CIO Viewpoint

With base rates at 0.5%, there is really only one direction that interest rates can go from here and that is up. A key question is when? The recent messages coming from the Bank of England Governor, Mark Carney, may have provided some insights. The thinking now is that it could happen sooner than the markets think. Most traders had already factored in a hike in the early part of 2015, and if it happened, it would be the first one to occur since July 2007 following more than eight years of monetary easing. The view now is that this could transpire much earlier in October or November of this year. Though Carney did stress that the path to any increase would be “gradual and limited”.

But what of UK property? This is an asset class that has seen debt on real estate go from £53 billion in 1999 to £273 billion at the height of the boom, an increase of 5.5 times. Although that level of indebtedness has declined somewhat, it still remains high, currently standing at approximately £180 billion, representing an average loan to value of 28% (outstanding commercial property debt to the size of the UK commercial property market). Surely any interest rate rise is going to adversely effect the prospects of the sector, so is this the beginning of the end for UK property?

Logic would dictate it should be. In simple terms, higher interest rates means higher mortgage payments and therefore less income. Less income implies lower returns. However, there are three big factors at play which might help to avoid such an outcome.

• The first is margin levels that lenders charge over and above the base rate. This has declined rapidly from the highs of two or three years ago. We are seeing an increasing number of banks as well as new real estate debt players competing for business, the latter having raised lots of capital to be invested. With margins on senior lending having already come down by circa 100 basis points in the last 12 months alone, there is scope for further falls, given this increasing competition. Any reductions could help to offset the increases in mortgage interest payments.
• The second is associated with the strength of the UK economy itself. The ONS believed that GDP contracted by 5.2% in 2009, at the peak of the country’s recession. But new figures suggest that the drop was 1.1 percentage points less, at minus 4.1%. This adjustment has also led many analysts to suggest that recent positive GDP numbers could also be understating the strength of the UK economy. And we know rising and strengthening GDP is good for UK property even when interest rates are rising at the same time because of the likely upward pressure on rental levels.
• The third and final clue is Carney’s comments themselves in that any interest rate rise is likely to be “gradual and limited”. With interest rates coming off a low base any increase in percentage points will be seen as dramatic. A 50 basis point increase will be represented as a 100% rise in the base rate, i.e. a doubling of interest rates... the first in the Bank of England’s history. The associated sentiment and relative perceptions, not to mention the headlines in the press, will show this as a significant tightening, when in reality it will be small. Carney clearly has a balancing act to manage as he needs to avoid the counter effect of slowing things down too quickly. Hence also the reference to the “gradual” steps.

Furthermore, history shows us that UK property initially benefits from rising interest rates. There was only one period when this relationship broke down in May 2000 to December 2001, when UK capital values moved in an opposite direction to the trend in interest rates. Not the beginning of the end but maybe the start of the upward property cycle.

Kiran Patel
Chief Investment Officer