as the percentage change in IPD rents Two measures of the discount or required rate are used. The first measure is the yield on the tenyear gilt and the second measure is the ten dividend yield on the FT Actuaries all share index. Both series are obtained from Primark Datastream. Notation Y: IPD initial yield RENT: Percentage growth of IPD all property rents GY: Yield on ten-year gilts DIVY: Yield on FT Actuaries all shares

4. Results The IPD initial yield series is series is plotted in Figure 1 and summary statistics are given in Table 1. As it is illustrated in Figure 1 initial yields exhibited their lowest value in the late 1980s. From the beginning of the 1990s until mid-1993 yields rose and since they have shown a downward trend.

Figure 1: IPD initial yield series

10

4
19 87 :0 19 1 87 :08 19 88 :03 19 88 :10 19 89 :05 19 89 :1 19 2 90 :07 19 91 :02 19 91 :09 19 92 :0 19 4 92 :11 19 93 :06 19 94 :01 19 94 :08 19 95 :0 19 3 95 :10 19 96 :05 19 96 :12 19 97 :0 19 7 98 :02 19 98 :09 19 99 :04 19 99 :11

Table 1: Summary statistics

Yield value: December 1986 Yield value: March 2000 Mean Minimum (Date) Maximum (Date) Standard deviation Jarque-Bera normality test Skeweness Q-Statistic 1 (levels, 12 lags) Q-Statistic (1st differences, 12 lags) ADF2 test (levels) ADF test (1st differences) 6.00 6.58 7.06 5.03 August 1987) 9.01 (May 1993) 1.11 8.32 (p=0.01) -0.30 1617.5* 367.64* -2.01 -2.20**

1 Ljung Box Q-statistic for autocorrelation. 2 Dickey and Fuller tests for unit roots. The presence of a constant, a trend
and the number of augmentations in these regressions is determined by the Schwarz criterion. * significant at the 1% level ** significant at the 5% level. Sample period: December 1986 March 2000

The mean value of the series has been 7.06 per cent and the standard deviation is 1.11%. This suggests that the series shows a variation of about 17% around its mean. The lowest value of the yields (5.03) was achieved at the beginning of the property market boom in the late 1980s and the

highest value in the aftermath of this boom when the property market went into a severe and prolonged recession [Figure 1]. The information in Table 1 also shows that the distribution of the values of the yield series does not have the characteristics of a normal distribution. The probability of the Jarque-Bera statistic is too small to accept the hypothesis of normality. Also, the distribution of the yield values is left skewed compared with the normal distribution. The computed Q-statistics indicate that the yield series is highly autocorrelated. This is a common problem with appraisal based data that has modelling implications. The fact that the data is of monthly frequency accentuates the problem. When first differences are taken autocorrelation is reduced, but as it is suggested by the Q-statistic it is still present. The final test, on the presence of a unit root in the series, indicates that in levels the yield series has a unit root but the ADF test indicates stationarity in first differences. In the first stage of the empirical analysis tests for the presence of cointegrating relationships between property yields and the rental growth rate, the yield on ten-year gilts and the dividend yield are undertaken. Initially the order of integration of the variables is examined. Table 1 showed that property yields are of order 1, that is the series does not have a unit root when it is differenced. ADF tests were applied to the other series. These tests showed that in levels these series are not stationary. The exception was the yield on ten-year gilt series that appeared to be stationary at the 10 per cent level when a trend and a constant was included. In first differences all series are stationary at the 5% level of significance as Table 1 shows. The yield on ten-year gilts was also differenced in order to achieve stationarity at the 5 per cent level of significance. Table2: Tests for unit roots
Variable Yield on 10 year gilt (1st differences) Dividend yield (1st differences) Rent growth (1st differences) ADF tests -10.33* -10.61* -17.41*

* denotes significance at the 1% level The application of cointegration tests showed that a cointegrating relationship can be found between the property yield series and those of ten-year gilt yields and dividend yields. Table 3: Cointegration results: Property yield, ten year gilt and dividend yield
Number of cointegrating equations None At most one At most two ** significant at 5% level
Johansen tests were run with a linear deterministic trend in the data and four lags

Likelihood ratio 33.98** 10.30 1.87

Critical values 5% 29.68 15.41 3.76 1% 35.65 20.04 6.65

ADF on residuals of cointegrating equation -2.13** -

The Johansen test shows that the hypothesis of no cointegrating relationship between these variables can be rejected at the 5% level. The application of the ADF tests for unit roots in the residuals of this cointegrating relationship indicates stationarity and confirms the results of the Johansen test. Therefore a vector error autoregression model (VECM) can now be built to explain and forecast

property yield movements. The preferred VECM is given in Table 4. The number of terms included in the system is determined by the minimisation of the Schwarz criterion. This model explains about 58% of the variation in yields and the F-test is significant at the 1% level confirming the overall significance of the terms in the VECM. It is interesting to note however that the error correction term is not statistically significant which means that it may not have the expected significant effect on the determination of yields since the model is derived from a long-run relationship. Table 4: Error correction model of property yields
Variable Constant Y(-1) Y(-2) Y(-3) GY(-1) GY(-2) GY(-3) DIVY(-1) DIVY(-2) DIVY(-3) ECM Dependent variable: Y Coefficient 0.001 0.26 0.16 0.45 0.02 -0.02 0.06 -0.003 0.10 -0.04 -0.003 t-ratio 0.3 3.6 2.3 6.1 1.1 -1.4 3.3 0.1 3.5 1.4 1.1

R-bar squared: 0.58 F-statistic: 21.96 ADF on residuals: -12.79 (significant at the 1% level) The error term is: -6.13 + Y(-1) + 2.57GY(-1) - 5.73DIVY(-1)
Sample period: May 1987 March 2003

Table 5: ARIMA models of property yields

Dependent variable: Y Variable Constant AR(1) MA(1) MA(-3) Coefficient -0.00 0.79 -0.50 0.45 t-ratio 0.0 11.7 6.7 6.7

R-bar squared: 0.53 F-statistic: 59.64 ADF on residuals = -12.79 (significant at the 1% level) Y is first differences in initial yields
Sample period: March 1987 March 2003

The AR and MA terms, which minimised the value of the Schwarz criterion, are reported in Table 5. This ARIMA equation explains 53% of the variation in the first differences of property yields. For this type of model this is a very good explanatory power. Table 6: Regression model of property yields
Dependent variable: Y Variable Constant Y(-1) Y(-2) Y(-3) Coefficient 0.26 1.12 0.24 -0.40 t-ratio 3.9 24.4 2.4 -5.4

RENT(-1) -0.05 -3.3 R-bar squared: 0.998 F-statistic: 15728.62 ADF on residuals = -11.88 (significant at the 1% level)
Sample period: May 1987 March 2003

The regression investigation that incorporates influences of past yield values and current and past values of rental growth demonstrated the important influences of past values of yields. This is not surprising given that the yields are included in levels and the high autocorrelation of the series. Rent growth influences are summarised in the first lag of rent growth. The model presented in Table 6 achieves stationary residuals and its explanatory power is very high. 5. Forecasting performance Tables 7 and 8 present forecasts based on these models for two six-month periods: April 1999 September 1999 and October 1999 to March 2000. These dynamic forecasts are then evaluated on the basis of commonly used criteria. The production of dynamic ex-post forecasts from the VECM model would require forecasts of the gilt yield and dividend yield rates. Future values of these variables are produced within the VECM model. Forecasts from the ARIMA model are obtained for the first differences of property yields. From the yield forecast values in first differences forecasts of yields in levels are obtained. Finally the regression model requires forecasts of the rental growth rate as in input for the predictions of the yield rate. Such rent growth forecasts are produced by an ARIMA specification that is fitted to the first differences of the actual rent growth series (it was necessary to fit the ARIMA in the first differences of the series since the percentage growth of rent series was not stationary).

Table 7: Ex post property yield forecasts: April 1999 September 1999

Actual 99-Apr 99-May 99-Jun 99-Jul 99-Aug 99-Sep MAE MAPE RMSPE
MAE: Mean absolute error MAPE: Mean absolute percent error RMSPE: Root mean squared percent error

VECM Forecast % error 6.95 6.94 6.94 6.95 6.95 6.95 0.08 1.17 0.012 0.6 1.0 1.2 1.3 1.6 1.3

ARIMA Forecast % error 6.96 6.94 6.92 6.90 6.89 6.88 0.05 0.70 0.007 0.7 1.0 0.9 0.6 0.7 0.3

Regression model Forecast % error 6.96 6.97 6.97 6.98 7.00 7.01 0.12 1.68 0.018 0.7 1.5 1.6 1.7 2.3 2.2

6.91 6.87 6.86 6.86 6.84 6.86

Forecast Evaluation

Table 7 shows the forecasts for the first six-month period. Overall, the absolute percentage errors each month are considered very small for the three models. The regression model, despite its very high explanatory power, produces the least accurate predictions. The three evaluation criteria suggest that the ARIMA model seems to be the best performing model since it produces the lowest values for the forecast evaluation criteria. Table 8: Ex post property yield forecasts: October 1999 March 2000
VECM 99-Oct 99-Nov 99-Dec 00-Jan 00-Feb 00-Mar Actual 6.82 6.84 6.85 6.82 6.71 6.58 Forecast 6.89 6.88 6.91 6.94 6.96 6.98 0.16 2.34 0.031 % error 1.0 0.6 0.9 1.8 3.7 6.0 ARIMA Forecast 6.88 6.91 6.94 6.96 6.98 7.00 0.18 2.61 0.033 % error 0.9 1.0 1.3 2.1 4.0 6.4 Regression model Forecast 6.86 6.85 6.86 6.86 6.86 6.87 0.09 1.35 0.02 % error 0.6 0.1 0.1 0.6 2.2 4.4

Forecast Evaluation MAE MAPE RMSPE

MAE: Mean absolute error MAPE: Mean absolute percent error RMSPE: Root mean squared percent error

Table 8 presents the forecasts for the second in sample period. The main observation that can be made is that the forecasts of all models worsen as we move into 2000. The forecast errors become larger in February and March of 2000. The best performing model is now the regression model

whereas the ARIMA model is the worst model. The findings of the evaluation of the forecast performance of the three models over the two sample periods do not depict a clear picture about which model is the most appropriate for forecasting purposes. However, it should be noted that the more complicated VECM does not become the best performing model in either of the two periods but at the same time it is not the worst. The performance of the VECM model is affected by the importance of the error term. However it should be noted that within the VECM two other variables are forecast the yield on gilts and the dividend yield. The VECM provides a framework within which the sensitivity of the yield forecasts to assumed or expected future values of gilt yields and dividend yields are tested.

Table 9: Ex ante property yield forecasts: April 2000 September 2000

00-Apr 00-May 00-Jun 00-Jul 00-Aug 00-Sep VECM 6.53 6.43 6.32 6.27 6.20 6.12 ARIMA 6.52 6.42 6.30 6.21 6.14 6.08 Regression 6.53 6.48 6.42 6.40 6.38 6.37

Finally, Table 9 presents the yield forecasts generated by three models for the period April 2000 September 2000. The main characteristic of this output is that yields are forecast to show a downward trend. The largest fall is predicted by the ARIMA model and the least one by the regression model. Again the VECM seems to forecast values between those of the other two models.

6. Conclusions The aim of the present study is to test the forecasting capability of property yield models. There have been several specifications put forward in the existing literature that analysts can benefit from in terms of methodology and variables to be included to a model of property yields. Although the explanatory power of these models is significant the authors have not undertaken an evaluation of how useful these models are for forecasting purposes. Models first of all need to be tested for their ex post forecasting performance. When actual values of the assumed independent and exogenous variables in the models are used in the ex post forecast evaluation tests, perfect knowledge is assumed, which may be a shortcoming, but still it provides a useful exercise of evaluating the strengths of different models. Secondly, when forecasts are evaluated the analyst can examine whether more complicated models, especially those which forecast inputs from several other variables, fare against more simplistic models that are less data intensive or need less forecasted input from other variables. In this study three models are adopted for yield forecasting and their forecasts are evaluated. The first model makes use of long run information between a number of variables. These variables are those that are suggested by a simple model of income yield determination in the property market

and are: growth rates of rents, the yield on ten-year gilts and the yield on FT Actuaries all shares. The second model does not include any information from external variables. It makes use of the past information of yields and the effect of shocks on yields. The third model is a model that can be easily estimated by researchers and incorporates the information contained in past yield values and current and past rents. The forecasting adequacy of these models was assessed over two six-month periods. The yield forecasts over these periods were dynamic and did not assume certainty. Therefore, any future values that had to be used in the forecasts were also predicted either within the models (VECM) or separately through other methodologies (as in the case of the regression model). The forecast evaluation results showed that no single model performs best over the two sample periods. In the first period an ARIMA model of yields provides the most accurate forecasts and a regression model of yields the least accurate predictions. In the second ex post forecast period the ARIMA is the worst performing model and the regression model the best. It is also found that the models cannot capture the falling trend in property yields in 2000 when they predict an increase in yields. This study concludes that forecasting yields does not appear to be a simple exercise and more research resources need to be devoted towards developing models that consistently perform well in forecasting.

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Johansen, S. and Juselius, K. (1990) Maximum likelihood estimation and inferences on cointegration with applications to the demand for money, Oxford Bulletin of Economics and Statistics, 52, 169-210. Keogh, G. (1994) Use and investment markets in British real estate, Journal of Property Valuation and Investment , Vol.12 No.3, pp.58-72. Nourse, H. (1987) Cap Rates 1966-1984: A test of the impact of income tax rate changes in income property, Land Economy, 63:2, 147-152. Sivitanidou, R. and Sivitanides, P. (1999) Office capitalisation rates: real estate and capital market influences, Journal of Real Estate Finance and Economics 18(3), 297-322. Tsolacos, S., Keogh, G. and McGough, T. (1998), Modelling use, investment and development in the British office market, Environment and Planning A, Vol.30, pp.1409-1427.