Property fundamentals are “sound”, as long as there are no shocks
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According to the IPD monthly index, for the first time since the recovery began back in May 2013, the contribution to monthly capital value growth coming from rents equaled the contribution from the investment market with yield and the rise in rental values both boosting capital values by 0.2%mom in February. For the prior 21 months, capital value growth had been driven almost entirely by yield compression.
This development suggests that the recovery is maturing and becoming more durable with rental growth supporting price appreciation. But over the last three decades, there have been three other periods in which yields have been the main driver of capital values: May 1991 to August 1994, May 2002 to January 2007, and June 2009 to November 201.
In each case, when the pace of yield compression fell back into line with the pace of rental value growth this signalled a peak for capital values, not the start of a second phase of the upswing. Indeed on each occasion, capital values began to fall within six months. Meanwhile February’s IPF Consensus forecasts are for 7% and 3% growth for this year and next.
A common feature of both the downturns that began in 1994 and in 2007 is that they began with markets overvalued and investors were wrong-footed by shifts in monetary policy. Thus in January 1994, the spread between property and bond yields stood at 200bps, despite property yields having fallen by 75bps in the preceding six months. Then, when the US Fed began to tighten policy in March, gilt yields rose 260bps, UK property went from being fairly priced to overvalued in 6 months, and investors bid yields up and prices down.
Similarly, in mid-2007, whilst the Bank Rate had been below 5% for the previous five years, the Bank of England hiked rates to 5.75%, property yields had been at parity with gilts, and the subsequent 100bps rise in bond yields left property looking overpriced. Property then faced both a valuation challenge and ‘risk-off’ with the collapse of Lehman and onset of the global financial crisis. In addition in both 1994 and 2011, investors’ expectations for rental values turned out to be far too optimistic and on both occasions, the wider economic backdrop changed badly, just at the point where yield compression began to slow.
Today, the start of the Fed’s tightening cycle has been widely anticipated so we need not anticipate a major shift up in bond yields, and meanwhile the gap between property yields and gilt yields currently stands at over 360bps. That suggests that the market could absorb 250bps-300bps upshift in bond yields before property valuations look seriously stretched.
In the context of relative valuation, property does now look expensive versus equities. But it is hard to expect a major asset allocation shift given that equities are seen as more risky than property and higher interest rates would threaten equity prices as well as property returns.
Looking forward, the RICS commercial property market survey reports that availability is falling at its fastest rate on record, suggesting that rental value expectations might prove resilient. If interest rates peak at a low level such as 3%, then property yield compression may have further to run, with yields perhaps falling a further 30bps to 40bs from current levels.
That said, today’s economic and financial market backdrop can be seen as similar to 2011’s. With property valuations relative to both bonds and equities broadly comparable to today’s, and despite annualised economic growth of 2.2% and no shift up in official interest rates or bond yields, property markets suffered on the back of the crisis in Euroland, and we cannot anticipate that there will be no flare up this time with a knock on hit to confidence.
What’s more, there are other risks, and on the flip side, prime property prices in the UK currently incorporate a safe-haven premium. If sentiment towards the UK deteriorated, perhaps as result of tricky politics and policies after the General Election, or investors reduced their demand for safe haven assets, yields could rise and capital values fall.
Our conclusions are that whilst there is no reason to anticipate that the recent fall in the pace of yield compression points to a turning point for capital values, the UK property market is as always, vulnerable to any major adverse shock, but in its absence, property market fundamentals still look reasonably sound.
James Bevan is chief investment officer of CCLA, specialist fund manager for charities and the public sector. CCLA launched The Public Sector Deposit Fund in 2011 to meet the needs of local authorities and other public sector organisations. You can follow James on twitter @jamesbevan_ccla
