The initial UK commercial property market recovery from the great crash of 2007, 2008 and 2009 when capital values fell 44% lasted just 27 months before the full implications of the Government’s austerity programme were considered. The second leg of recovery which set in once a wider economic recovery became entrenched has now lasted 16 months and values are now 26% higher than they were at the bottom of the market.
At this stage in the cycle should investors be cautious about putting more money into the market or indeed consider taking some money out.
In 1993 after 16 months of falling values an initial recovery lasted 13 months before petering out as rental values continued to fall. The return of rental growth in mid-1996 heralded a return of confidence and values increased for all but three out of the next 57 months as the UK economy grew by 3% a year over that period.
The recovery from the dip caused by the bursting of the dot-com bubble and recession in the United States stretched out for 65 months as the UK economy again grew at an annualised average of 3%. So by the standards of the recent past we could expect this growth stage of the current cycle to stretch out for a further 40 months or so.
The key driver of performance in each period was strong underlying macro-economic performance. Today it is no coincidence that the robust performance from commercial property has coincided with growth in UK output which has averaged 2.9% a year since the end of 2012. Recent statements from the IMF and the Bank of England’s Chief Economist, however, indicate that growth in output is set to weaken over the coming months. Consequently, expect growth in the capital values of UK commercial property to slow from the current rate of 7.4% a year achieved since December 2012.
Values remain 29% below their peak suggesting that the recovery has plenty left in its legs yet.
It is by no means certain, however, that the market will recover its 2007 high. During the dot-com boom the FTSE100 index peaked at 6,930 in December 1999. As that bubble burst, the market more than halved in value to 3,287 in March 2003. The index recovered to 6,732 in June 2007 before the onset of the credit crunch and Great Recession sent the market back down to 3,512 in March 2009. Now almost 15 years later the FTSE100 index stands at 6,260, still 10% below its 1999 peak.
Valuations were so stretched by June 2007, that as interest rates peaked at 5.75% and the sub-prime mortgage crisis in the USA triggered the credit crunch, they fell for 12 consecutive months before the onset of the Great Recession and without any corresponding decline in rental values.
The All Property initial yield is currently 5.7%. At the top of the market the property yield was 4.6%. As we have noted above this level was unsustainable and reference to the average initial yield over the last 10 years of 6.0% sheds a different light on the valuation of the current market.
Across each market segment capital values have reached a level that reflects an initial yield below the 10 year average with the exception of Rest of UK shops and retail warehouses. The valuations of Central London shops and prime Central London offices reflect yields that are lower than those achieved at the top of the market. This simplistic analysis would indicate that investors will be unlikely to benefit from any further yield re-rating of any significance.
Risky assets such as equities and commercial property should be valued by reference to the risk free rate which is taken as the rate offered by benchmark government bonds; Treasuries in the USA and gilts in the UK. At its current level the All Property initial yield benefits from a 360 basis point margin over the 5-15 year gilt yield of 2.3%. The average yield gap over the last 10 years of 226 bps suggests that there may yet be scope for further capital value growth.
Interest rates are, of course, at record lows and will only increase from their current level. In the last two months, two dissenting voices have appeared on the minutes of the interest rate setting Monetary Policy Committee arguing for an immediate increase in rates.
If All Property yields remain static, an increase in interest rates of 1% together with a corresponding increase in gilt yields would reduce the property –gilt yield gap below the 10 year average and that starts to make property valuations look expensive.
When are interest rates likely to rise?
In September inflation fell to 1.2% year on year and is comfortably below the 2.0% target. This would normally suggest that interest rates should be reduced further rather than increased.
Pressure on interest rates from wage growth is also limited. The latest figures show that although the economy generated more than 750,000 jobs over the last 12 months, average earnings were just 0.7% higher in the year to July 2014. In his speech to the TUC Congress in September, Mark Carney, The Governor of the Bank of England, noted that, “adjusted for inflation wages have fallen by a tenth since the onset of the crisis. And in order to find such a fall in the past, you would have to go back to the early 1920s.” He believes that as a result of an increase in part-time work and self-employment wage are as low today as if the unemployment rate were 10%, not the 6.0% rate it currently is. Consequently, the Bank’s latest forecast is that it will be the middle of 2015 before any real wage growth is experienced.
Not surprisingly, the October edition of Forecasts for the Economy published by the Treasury shows that independent forecasters expect interest rates to remain unchanged at 0.5% at the end of the current year but to rise by 0.75% to 1.25% in 2015. In addition, the path of bank rates in the future implied by certain financial market instruments which condition the MPC’s CPI and GDP forecasts, indicate that the bank rate is expected to rise further to 2.0% by the end of 2016.
Even when the Bank Rate does eventually increase the impact on the longer term interest rates used to benchmark property pricing could be limited. Longer term gilt yields have consistently been pricing in an increase in Base Rate See chart).
Investors adopting a risk averse approach should not rely too much on any further re-rating of yields to drive returns. On the up-side property yields are unlikely to soften in response to the expected rise in Base Rate. Investors should instead look to growth in rental values to support valuations. Encouragingly All Property rental values have been improving throughout the year and are now running at 2.5% year on year. The down side is that a slow-down in economic growth will restrain rental growth and any further tightening in yields may be unwound.