Bears of commercial property point out that current rental yields are low by historical standards. The CBRE all property prime yield edged up to 5.1% in the third quarter but remains well below its average of 6.4% over 1972-2006. However, the long-run average may be a poor guide to current “fair value”, for two reasons.

First, rents fluctuate significantly with the economic cycle. A high yield may not indicate that property is cheap if rents have been boosted above a sustainable level by a buoyant economy. Conversely, it may be right to invest when yields are low if rents are below trend and likely to benefit from future strong economic growth.

Secondly, any judgement about valuation must take account of returns on competing assets. The rental yield is often compared with yields on conventional gilts but this is invalid because bond interest is fixed while rents rise with inflation over the long run. In other words, the rental yield should be compared with real not nominal interest rates.

The chart shows a measure of valuation that incorporates these considerations – the gap between the normalised or cyclically-adjusted rental yield and real yields on long-term index-linked gilts. The normalised yield is currently lower than the actual yield (4.8% versus 5.1%) because rents are estimated to be 7% above trend, reflecting the economy’s recent strength. (There were much greater deviations in the early 1970s and late 1980s, when rents overshot by 30-40%.) However, the low level of the normalised yield is counterbalanced by similarly modest yields on index-linked gilts. The gap between the two is therefore only 20 basis points below its long-term average. In other words, based on current index-linked yields “fair value” for the actual rental yield is about 5.3% compared with the third quarter level of 5.1%.

Commercial property valuations are clearly much less compelling than in the 1990s but look defensible relative to bonds.