While the risk-free rate (10-year government bond) might begin to rise from its current low level sometime during 2017 or 2018, we expect the effect on property yields to be limited due to the expected overall economic upturn ahead, which leads investors to lower their risk premium requirements.

Danske Bank’s macro forecasters recently raised their expectation towards upcoming U.S. interest rate hikes and are now of the opinion that the U.S. central bank, Federal Reserve, will raise its interest rate three times during 2017 (including the hike on March 15th). In Europe, the picture is different, as Danske Bank do not expect an interest rate increase until sometime after January 2018. However, just the expectation of interest rates hikes might result in changes to the risk free rate, which is currently at very low levels. History shows us that we can expect investors to loosen their risk premium requirements during economic upturns and as such, we expect property yields to stay flat going forward, as the rise in the risk-free rate is counter-balanced by lower risk premium requirements.

NOMINAL RISK PREMIUM TEND TO DECLINE IN PERIODS WITH GDP-GROWTH
In the graph, one can observe that the nominal risk premium (measured by a real property yield plus inflation and minus the 10-year government bond rate) tend to increase in periods with low GDP growth and tend to decline in periods with high GDP growth. During periods of high economic activity, positivism is higher, credit is abundant and thus a fiercer competition for the assets makes investors reduce their risk premium.

NOMINAL RISK PREMIUM AT 20 YEAR-AVERAGE
The nominal risk premium is currently hoovering around its 20-year average, meaning that, there is still room for investors to lower their required risk premium during a sustained economic upturn. The Danish National Bank estimates GDP Growth in 2017 and 2018 to be 1.6% for both years, which can be characterized as a healthy economic development.

Hence, in a healthy economic environment with a rising risk-free rate, history shows us that we can expect investors to loosen their risk premium requirements and as a consequence, we expect property yields to flatline going forward, as the rise in the risk-free rate is counter-balanced by lower risk premium requirements.