MIPIM 2018: ‘new normal’ financial environment to transition UK property into new era of low volatility and stable returns

By James Wallace - Tuesday, March 13, 2018 13:30

The financial environment is on the brink of another transformation. Base rates, debt costs and bond yields in the UK and Europe are on the cusp of an inevitable rise over the next five to 10 years which will herald a ‘new normal’ for UK property returns characterised by low volatility and single-digit annual returns.

That is the verdict of Colliers International’s research team, led by chief economist, Walter Boettcher, and head of research and forecasting, Mark Charlton.

Bond yield movements are fundamental to pricing benchmarks for commercial property, therefore, the expected pace of will be monitored closely by property investors. Currently, European and UK 10-year bond yields are still 1.5% to 2% lower than US 10-year Treasuries.

The team predicts a reversal of “real bond yield bull run”, defined as nominal yields minus CPI inflation, which have broadly fallen over the last 36 years, according to Oxford Economics data. This financial environment has supported asset prices, including equities and real estate, through its impact on fund investment allocations. In addition, it has led to historically low cost of debt which, in turn, has driven down real estate yields “to extremely low levels globally”.

But this era is coming to an end with a likely “gradual, possibly a decade-long liquidation of QE bond holdings” which will result in new high watermarks for bond yields at varying paces across Europe and the US, predicts Boettcher and Charlton.

The emphasis here is on gradual. “The transition period will be measured in years and will most likely move in line with the natural expiration rate of the QE bonds that are held, rather than any aggressive programme to begin selling the accumulated stock of bonds. In this respect, the financial tide may have turned, but it looks more like a gradual medium-term transition to a ‘new normal’ rather than a rapid return to the previous financial regime.”

For commercial property markets, the question is less about whether bonds will rise, but rather how far they will rise, and when?

Colliers offers its predictions. In the UK, bond yields are predicted to reach a new high watermark of 4% in 2023; in the eurozone, the 3.8% is expected to be reached by 2030; and in the US, 3.5% is predicted in 2022. “Given the ‘enduring factors’, bond yields will rise more slowly than general economic conditions might otherwise seem to warrant,” Boettcher and Charlton wrote, adding that base rates are expected to follow a similar pattern as bonds and, like bonds, will peak at lower levels than previously.

They wrote: “For global property, the relatively benign environment suggests that any softening in pricing and outward yield shift will be gradual and more modest. Lower volatility looks increasingly like the long-term norm for property pricing.

“Of direct relevance to UK property is the shortage of ‘safe’ assets globally. While this shortage has driven bond yields lower, it has also driven yields on prime commercial real estate assets in central London and other gateway cities lower through direct investment given their appeal as wealth preservation assets.

“UK property is also supported by an ongoing currency arbitrage that is not likely to disappear until the terms of any political settlement with the EU have become clear and are agreed.”

Sterling remains almost 10-15% down on its average level in the six months prior to the EU referendum. For an overseas UK property investor who expects sterling to revert to its long term value, this arbitrage works out to the equivalent of between 50 to 100 bps in yield.

“Increasingly, investors are looking beyond London into the regional growth cities. Since the early 2000s, international investors have invested successfully across the UK and this familiarity has widened the investible UK universe. The Brexit negotiations may have caused some investors to pause and take stock, but very recent evidence suggests that international occupier demand for space in Central London and the UK has accelerated, even in the absence of a clear Brexit agreement."

Boettcher and Charlton conclude that barring a new financial, economic or geopolitical calamity, the long-term outlook looks stable, with the financial environment settling into a new normal over the next five to 10 years that looks more benign than the pre-Great Recession period.

“Much of this stability can be traced in various ways to a ‘demographic super-cycle’ that is set to last for at least another 10 to 15 years. This is not to say that the original property bull market will rumble on for a generation, but it is to say that the sector looks to have reached a new level of maturity in the UK, with a wider range and geography of prime assets now elevated to the status of ‘safe haven’ investments.”

James Wallace is a freelance consultant and can be reached via WhatsApp on 07825 382670 or email: jawallace32@gmail.com


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