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Yielding to pressure

8 September 2014

Bill Page considers how recent market movements have affected assumptions of
rental returns and investment behaviour

In 2007, the bank base rate hit 5.75% while 10-year UK government bonds yielded 5.5%. A
rational market, other things equal, would have targeted property returns around 3.5% above
the gilt yield (the risk free rate). However, the combined weight of leveraged money,
aggressive fund inflows and global capital compressed all property initial yields to below 4.5%,
meaning that ambitious assumptions on rental growth and void erosion were necessary to
deliver sufficient expected returns.

As debt markets froze that summer, property values fell. At the time, markets thought (or
hoped) that, as GDP and occupational markets remained buoyant, the effects of this credit
crunch would be confined to investment markets. But in 2008 it became a full scale economic
crisis and values entered a sharper phase of decline, this time exacerbated by rental
decreases. By the time property values stabilised in Q2, 2009 values had fallen 42% below
their peak in just 8 quarters. Today, despite a rapidly rising market, they remain 28% lower.

This context is important when we consider the current market, which in places appears to be
characterised again by over-enthusiastic bidding and questionable pricing assumptions.
However, there are material differences.

Relative pricing

Current gilt yields are just under 2.6%. Although these have increased over the course of the
year, from 1.7% at the end of April 2013, ongoing quantitative easing (QE) has kept them low.
So, while yield impact has driven most of the 25% capital growth seen since the market
troughed, current property pricing has to be seen in the context of other asset classes. In this
regard, property investment remains entirely rational. In fact, with equivalent yields running at
6.6%, the spread between yields at which most properties are valued and other asset classes
are at or above historic averages. Certain markets, however, have seen yields compress to
levels not seen since 2007 and this is what is causing consternation. The problem is two-fold:

- Current deals look expensive on the basis of the pricing that would have been
achieved 6 to 12 months ago, not to mention 2 to 3 years ago. Behaviourally, this
creates acquisition challenges: memories of the global financial crisis are still fresh
and the sense of a lost buying opportunity is strong, with many conveniently
forgetting that the money and/or the will may not have been as strong then as now.
- Most analysts have high conviction that gilt yields will rise from current levels. At
some point soon the Bank of England will stop reinvesting receipts from its 375bn
QE programme and, although we can expect it to retain the vast majority of bonds it
has purchased, the downward pressure on gilt yields will ease. Despite global bond
yields hardening over the past few weeks, forecasts would have UK gilts peaking in
2018 between 4% and 4.5%. Although this represents a two-thirds rise on today?s
rates, it is comfortably below 2007?s 5.5% and a 20-year average of just under 5%.

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Sources of capital

Simplistically, investment in 2006 and early 2007 was characterised by:

- aggressive domestic fund inflows (in June 2007 the Association of Real Estate
Funds recorded a peak of 5.4bn of new money raised over a 1-month period)
- unsustainable leverage (De Montfort University?s Commercial property lending
report found that loan originations peaked at around 85bn in 2007 with
loan-to-value (LTV) ratios of up to 80% in the run up to the crisis)
- exuberant overseas investment (35% of UK transactions were acquired by overseas
investors in 2007).

The current market in places appears to be characterised by over-enthusastic bidding and

questionable pricing assumptions

Currently, although the proportion of the market purchased by UK institutions is at similar

levels to 2006 (around 26%), fund inflows are running at half their 2007 peak, despite recent
increases.

Debt is ? relatively ? under control with De Montfort?s latest numbers for 2013 showing the
overall debt pile has reducedby around 30% since its peak with LTVs running at a more
sensible 65% or under. Overseas capital, however, has become more plentiful, acquiring
45% of the market in 2013. Many of these buyers have different performance hurdles
compared to their UK counterparts, as well as different holding periods, which may
ultimately mean a more restricted supply of stock to the investment market.

The cycle

Claiming that ?the cycle is broken? or even that new safeguards are sufficient to prevent
another calamity carries a major risk of egg on the face, but analysts should go beyond
variations of ?what goes up must come down? when pontificating on future pricing.

There are valid reasons to think that the current upswing may be different. Yields first
compressed between mid 2009 and the end of 2011 despite rental growth remaining
recessionary in what proved to be a short-lived recovery. Values then fell again until May
2013, driven by negative sentiment surrounding the eurozone and domestic economy, while
rental growth remained broadly absent. The current recovery is only a year old but rents and
yields are now working together.

As the impact of yield compression diminishes from next year, rental growth will be the
principal driver of performance. Although the past is no guarantee of the future, over
previous prolonged periods of capital value growth there have been in the order of 15
consecutive quarters of rental increases ? so far there have only been 4. This means risks
become more identifiable. For pricing, the main risk is rising interest rates. For leasing
markets, risks to rental performance will come from supply ? a tangible indicator that can be
measured and predicted with a reasonable amount of certainty (relative to other metrics) ?
and demand, which boils down to GDP growth.

The principal risk to supply is if the market builds too much too soon, which, although
construction orders are picking up, is not a current danger. The risks for demand are factors

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that could take the steam out of GDP growth and include EU and domestic referenda, poorly
considered policy (particularly concerning banking andfinance), or, circling back to relative
pricing, unexpectedly rapid interest rate increases destabilising the economy.

Rising risk free rates

An institutional investor will judge property acquisitions against a target rate of return. This
rate is given by the gilt yield plus a risk premium. The historic risk premium can be defined
as the yield from property less the gilt yield. Historically this has averaged around 3.5%.

As gilt yields rise amid what should be a flat property yield environment from next year, so
will the requirement for rental value growth to boost returns. Figure 1 illustrates this
concept, using the long-term average risk premium. Over the past 5 years, yields have been
above target rates ? broadly, this has enabled a focus on income preservation to translate
into positive relative performance. With the target rate rising from 6.4% today to around 8%
in 2018 we are at a crossover ? yield preservation will no longer be enough to outperform
and investor behaviour has to adjust. This has pulled investors toward more equity style,
rather than bond like, investments. In other words, assets that are more likely to achieve
rental growth, or that can be proactively asset managed to align them with rental growth, will
outperform more stable, defensive assets; this means embracing more risk.

Where are we now?

Phase 1 of the global financial crisis was the credit crunch. Phase 2 was the resultant
economic and occupational market collapse. This was followed by a short-lived quantitative
easing-driven rebound, mainly felt in equity markets but also in property, and the eurozone
crisis. Currently, the market could be characterised by rising asset prices, economic recovery
and (in part) stabilising sovereign risk. What should be the final chapter of the global financial
crisis will soon be on us, where markets respond to the lifting of QE.

Forecasting the impact of the end of the ?greatest ever global monetary experiment? is a

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tough call but, providing economic growth is entrenched when the foot comes off the
accelerator and presses the brake we can hope for an orderly, managed and predictable
increase in interest rates. This scenario will provide upward pressure on property yields but
this is already factored into forecasts.

Rental growth will be critical for returns, and assets that offer this prospect at a reasonable
current yield will be highly sought after. The competition for assets means that managers need
to be creative with good sector calls, stock selection and active management. Subject to
getting these elements right the prospective returns into the medium term are stronger than
they have been at any time since the financial crisis.

Bill Page is Business Space Research Manager at Legal & General Property

Further information

Related competencies include Investment management

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