Performance across the UK real estate landscape has varied massively over the last decade. In the 10 years to June this year, office values increased by an average of 42%, residential lets by 57% and industrial values climbed by a staggering 169%. In contrast, the average retail value today is 16% lower than it was 10 years ago.
Yet this huge variance came as all sectors were benefiting from the same powerful tailwind – a relentless decline in long-term interest rates. When the 10-year Gilt yield dropped below 2% for the first time in 2011 it felt like an aberration, yet the once-remarkable gradually became the norm. For the six and a half years between November 2015 and April this year, the benchmark ten-year Gilt yield never once got as high as 2% again. The mindset of “lower for longer” increasingly underpinned investment decisions across the property market.
Lower long-term interest rates reduce the required return for real estate, boost allocations to the sector and increase the power of leverage. The unsurprising result was a steady compression in property yields, with the average equivalent yield sliding from 7.1% in June 2012 to 4.9% ten years later. This yield shift explains more than three-quarters of the capital growth delivered by the commercial property market over the last decade.
Of course, yield movement is not purely a function of interest rates, rental growth expectations are also an important factor. Yet even in the industrial sector, which has benefited from powerful structural tailwinds, rental value growth of 4.1% a year was a minority factor in capital growth north of 10% a year.
On the flipside, the retail sector, which has seen rental values fall by 16% in nominal terms over 10 years, would surely have seen capital values fall even further in the absence of such a supportive monetary environment. In essence, property investors have been going with the flow for the last 10years, but the tide has now turned, and capital growth is going to be a lot harder to come by.
The power of yield shift was illustrated in microcosm by the performance of the Industrial sector in the MSCI Monthly Index in July. Just 10 basis points of outward movement knocked almost 2% off capital values even though rental values continued to rise. It is sobering therefore to reflect that since those July valuations were signed off, Gilt yields have climbed by more than 100 basis points. From this time last year, 10-year Gilt yields are up by more than 200 basis points whilst five-year swap rates have increased by a factor of seven, from less than 0.5% to almost 3.5%.
The pass-through from interest rates to property yields will not be one-for-one, with the latter being less volatile. However, it would take heroic assumptions on economic growth to believe that what we’ve seen so far is anything more than the first stirrings of a material re-rating of property yields.
In such an environment, market beta over a medium-term investment horizon is going to be low if not negative. Existing holders of core investments are therefore likely to face a period of weak returns. Those looking to acquire core assets over the next couple of years may find that the entry price is more attractive than it has been for some time, but risk-adjusted returns are still unlikely to excite. The model of buying off distressed vendors and riding the yield back in – deployed successfully by some investors in the last cycle – also seems much less likely to deliver stellar returns this time round.
Investors who make strong returns over the next few years are going to have to do it the hard way – by delivering material income growth – and contrary to some rather wishful thinking, high inflation does not automatically support that outcome. Historical periods of high inflation which coincided with strong rental growth were also backed up by robust economic growth. In the lower growth environment that we expect today, inflation will only benefit those investors able to deliver high quality space into genuinely supply constrained markets. Urban logistics, low-carbon city centre offices, quality family housing, and student halls close to growing universities will be amongst those assets best placed to buck the impact of rising yields.
Tom Sharman, head of strategy for real estate finance at NatWest Group