CIO Viewpoint

Today’s UK property market is gaining momentum. Just a quick look at IPD numbers shows that the last six months returned 8.8% (to 31 March 2014) compared to 4.8% six months before. Competition for assets is fierce with many managers, on behalf of their clients, looking to deploy increasing amounts of capital. Demand has never been so strong. Property’s stable income characteristic is a big draw. In such an environment, yields are falling fast, and in some cases, approaching historic lows. But where next and are they factoring in all the good news?

Forecasting property yields is never an easy task, but as an old saying goes, “A good forecaster is not smarter than everyone else, he or she merely has his or her points better organised”. In that respect, I list the five points why I expect property yields to fall further:

1. The elevated spread between gilt yields and average property yields as reported by IPD stands at approximately 420bp. This still provides a reasonable level of risk premium for investing in property; more so when you consider that the average spread over the last 25 years has been 230bp.

2. It has never been so attractive to use debt as a way to enhance returns. We have the lowest interest rates in the Bank of England’s 320 year history. Furthermore, margin levels appear to be declining from the highs of two to three years ago. We are seeing an increasing number of banks as well as new real estate debt players competing for business. The current lending dynamics are proving to be favourable but the counter-argument is that interest rates from here, can only go one way: up. It’s in noone’s interest for base rates to be driven up in a dramatic fashion. As they are being politically managed today, we believe this will continue in the future. If you follow the modified Taylor Rule, interest rates should have been over 2% a year ago even on conservative assumptions. Don’t expect high interest rates anytime soon and any increments are likely to be modest.

3. Past experience has shown us that it takes time for economic activity to impact on property rental growth. There is no question that prices being paid today anticipate some of that good news already. But are we fully factoring in all the rental growth potential? History has highlighted that we underestimate the upswings (and downswings for that matter). The economic cycle is no different. The Office for Budgetary Responsibility, the Bank of England and the International Monetary Fund, have all continually revised upwards their GDP forecasts for the UK economy in the last 12 months. If the drivers of rental growth are being underestimated, there is a high probability that we may be underestimating the quantum of that (rental) growth itself.

4. Unlike previous property cycles, this cycle has been fairly muted in terms of new development activity. Property has aged and given the trends in sustainability, depreciation has been quicker than anticipated. Today’s economic recovery is therefore not constrained by (?) a major overhang of prime/quality stock which both occupiers and investors seek. Although London’s development pipeline was re-started some two to three years ago, development in the regions has yet to take off in any meaningful way. There remain pockets of limited good quality stock.

5. The rotation in asset allocation is favouring real estate. There are many new investors who are now looking to build an exposure and we are hearing of increasing appetite from Asian and US investors looking to hold UK assets. In addition, there are existing UK property investors who are looking to increase their allocation to a new higher strategic level. It is difficult to ascertain if these trends are all cyclical or there exists an element of structural shift. Either way it highlights ongoing demand for real estate which can only be met with existing stock, as it will take time for new supply to come through.

It is therefore too early to be taking profits from UK property. However, there is a rising risk that the real estate market can move into expensive (overpriced territory). It all depends on the speed and quantum of investment activity in the coming 12-18 month period.

Some also view forecasting as an art “of saying what will happen, and then explaining why it didn't”. At least one can go back to the five points above to see if they really were supporting factors.

Kiran Patel
Chief Investment Officer