The latest IPF survey of forecasts of the UK real estate market shows diverging perspectives on the outlook (21 May, p48). Clear disagreement is apparent on the likely future course of both occupier and investment demand. While market bears assume 2005 total returns of under 9%, more bullish commentators assume returns of almost 16%. These differences persist through 2006 and 2007. At the same time, some leading economists are suggesting that changes to investment demand for income might lead to even lower interest rates.
Bears assume that declining GDP growth prospects, combined with a slowing housing market and weak consumer confidence, will lead to limited rental growth prospects and, therefore, flat incomes and rising yields. Concurrently, interest rates will start to rise to offset enhanced inflationary pressures, thus enhancing outward pressure on yield levels.
In contrast, bulls assume more robust GDP growth, causing unemployment to remain low and limiting the downside associated with weak housing and consumer markets. Furthermore, the success of independent monetary policy limits inflationary expectations while robust occupier demand enhances rental growth potential and leads to continued downward pressure on yields. Returns are, therefore, supported by both income and capital growth.
Scenarios are closer than they seem
However, such a bifurcated view is probably a mistake. Under the bearish scenario, the monetary policy committee is likely to resist pressure for significant monetary tightening in order to minimise economic slowdown. In addition, the combination of weaker economic growth with fierce global price competition and the relative flexibility of the UK economy should lead to sustained downward pressure on consumer prices. As a result, investors will look for the bond-like returns offered by property, so stable or falling yields are more likely than increases.
Similarly, under the bullish scenario, robust GDP growth might lead to enhanced demand for equities and, therefore, reductions in real estate allocations. In addition, although inflation is likely to remain under control, higher growth could lead to reduced wage restraint and higher interest rates. As a result, the positive impact of robust GDP growth on ERV levels might be more than offset by the reduced weight of money and more expensive capital.
Same return, different reasons
Soit can be argued that expected returns from UK real estate are likely to be similar under both scenarios, at around 9% pa for the next five years. Under the bullish scenario, real estate is likely to underperform equities but outperform bonds. Conversely, under the bearish scenario, real estate and bond performance are likely to be similar, while equities should underperform.
Although differences between the two possibilities are unlikely to alter the average level of returns, they will affect the type of properties likely to outperform and, possibly, the timing of returns. For example, the bullish scenario suggests limited capital growth and, therefore, a focus on assets likely to benefit from rental improvement. Conversely, the bearish scenario increases the importance of yield shift over rental improvement.
Separate analyses by HSBC and Morgan Stanley have suggested that further inward yield shift is likely to occur, as pension deficits, an aging population and revised perceptions of equity risks drive demand for income. This raises the possibility of a further structural adjustment in real estate values, leading to a short-term increase in capital returns and a reduction in long-run yields.
Although the uncertainty outlined above might lead some investors to over- or under-invest in the real estate sector, it does create a good environment for the development of a market in property derivatives. Early signs of this are already apparent, with the IPD granting four licences to banks wishing to use the UK index as the basis of derivative products.
Investment uncertainty might make the difference between a successful and lacklustre market in UK real estate derivatives.
Dr Paul Kennedy is head of European research at Invesco Real Estate
