The Bank of England (BoE) is widely expected to raise rates in the UK at today’s monetary policy committee, potentially marking the first time the base rate has been above 0.5% since 2009. Could this be the start of a transition to a rising rate environment similar to that seen in the US, and what might this mean for UK property?
While the pace and extent to which rates will rise in from here is still uncertain, what we can do is consider lessons from the past and use statistical analysis to consider what the impact may be on UK property in the future.
In this blog, we look specifically at the impact on commercial property yields from rising bank rates or gilt yields by analysing the situation in the US where interest rates have been rising since late 2015. What light does this shed for the UK market? In the UK, it is clear that the new “normal” for interest rates is up for debate.
Transition to “new normal” for interest rates
We expect the BoE to pursue a strategy of policy normalisation, involving a gradual transition towards a comparatively lower “new normal” for interest rates over the next five years. Since the start of 2017, five-year interest rate swaps in the UK have remained between 0.5% and 1.5%, implying markets do not expect rates to return to higher levels deemed to be “normal” before the financial crisis. This is in clear contrast to trends in the US.
Lessons from the US
In the US, where interest rates have been rising at a more rapid pace than anticipated in the UK, current market expectations on US long-term rates still remain low relative to pre-financial crisis levels.
The more nuanced relationship between property and bond yields is shown by the recent experience of the US property market, following the initial rate hike in 2015. Comparing prime yields for New York offices against 10-year US treasury bonds as an example, rising interest rates have so far not caused any major detrimental impact to US property yields.
Relationship between property and bond yields nuanced
Turning to the UK, correlation analysis based on data over the last 20 years shows an equally weak relationship between property yields and bank rates or gilt yields. This analysis includes lagging bond yields and interest rates to varying degrees to take account of the slow moving nature of property valuations. In all cases, property yields (both MSCI average equivalent yields and prime net initial yields) show a correlation with bonds and interest rates which sits well below the 0.7 watermark dividing a moderately positive relationship from a strong one. In many cases, the correlation is near-zero. Regression analysis of both gilt yields and bank rates has historically accounted for less than 50% of the shift in MSCI property yields.
This suggests that there is not an automatic linear relationship between property and bond yields. This is however a complex relationship that cannot be easily explained without considering other drivers of property values.
Property values supported by macro and market fundamentals
Rising interest rates typically occur during periods of economic growth and higher inflationary pressures. Real estate assets tend to perform well in such environments, as tenant confidence increases and businesses expand, providing support to rental growth and therefore boosting commercial property values.
Looking back at the impact of rising gilt yields on property capital values since 1989, in nearly all of the seven periods where bond yields have risen by at least 100bps, property values have also appreciated, supported by modest levels of rental growth.
Whilst economic downturns in the early 1990s and 2008 reversed this growth, in all other cases property values have held steady or continued to rise, while yields have typically flattened out. This relationship shows how rental growth and market-specific demand and supply fundamentals are key property value drivers.
Healthy risk premium priced into UK property
Given the relative pricing of property to government bonds – the risk-free rate – the current pricing gap relative to history is also an important factor influencing future property performance. The yield spread between property and benchmark 10-year gilts moderated during 2017, as long-term bond yields have priced in rising interest rate expectations. However, this spread remains significantly above the historical average by 75bps, with a healthy risk premium of 420bps priced in (as at March 2018).
UK real estate a global asset class
As UK property becomes an increasingly global asset class, the volume of global capital flows is also likely to distort the impact of domestic monetary policy changes. Central London offices, and more recently regional offices and industrial assets, have become key targets for international investors looking to diversify outside of their home countries into ‘safe-haven’ assets in markets backed by strong structural trends.
With Sterling weakness post-Brexit helping to attract more capital into UK real estate, yields on the highest quality property have held relatively steady despite gradually rising bond yields, which is expected to continue.
Mitigating the impact of rising interest rates
From current levels it seems likely that future total returns for UK property will be increasingly driven by income return and rental growth, with less scope for capital growth driven by further yield compression.
With UK occupational demand proving resilient and a current lack of high quality assets across the UK, there is scope to identify opportunities which stand to benefit from above average rental growth. However, should interest rates rise in line with current market expectations, careful selection, as well as the management of assets to enhance capital values, will be critical.