Real estate: Why it is important to embrace the gap
While many investors will be understandably nervous about a change in monetary policy, we believe those worries are misplaced where real estate is concerned.
It is clear that we are living through a change in monetary policy as quantitative easing starts to reverse and interest rates begin to rise. Many investors will be understandably nervous in these circumstances, worrying that rising rates will squeeze returns on bonds and assets priced off bonds, like property. We think those worries are misplaced where real estate is concerned. Our analysis suggests that a well-constructed portfolio should pay dividends in this environment.
It is of course true that some assets may struggle as rates rise, particularly if they rise more quickly than expected, but before assuming that property is amongst them, we would ask investors to consider the evidence.
History provides reassurance
Figure 1 shows that the current gap between the yield on 10-year government bonds (gilts) and property yields at around 3½% is wide by historical standards: the long-term average is 2%. And while property yields are also low by historical standards, having fallen since the financial crisis, they have fallen nothing like as far as those for gilts. This same weak link with gilts should also apply as yields rise.
Figure 1: the gap over gilts remains wide...
Indeed, our research suggests that only about 10% of the short-term variation in property yields is explained by gilts. Theory tells us that property yields comprise at least three other elements besides the “risk-free rate” represented by gilt yields. These are: (1) obsolescence and refurbishment expenditure, (2) defaults by tenants and (3) illiquidity, as well as an amount (4) that needs to be deducted to reflect future rental and income growth. While the first three elements do not change a great deal, rental growth is heavily dependent on economic circumstances. Thus, as Figure 2 shows, when the economy is strong – as it was in the run-up to 2007 – investors may accept a spread over gilts of 1% or less (indeed, during the last boom the gap turned negative). However, in a recession such as we experienced in 2008-09 something more like 3% to 4% may be demanded.
Figure 2: ... but does vary according to economic circumstances
Note the dashed line in Figure 2 provides a rough guide to fair value. A dot above the line suggests that real estate is good value relative to gilts and vice-versa.
The gap should continue to provide a cushion
Looking ahead, although we expect real estate yields to rise at some point between 2019 and 2021, we doubt whether they will rise in parallel with 10-year gilt yields. There are three main reasons:
- First, as discussed, the gap between real estate yields and gilt yields is high.
- Second, as we noted, property yields are heavily influenced by rental growth prospects and while we expect retail rents and office rents in central London to fall over the next couple of years, we expect office rents across the rest of the country and industrial rents to be stable, or to even rise slightly. This reflects Schroders central view that the UK economy should continue to grow steadily by 1.5%-1.7% through 2018-2020. (It is noteworthy that US office and industrial yields have barely moved over the last 18 months, despite an increase in 10-year Treasury yields, because investors remain confident about the outlook for rental and income growth.)
- Third, there is a large amount of capital in Asia which is targeting UK and European real estate. While some of this capital is tactical and therefore seeking to maximise short-term returns, quite a lot of Asian investors are taking a long-term strategic view and seeking diversification away from their domestic market.
Certainly it would be fair to expect property’s advantage over gilts to be eroded during that period, given the uncertainties over the economy, but we think a gap of 2% would still be reasonable in the medium term (Figure 3).
Figure 3: The outlook is for the gap to remain wide
There are of course risks to this outlook. The weaker UK economy will affect property yields, but we expect some sectors to suffer more than others, particularly those at the mercy of structural factors. Thus, for instance, the retail sector is already struggling as the internet takes more of the retail spend. Out-of-town supermarkets are no longer looking like the one-way bet they once were. As a long-term bond proxy indexed to inflation, they successfully rode the long-term fall in yields. But the general move away from superstores to convenience and discount stores has raised questions over whether property owners will get all of their capital back at the end of the lease.
By contrast, these same structural factors affecting shops are benefiting owners of warehouses used for internet distribution. All the more so if they are close to major conurbations. Another sector we favour are offices in dynamic regional cities such as Bristol, Leeds and Manchester. They are less dependent on international financial and business services than London, so less vulnerable to potential disruption from Brexit and they have seen little new office building over the last ten years. However, even in these favoured areas, stock selection will be important: properties held on shorter leases by weak tenants are likely to suffer in an environment of rising rates.
Exploiting the gap will require discrimination
There is no question that investors are sailing into more difficult waters. However, there are opportunities as well as risks. Our analysis is that real estate should be one such area. Absolute yields remain attractive compared with other assets and the wide gap over gilts should provide a margin of safety. However, investors can no longer rely on an indiscriminate approach to real estate. The property opportunity can only be exploited successfully through careful selection of the right sectors and, indeed, individual properties. For investors ready to embrace the gap, experience and expertise will count more than ever.