Real Estate Research
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.
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
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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