Research (Professional Only)

The attraction of property in a rising interest rate market

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, underpinned by earnings, appear to be better placed.

15 September 2014

Patrick Bone

Patrick Bone

Property Analyst

Introduction

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, underpinned by earnings, appear to be better placed. For those with an exposure to bonds, a key question is how to reduce their portfolio’s sensitivity to rising interest rates. One asset they might wish to consider is commercial property. 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).

As property yields fall, this spread may narrow. However, the long term average suggests property values are able to absorb a 1% contraction in the spread, even with the possibility of rising interest rates. In any case, when factoring interest rates, the long-term correlation between property yields and long-dated gilts remains weak 0.02%)1. Investment grade corporate bonds, an insurer’s default asset, by contrast are 0.60% correlated to gilts2.

The importance of rental income growth expectations

Property has fixed income cash flow characteristics – i.e. the fixed rental income 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. This is opposed to corporate bonds, whose fixed coupons decline as yields rise.


We illustrate the importance of rental growth expectations to property valuations in chart 2 above.We compare the spread between property and bonds, relative to rental growth expectations (based on estimated rental growth in the preceding 12 months and the forecast rental growth for the next 12 months). The two main explanatory variables for property pricing are the spread over the risk free rate and rental growth expectations, therefore the line of best fit should provide a good guide of fair value.

1IPD monthly equivalent yields v UK Government 10 year yields, August 2014
2 Bank of America Merrill Lynch BBB corporate bond yields v UK Government 10 year yields, August 2014

Important Information:
The views and opinions contained herein are those of Patrick Bone, Property Analyst at Schroders, and may not necessarily represent views expressed or reflected in other Schroders communications, strategies or funds.

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Important Information: The views and opinions contained herein are those of the author(s) on this page, and may not necessarily represent views expressed or reflected in other Schroders communications, strategies or funds. This material is intended to be for information purposes only and is not intended as promotional material in any respect. The material is not intended as an offer or solicitation for the purchase or sale of any financial instrument. It is not intended to provide and should not be relied on for accounting, legal or tax advice, or investment recommendations. Reliance should not be placed on the views and information in this document when taking individual investment and/or strategic decisions. Past performance is not a reliable indicator of future results. The value of an investment can go down as well as up and is not guaranteed. All investments involve risks including the risk of possible loss of principal. Information herein is believed to be reliable but Schroders does not warrant its completeness or accuracy. Some information quoted was obtained from external sources we consider to be reliable. No responsibility can be accepted for errors of fact obtained from third parties, and this data may change with market conditions. This does not exclude any duty or liability that Schroders has to its customers under any regulatory system. Regions/ sectors shown for illustrative purposes only and should not be viewed as a recommendation to buy/sell. The opinions in this material include some forecasted views. We believe we are basing our expectations and beliefs on reasonable assumptions within the bounds of what we currently know. However, there is no guarantee than any forecasts or opinions will be realised. These views and opinions may change.  To the extent that you are in North America, this content is issued by Schroder Investment Management North America Inc., an indirect wholly owned subsidiary of Schroders plc and SEC registered adviser providing asset management products and services to clients in the US and Canada. For all other users, this content is issued by Schroder Investment Management Limited, 31 Gresham Street, London, EC2V 7QA. Registered No. 1893220 England. Authorised and regulated by the Financial Conduct Authority.