"You've got interest rates coming down, therefore discount rates should be coming down, therefore property values should be going up," Mr Hession said.
Two comments.
First, when measuring the value of an enterprise, the relevant discount rate is the weighted average cost of capital (WACC), not simply the debt rate. WACC is based on the rate of return expected by the providers of capital (funds), which are shareholders (equity) and lenders (debt). Equity holders will want a return equal to that available to them on the best available investment opportunity of commensurate risk. When a company is highly leveraged, the financial risk rises and therefore all things being equal, the return expected by equity holders will rise. Accordingly, due to the current GFC we are seeing situations where interest rates are falling (for some) but due to leverage and the lack of liquidity, WACC is increasing. As WACC (the discount rate) increases, enterprise value falls (again, all things being equal).
Second, we see with bonds that prices fall when interest rates rise and conversely prices rise when interest rates fall. Thus, pricing changes to adjust to a yield that is equal to current rates. At the asset level, if the bond pricing model applied to REITS (which is what “Mr Hession” seems to be suggesting) we would see the same thing. All things being equal, if cap rates fall in correlation with falling interest rates then property prices should rise and vice versa. This would not be the case, however, if returns fell due to lower rental income (caused by lower occupancy or simply a fall in rental rates). It appears, therefore, that current pricing of commercial property reflects a risk that rental income might fall.
CER Price at posting:
3.2¢ Sentiment: Hold Disclosure: Held
