Tuesday, May 26th, 2015

Cooler on Real Estate

2014 was a great year for UK Commercial Property, with the index we follow posting a 20% total return. Even better, we had an overweight recommendation for the whole of the year, and for most of the year we were at our maximum permitted weight. There was however nothing remotely controversial about this call because every forecaster was predicting double-digit rental growth and a decline in bond yields. The consensus forecast for total returns in 2015 ranges from 10-13%, and most asset allocators continue to recommend an overweight position. So why have we changed our view?

The first point is that we have only reduced our recommendation to Neutral. We are happy holders, not sellers. We just don’t see the need to rush out and buy more. Part of the reason is the better performance from UK equities, which has boosted the hurdle rate against which commercial real estate has to be compared, but the other part is a decline in the momentum of returns from a run-rate of 20% in December to 12% at the end of April. Some of this may be due to pre-election nerves and it is possible that there will be a pick-up in the months ahead, but it would have to be a very dramatic improvement to take us back to the earlier run-rate.

As a general rule we avoid forecasts, but there is nothing very wrong with the consensus of high single-digit rental growth, driven by falling vacancy rates and a modest increase in new space. We think that the Bank of England is likely to raise base rates in 2015 – but only once – and that the rate of increase in 2016 will also be slow. We may be a little more hawkish than consensus, but we do not believe there will be pre-emptive strike against inflation or a rush to normalise rates in line with pre-crisis norms.

For us the key words are “term premium” and “liquidity” and here is where comparisons with the US are useful. We are now Underweight US REITs against the equivalent 50/50 portfolio, even though the performance of equities and bonds year-to-date has been worse than the UK. This is because we are concerned about the outlook for the long-end of the yield curve, which is much more important than base rates for the valuation of commercial property. In recent speeches Janet Yellen has drawn attention to the lack of a term premium in US bond markets (a.k.a. the shallowness of the yield curve) and said that (1) this increases the likelihood of capital misallocation, and (2) is a sign that capital markets are still not restored to full health. Stripping away the jargon, this means that the FOMC wants long rates to rise by more than short rates, and that it may consider special measures (such as reverse repos) to make sure that this happens.

Mark Carney, the governor of the Bank of England, does not quite use the same language. Instead he talks about the need for investors to recognize that certain assets are fundamentally illiquid (a category which includes investment grade credit as well as commercial real estate) and that valuations need to reflect the extra risk of not being able to sell on demand. Holders of commercial property are therefore being warned that the yield curve may start to steepen on both sides of the Atlantic and that central banks may not provide liquidity in the event of a market malfunction. Caveat emptor.

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