New Zealand Interest rate outlook and its property yield implications

Key Points

• Following two years of rising interest rate driven market uncertainty, recent months saw good progress in the property market’s price discovery journey, which indicates that market yields are near their cyclical peak.  Our report looks at prospects for yield movements in the context of expected interest rate changes and the historic margins between interest rates and property yields.
• Current financial market expectations show the fall in wholesale interest rates taking a breather before resuming their declines as OCR cut expectations become more entrenched and their timing more imminent.  Assuming OCR cuts start before the end of 2024, current forecasts show steady declines in interest rates through to late 2025. 
• Our research shows significant margin fluctuation between interest rates and property yields over the past thirty years, reflecting changing mixes of monetary and property market conditions that sometimes reinforced each other and sometimes showed discord. 
• The interest rate rises of the past two years have not translated to a one-for-one increase in property yields.  Instead, the wide margins that have prevailed since the GFC compressed back towards the narrower margin norms of the pre-GFC era.
• The question is; how will the outlook for interest rates over the next two years translate to property yields?  Will falling interest rates translate to falling yields, or will this be a chance for the market to rebuild yield to interest rate margins closer to post-GFC norms, implying limited yield movement?
• Our answer is that yields will  remain at current levels until late 2024 and then decline moderately once economic conditions turn more positive and interest rate falls are entrenched.  This scenario leads to average (across office, industrial, and retail centres) Prime yields falling from their cyclical peak of 6.80% in mid-2024 to 6.40% in December 2025.  It also implies the average Prime yield to 2 year swap rate margin expanding from the current 175 bps to c280 bps, higher than the pre GFC average but materially below post GFC.