Although it’s not really about real estate, it’s certainly crucial to real estate markets. Summarising the concern of a lot of analysts, Michala Marcussen argues that identifying the market risk-free rate is becoming increasingly problematic and distorted by policy-makers.
…the proxy of sovereign bond yields for the “risk-free” rate of return is becoming an increasingly imperfect substitute with potentially dangerous consequences…Less discussed in the textbooks, is the extent to which the risk-free rate should be market-determined. Central banks have historically set the short-term key rates but new unorthodox tools (and regulatory requirements) mean that the risk-free rate even on longer maturities is moving closer to a policy-determined price as opposed to a market-determined one. While there are many arguments that favour the actions of central banks, there are also drawbacks, and these increase over time…Top of the list, the disruption of price discovery renders the risk-free rate an unreliable measure of investor expectations with respect to future trends on inflation and growth…Moreover, as the risk-free rate is the anchor for all risky assets, asset price bubbles may result. While this may be a goal of QE, the basic idea is that the policy should be shortlived to help the economy regain momentum and then for better fundamentals to take over to support risky asset prices. But when QE becomes entrenched, the roles are reversed and even small changes in fundamentals can lead to very substantial and disruptive financial asset price movements.
Setting a risk premium for real estate investment has always been the main problem in setting the target rate of return. Things get worse when you are unsure of the risk-free rate. It’s that word ‘normalisation’ again.