Rising rates to leave property prospects undimmed
As the UK economic recovery goes from strength to strength, the path and timing of interest rate rises assumes greater importance for financial assets.
Broadly speaking, fixed income assets appear to be the most vulnerable to an increase in rates, while growth assets such as equities, underpinned by earnings, appear to be better placed. Property has both fixed income and equity characteristics so while exposed to interest rate movements; it is also responsive to improvements in the general economy. In our view, the commercial property market seems fairly priced.
UK commercial property at fair value
Broadly speaking, UK commercial property appears to be well positioned to absorb a small rise in interest rates. We take comfort from the fact that in contrast to most other financial assets, property yields have not re-priced to adjust to the current and very low interest rate environment. As an example, the spread over 10 year gilts is currently around 3%, well above the long-term average yield gap of 2% (see chart 1).
Chart 1 - Property appears to be sensibly priced relative to gilts
The importance of rental income growth expectations
Property has fixed income cash flow characteristics due to the rental income that the tenant pays to the landlord. Importantly, it is also a growth asset, with owners of property able to increase the level of income they receive.
In normal circumstances, property income rises as interest rates rise. This is partly due to the property rental cycle, which coincides with the broader economic cycle. As occupiers become more profitable and demand for commercial floor space increases, the open market rental value of properties usually rise. During periods of strong economic growth, property investors are often prepared to tolerate a lower yield spread over gilts because they are confident that the rental income on which the yield comparison is made will grow, adding to returns.
A positive outlook for rental growth
Indicators suggest that the UK economy will continue to grow at trend levels over the coming years, which should underpin rental income. Supply and demand dynamics remain supportive, and we are unlikely to see an oversupply of floor space in the coming years. Levels of new development have not recovered since their dramatic cut following the onset of the global financial crisis in 2007. We would not discount a supply response from 2017 as developers respond to the pick up in rental growth, however the current pipeline would suggest this remains subdued. Combining low levels of supply with an improving macroeconomic picture, we forecast rental growth of 2-3% over the next five years.
A selective approach to property investing
Although we think the UK commercial property market as a whole looks well placed to withstand a rise in interest rates, some areas of the property market look more vulnerable than others. In particular, we are wary of low-yielding, income-secure real estate. A number of these assets were acquired as bond substitutes, and benefited from the move to lower bond yields. We consider this area of the market to be more vulnerable to a rise in interest rates and as such, seek to avoid them.
We believe that commercial property is an attractive investment proposition in this low and rising interest rate environment. It is fairly valued and in addition to its bond-like series of contractual cashflows and its low correlation to gilt yields, future returns look well supported by strong rental growth prospects.
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